## Monday, April 30, 2007

### Diminishing Marginal Returns

This is a review of the law of Diminishing Marginal Returns. Wikipedia says that

"According to this relationship, in a production system with fixed and variable inputs (say factory size and labor), beyond some point, each additional unit of variable input yields less and less additional output."

What does this mean? Notice that the first part of the definition says "fixed and variable inputs." If you have both fixed and variable inputs you know that you are in the short run (in the long run, every input is variable.

Second, the law is saying that beyond some point, adding additional variable inputs yields less and less additional output. In the graph above the MPP (Marginal physical product, which is a fancy way of saying Marginal Product) curve is plotted. Notice that initially the MP curve is going up. Adding additional inputs (workers) yields more additional output. Say adding 1 worker adds 2 extra units of output. Then adding another adds 3 extra units.
However, the law states that beyond some point the MP curve will start to yield less and less additional output. So we go from 3 extra units to 2 if we higher another person and then to 1 if we decide to go even further.
What is happening here is that initially the workers are gaining from specialization, hence MP is increasing. Once that disappears, however, we are cramming more and more people to try and get additional output. Beyond some point, the extra output we get starts becoming less and less until adding another worker would actually start hurting output.
Remember the story of the Hot Dog stand. Initially, hiring additional workers boosted output at an increasing rate because one guy was able to focus on making the hot dogs and the other guy focused on handling the customers. However, as the firm kept adding workers the extra output started diminishing. Think about having 10 workers in one hot dog stand. Hiring the 11th might not do you much good as you already have 10 people there. So you don't get many more hot dogs for the added worker.
Finally, note that in the example above, I had a fixed cost: the hot dog stand. Since this is the short run, I cannot change hot dog stands. If demand is increasing, the only thing I can do in the short run is the higher more workers. In the long run this does not hold as I can always move to a bigger hot dog stand.

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