The law of diminishing returns is an important concept in economics describing what happens when one input factor in production is increased while others are kept the same. Initially, an increase in production will occur in response to the increased input. However, as the input is increased, production will start to level off and a state of inefficiency will be reached. In extreme cases, production can actually decline. This concept plays an important role in making decisions about business practices and planned business activities.
In a simple example of how the law of diminishing returns works, if a farmer plants a set amount of seed on a field for a given return, the farmer might be tempted to plant twice as much seed in the following year for a larger return. The return would be bigger, but it would not be twice as large; there would be less output per unit of seed than there was before. If the farmer decided to triple the seed, so much overcrowding might be created that the overall production could decline because the plants could not thrive.
When people are balancing inputs, they want to hit the point where they get the maximum return per unit of input. Increasing inputs beyond that point increases costs and decreases efficiency. The law of diminishing returns can be used to project changes in output by changing the number of people in a workforce or adjusting other input factors like the size of a factory or its operating hours. Eventually, a point will be reached where the additional cost provides no additional benefit, or not enough of a benefit to justify the cost, running afoul of the law of diminishing returns.
This concept plays a role in everything from developing business plans to making decisions about cost cutting measures. People who run businesses work on creating a balance between having inputs high enough to generate maximum returns while not going overboard and ending up with costly inputs and comparatively low returns; doubling a workforce, for example, might not necessarily cut production time in half or double the rate of production.
The law of diminishing returns can also be seen playing out in decisions about investments and fund allocations. Companies plan out investments to avoid situations where the money going into a project does not come back out in the form of increased returns. On long term projects, funding decisions involve weighing a choice between continuing with funding and hoping that the project will pan out, and suspending funding for a project that is clearly not successful.
