The Law of Diminishing Returns : Production in agriculture or industry is possible due to the employment of the factors of production. The quantity of production of a commodity can be increased either by increasing the quantity of factors of production or by changing the proportions of the factors of production.
Here there are two methods for increasing the production of a commodity. They are 1 ) increasing the production by keeping some factors constant while changing the other factors 2) Increasing the production by increasing all the factors. The Law of Variable Proportions (also known as the Law of Diminishing Returns) which explains how production can be increased by keeping a factor constant while increasing the proportion of the remaining factors.
At first, the classical economists have applied the Law of Diminishing Returns only to agriculture. Let us suppose that land is fixed and labourers vary in the field of cultivation. We increase the number of labourers (without varying the size of the land), agricultural output at first increases, remains maximum in the second stage and begins to decrease in the third stage. The classical economists and neoclassical economists like Marshal viewed this law as applicable to land only.
Marshall defined the Law of Diminishing Returns as follows “An increase in capital and labour applied in the cultivation of land causes in general a less than proportionate increase in the amount of produce raised, unless it happens to coincide with an improvement in the art of agriculture”.
The Law of Diminishing Returns may be explained with the help of the following table:
In the above table, Total product, Average product and marginal products are three different types of products, obtained from the cultivation of the fixed factor, i.e. land. Total product is the product obtained due to the employment of particular number of labourers. It increases with every increase in the number of labourers. Average product is obtained by dividing total product with the number of labourers. Marginal product is the additional product obtained due to the employment of one more unit of labour.
As shown in the above table, total output gradually increases during the first stage. This is due to the operation of increasing returns. Agricultural output remains constant during the second stage. Here, constant returns to scale operate. The economies and dis-economies remain equal at here. Lastly during the third stage, total product and Average product fail and marginal product becomes negative.
Here the proportionate increase in output is less than the proportional increase in inputs. The farmers face diminishing returns to scale and get losses. Thus, we observed increasing, constant and diminishing returns due to a change in the proportion of some factors, while keeping a factor constant.
Average product falls with a fall in the total product. Marginal product increases and decreases at a rapid rate when compared to the total and average products. Marginal product is zero when total product is at maximum. It becomes negative when total product is falling.
Graphical Representation of the Law of Diminishing Returns
In the diagram OX represents the number of labourers (the variable factor). OY denotes the size of output. TP is the total product curve. MP is the Marginal product curve, AP is the average product curve. At point ‘C’ Marginal product and average product are equal.
Here the Marginal product curve intersects the average product curve and slopes downwards steeply. Up to this point total product increases at a rapid rate. Up to here, the proportion of output is greater than the proportion of the inputs. The farmer will be in increasing returns. After point ‘C the second stage, constant returns operate. Here the proportion of increase in output and the proportion of increase in inputs remain equal. At point ‘B’ on OX axis the total product is maximum and Marginal product is zero.
The second stage namely constant returns ends here. Later on the third stage commences with the negative slope of the Marginal product curve( below the ox axis). This is due to the operation of diminishing returns to scale. Here the costs exceed the output or revenue. Thus, there are three stages increasing, constant and diminishing returns.
A wise producer neither stops his production after first stage nor continues after third stage. He produces maximum output by continuing his operations up to the second stage. The classical economists viewed that this law is applicable to agriculture only. They believed that industries are subjected to the law of increasing returns. They stated “the part played by Nature conforms to diminishing returns while the part that man plays conforms to increasing returns”. They further stated that diminishing and increasing returns are two different laws having no homogeneity.
The modern economists like Benham viewed this law as universal law applicable in any field of production. They considered that this law is applicable to agriculture, industry, mining, transport etc. Professor Benham defined this law as follows: As the proportion of one factor in a combination of factors is increased after a point first the marginal and then average product of that factor will diminish”.
Professor Stigler defined the Law of Diminishing Returns as follows, “if the quantity of one productive factor is increased by equal increments, the quantities of other productive factors remaining fixed. The resulting increments of product will decrease after a point”. Thus, while the classical approach limited this law to agriculture only, the modern approach extended its applicability to every field of production.
There is another noteworthy difference between the two approaches. The proponents of classical approach considered increasing and diminishing returns as two separate laws. But the proponents of modern approach viewed increasing and diminishing returns as two parts of one law, namely, the law of variable proportions.
Causes of Diminishing Returns : The Law of Diminishing Returns arises due to the following causes.
1. Scarcity of factors : Factors of production are scarce in supply. As population increases, production has to be increased for satisfying the desires of the people. But it is not possible to increase the supply of all factors of production. So the producers make efforts for increasing production by keeping the scarce factor as constant and by changing the proportions of other factors. As a result quantity of output can’t be increased in proportion to the increase in the factors. This leads to the operation of diminishing returns to scale.
2.Imperfect substitute-ability : It is not possible to perfectly substitute one factor in place of another. So it is also not possible to continue production,to substitute another factor in the place of scarce factor. For example, land can lot be substituted by any other factor as it is the gift of nature. Elasticity of substitution is not infinite. As Mrs. Robinson stated that diminishing returns arises due to the existence of limitations in substituting one factor for the other.
3. Factors – not homogeneous : Factors of production are not homogeneous. Even the units of a single factor are not homogeneous. For example, no two pieces of land possess the same fertility. Similarly, labourers differ in their efficiency, skill, attitude etc. So diminishing returns arises due to the substitution of less productive factors in the place of scarce factors.
4. Wrong combination of factors : Wrong combination of factors arises due to the scarcity of factors of production and their imperfect substitute-ability. Wrong combination leads to a decrease in the output. The fixed factors becomes less when compared to the factors substituted. This Wrong act leads to the operation of law of diminishing returns.
Assumptions of the Law of Diminishing Returns And its applicability :
The Law of Diminishing Returns or law of variable proportions becomes real only under the following assumptions or conditions
1) It is possible to change the proportions in which the factors of production are combined. This law is not applicable to those cases where the factors have to be combined in fixed proportions.
2) One or some factors of production must be kept constant. Then only we can estimate the influence of other variable factors of production.
3) Technical knowledge or the methods of production must remain constant. There must be no change in the methods of production.
4) Product obtained due to the combination of factors must be measured in physical units.
5) The Law of Diminishing Returns is applicable only in the short period. It is based on the assumption “Other conditions remaining the same” . In the long period this law is not applicable as all factors can be changed in that period.
6) All the units of the variable factors must be homogeneous. They must be of same kind and efficiency.
Importance or significance of the Law of Diminishing Returns:
The Law of Diminishing Returns is an important law of Economics. It has several theoretical and practical usages. Its importance is explained as follows:
1) This law is the basis of Malthusian Theory of Population.
2) It is also the basis for Ricardian Theory of Rent.
3) Several theories relating to wages, interest and profits are propounded on the basis of the Law of Diminishing Returns. The theory of distribution of national income is also based on this law.
4) The Law of Diminishing Returns is highly useful for understanding the problems of developing countries. Because agriculture is the main occupation and primary sector in these countries. As agriculture is subjected to the application of the Law of Diminishing Returns, it is used for increasing the productivity in agriculture.
5) The theory of pricing of factors of production is also based on the Law of Diminishing Returns.
6) The least combination of factors is based on this law.
7) The Law of Diminishing Returns is also the basis for explaining the behaviors of cost of production.