Law of diminishing returns
The law of diminishing returns states that a point will be reached when further additions of a variable input will yield diminishing marginal returns per unit of that variable. This is one of the most fundamental principles in economics. For example, a grocery store that raises the price of milk will make more money in the beginning. But if they raise the price too high, shoppers will go elsewhere for milk, thus reducing the store's profits.
Note that marginal returns may increase at first based on increases in an input, and the law of diminishing returns merely states that eventually a point of diminishing returns will be reached for each input.
The reasoning behind The Law of Diminishing Returns from a producer's point-of-view in terms of hiring employees, can be simplified into three stages: Specialization, Saturation, and Congestion:
- In the first stage, the addition of more workers allow for specialization of job responsibilities and an increased production efficiency. The result is a larger output return for each additional unit of input.
- The second stage is where inputs equal outputs. Each new employee added will continue to increase production, but only at the same rate as the increased input of labor.
- Congestion refers to the phase when additional workers will start to decrease production efficiency because the work environment is fixed in the short-run. This results in returns that are less than the labor input.
From a consumer's standpoint, an easy-to-remember example of this law is a person's decrease in satisfaction from eating more and more french fries.