Diminishing Marginal Returns vs. Returns to Scale

Input vs. Output

A level of optimal production ensures that all factors of production are used efficiently. Revising production factors, or inputs, affects output. Diminishing marginal returns result from increasing input in the short run after an optimal capacity has been reached while keeping one production variable constant, such as labor or capital. Returns to scale refers to how the degree of change in input factors changes the output proportionally during production.

Diminishing Marginal Returns

In economic theory, the law of diminishing marginal returns predicts that when an optimal level of capacity is reached, adding another unit or factor of production will result in smaller increases in output. A larger amount of one factor of production, ceteris paribus, inevitably yields decreased per-unit incremental returns. For business profitability, it is important to calculate the returns they might achieve from increased production.

Reducing the impact of the law of diminishing marginal returns may require discovering the underlying causes of production decreases. Businesses carefully examine the production supply chain for instances of redundancy or production activities to reduce the impact of diminishing marginal returns.

Economists David Ricardo and Thomas Robert Malthus contributed to the development of the law. Ricardo was also the first to demonstrate how additional labor and capital added to a fixed piece of land, such as in farming, would successively generate smaller output increases.

Returns to Scale

Returns to scale measure the proportion between the increase in total input and the resulting increase in output. There are three kinds of returns to scale: constant returns to scale (CRS), increasing returns to scale (IRS), and decreasing returns to scale (DRS).

• A constant return to scale is when an increase in input results in a proportional increase in output.
• Increasing returns to scale is when the output is greater than the increase in input.
• Decreasing returns to scale means all production variables are increased but result in a less-than-proportional increase in output.

If a soap manufacturer doubles its total input but gets only a 40% increase in output, it has experienced decreasing returns to scale. If the same manufacturer doubles its total output, it has achieved constant returns to scale. If the increased by 120%, the manufacturer experienced increasing returns to scale.

Key Differences

Diminishing marginal returns primarily looks at changes in variable inputs and is a short-term metric. Variable inputs are easier to change in a short time horizon when compared to fixed inputs. Returns to scale focuses on changing fixed inputs and the long-term production metric.

Both show that an increase in input will increase output until a point. The main difference between the two is the time horizon and the inputs that can be changed, whether variable or fixed. Firms use both metrics in their decision-making process to reach optimal production and cost efficiency.

The Bottom Line

Changes to the inputs in production affect the output. The law of diminishing marginal returns shows that additional factors of production result in smaller increases in output at a point. Returns to scale measure the level of increase in output relative to the increase in total input.