Diminishing Returns

Say you wanted to wash the windows on your car. You get a wet towel and start going at it, and in a matter of ten minutes you've successfully removed about 10,000 specks of dirt through your efforts. Yet you're not satisfied with the result; the windows still seem unclean. So you go at it for about another ten minutes, but this time, you've only managed to remove an additional 2,000 specks.

There will come a point where it will take more than all of the time you've already spent before you will be able to remove even one more speck of dirt. So washing your windows doesn't mean erasing every speck of dirt from the surface of those windows; it means reaching a point at which you are either satisfied or unwilling to put in any more effort.

This scenario is but one example of the Law of Diminishing Returns, which is more formally described as follows:

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.

You might also say that beyond a certain threshold there is an incrementally increasing opportunity cost for each additional unit of output.

Like opportunity cost, the idea of diminishing returns is tied to the concept of scarcity. There is only so much of a given thing, and so as more of it is consumed it will become more costly to acquire any additional amounts of it.

Diminishing Returns cannot be done away with, but innovation can move the threshold forward. Moore's Law, for example, should not be seen as contradicting the law of diminishing returns. At a given moment, the processes used to create a computer chip can only produce so many before diminishing returns begins to bring up the costs of production beyond what is profitable.

However, in a competitive economy, the drive to create more efficient processes in order to lower one's costs and therefore increase one's profits is an ever-present pressure. Therefore, while a given process may experience diminishing returns beyond a certain threshold, the competition to raise that threshold will yield greater productivity at lower costs in the long run.

Gaining an understanding of opportunity cost and the law of diminishing returns helps provide an insight into the pressures faced by every decision maker, who must prioritize among the alternatives available to him.