Diminishing Returns

As we recall, Malthus is best known for his pessimistic idea that population growth would force incomes down to the subsistence level. What we are interested in here is not his conclusion, but the reasoning that took him there.

Malthus argued that land is a fixed input, but the growth of population makes labor a variable input. Malthus proposed a general law of economics, the Law of Diminishing Returns: when a fixed input is combined in production with a variable input, using a given technology, increases in the quantity of the variable input will eventually depress the productivity of the variable input. (Malthus argued that decreasing productivity of labor would depress incomes).

Was Malthus right? The answer is, of course, yes and no.

There is plenty of evidence, both observational and statistical, that the Law of Diminishing Returns is valid. For example, agricultural economists have carried out experimental tests of the theory. They have selected plots of land of identical size and fertility and used different quantities of fertilizer on the different plots of land. In this example, land was the fixed input and fertilizer the variable input. They found that, as the quantity of fertilizer increased, the productivity of fertilizer declines. This is only one of many bits of evidence that the Law of Diminishing Returns is true in general.

On the other hand, in the two hundred years since Malthus wrote, on the whole, population has increased but labor productivity and incomes have not declined. On the whole, they have risen. What seems to have happened is that technology has improved. Malthus recognized that if technology improved (in agriculture, at least), that might postpone what he saw as the inevitable poverty as a consequence of rising population. Some economists, and other people, believe that the Malthusian prediction will eventually come true. Perhaps: what is clear is that in two hundred years it has not.

But that doesn't mean the Law of Diminishing Returns is wrong! A "law" such as this can be true in general but cannot be applied when its assumptions (such as an unchanging technology) aren't true. The "Law" isn't wrong -- just inapplicable to that case.

There are many valid and useful applications of the Law of Diminishing Returns in economics. In this chapter we will look at two.

We will use Diminishing Returns and related concepts to get a better idea of the meaning of the phrase "efficient allocation of resources" and some guidelines for efficiency in that sense.
We will explore how a business firm should direct its production in order to get maximum profits, and that will give us a basis for a better understanding of the economics of supply.

First, though, we will need to look at production and diminishing returns in general in a little more detail.