User:Paul Schächterle/Notebook

Law of diminishing returns (Raw draft)

The law of diminishing returns (LDR) is a concept in economic theory. It states that the output per input (productivity) declines if the input of a production factor is increased over a certain limit. Under the name law of diminishing returns actually exist two different concepts: one classical and one neoclassical. These concepts bear similarities but are based on different reasons.

The classical concept

In classical economics the LDR states the following: If you have at least two different production factors, the highest productivity is gained if an optimal proportion between these factors is kept. Any divergence from that proportion will result in lower productivity.

If one production factor is fixed, the proportion between the production factors will change with rising production i.e. rising input of the variable factor. According to the classical LDR this leads to a production function that has four phases with the following characteristics:

1. Rising marginal productivity, rising average productivity.
2. Diminishing marginal productivity, rising average productivity.
3. Diminishing average productivity.
4. Negative marginal productivity, i.e. an increase of the variable factor will result in a decrease of the overall product.

(Graph)

History

Historically the concept was developed independently by J. Turgot and J. v. Thünen. It was mainly related to agricultural production and the use of fertilizer in relation to a fixed amount of soil.

(Ref. to Turgot and Thünen?)

The neoclassical concept

In neoclassical economics the LDR signifies that an increasing input of any production factor will result in diminishing marginal productivity. This leads to a production function with the following characteristics:

• Zero input of a production factor results in zero output i.e. the graph starts at the origin.
• Marginal productivity is highest at the first unit of output.
• Marginal productivity decreases continuously.

(Graph)

History

The origins of the neoclassical production function i.e. the neoclassical LDR date back to the time of classical economics. Then the concept was used to describe the effect of an increase in wheat production where good soils were limited. To increase the production of wheat inferior soils would have to be used, which would deliver less wheat for the same amount of labour.

(Ref. to Ricardo, Malthus?)

Neoclassical economists extended the idea to the claim that any economically rational producer would use a production factor first for the most productive task, then for the next productive task, etc. (Ref. to whom?) Thus it can be applied to all production factors.

3-D Representation

In modern neoclassical theory two factors of production are assumed: capital and labour. With two production factors the production function can be represented by a 3-dimensional graph.

(Graph)

Image: Cobb-Douglas production function with 2 factors and production elasticity complying to the neoclassical LDR, i.e. Y = AC^αL^β, α, β < 1.

Implications

The neoclassical LDR is one cornerstone of the General Equilibrium Theory.