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Law of Diminishing Marginal Returns

In the microeconomic theory, impact of labor, capital and other factors on the production process is explained through the concept of their marginal products. Marginal product of labor is an additional unit of output that is produced after labor input is increased by one unit. Marginal product of capital and other production factors can be defined in the similar fashion.

Increase in the output due to extension of one of the production factors (keeping other factors of production constant) continues until the point of saturation is reached. Then, additional unit of considered input (labor, capital, etc.) does not bring increase in the output. Moreover, further increase of the particular input will decrease production after reaching this point. This phenomenon in the microeconomic theory is known as law of diminishing marginal returns. It holds for almost all kinds of production processes (Pindyck & Rubinfeld, 1997).Marginal product is increasing as long as its efficiency is increasing. However, efficiency of the production factors is limited.

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Consider agricultural production process. In case if labor input is small (land and capital are fixed), then small increase of labor will contribute substantially to the increase in output. However, eventually, according to the law of diminishing returns, at a certain point hiring additional labor would become inefficient, and marginal product of labor will fall. Naturally, overcrowding of people on the same land area with fixed capital will not increase output.

It should be noted that law of diminishing returns is mostly applicable in the short run under conditions that other factors of production are kept fixed. Sometimes, it is also applicable in the long run.

Sherf (2009) suggests that law of diminishing marginal returns is not applicable to the public companies and financial market. He considers that participating in the public companies is the best opportunity for individuals to increase their assets. Investments in the stock market through public companies generate increased returns on capital. However, in practice, due to the structure of public companies and stock market, law of diminishing marginal returns is not applicable in this situation.

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