Question

In the context of long-run growth what is meant by diminishing returns to capital and why will diminishing returns to capital occur?

Answer 1

Definition

At a certain point, employing an additional factor of production causes a relatively smaller increase in output.

• Diminishing returns occur in the short run when one factor is fixed (e.g. capital)
• If the variable factor of production is increased (e.g. labour), there comes a point where it will become less productive and therefore there will eventually be a decreasing marginal and then average product.
• This is because, if capital is fixed, extra workers will eventually get in each other’s way as they attempt to increase production. E.g. think about the effectiveness of extra workers in a small café. If more workers are employed, production could increase but more and more slowly.
• This law only applies in the short run because, in the long run, all factors are variable.

Law of diminishing marginal returns to capital explained

• Assume the wage rate is £10, then an extra worker costs £10.
• The Marginal Cost (MC) of a sandwich will be the cost of the worker divided by the number of extra sandwiches that are produced
• Therefore as MP increases MC declines and vice versa
• Total Product (TP) This is the total output produced by workers
• Marginal Product (MP) This is the output produced by an extra worker.

• The first worker adds two goods. If a worker costs £20. The MC of those two units is 20/2 = 10.
• The 3rd worker adds six goods. The MC of those six units are 20/6 = 3.3
• The 5th worker adds an extra ten goods. The MC of these 10 is just 2.
• After the 5th worker, diminishing returns sets in, as the MP declines. As extra workers produce less, the MC increases.