A diminishing return happens when adding units of a resource (for example, workers, raw materials, capital) in the act of creating a product does not yield as much benefit as previous, equal units of the same resources did. One resource unit must always be identified as the measure for the return, and diminishing returns can be calculated only for short-term, as all factors are actually variable in the long run. Economists in the 19th century set forth a formula in an effort to easily calculate at what point additional resources produce a reduction in the ratio of input cost to output. Although this point of diminishing returns was originally intended to deal with production economics, many people also consider it valid in general problem-solving.
Determine which resource unit (workers, capital, etc.) will be the base for your measurement of diminishing returns. Each resource unit must have a specific, fixed monetary cost.
Determine the baseline cost for the total product output. For example, if you pay $10 for the raw materials to make a single widget, you pay your widget workers $10 per hour, and each worker can assemble one widget every eight hours, then your workers will produce three widgets per day (the total production output) at a cost of the raw materials ($30) added to the wages ($10 multiplied by 3 workers, multiplied by 8 hours = $240), for a total production cost of $270 per day.
Gradually add units of one resource (workers, raw material, hours) and after each addition, measure and recalculate the total product output. At some point, you will notice that the addition of one more resource results in a drop below your original total output calculation. The final resource unit you add that causes the drop in efficiency is the point of diminishing returns.
The point at which the law of diminishing returns begins to operate is frequently difficult to detect. Factors such as improved production technique and technological advances may offset other increases or reductions in productivity.
Diminishing returns and diminishing marginal returns are not the same thing, and are not determined using the same formula.
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