Law of Diminishing Returns Defined

If anyone has taken an economics class in college, they have come across the economic principle of the Law of Diminishing Returns.  Microeconomics textbooks typically define it as:

The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant (“ceteris paribus”), will at some point yield lower incremental per-unit returns.[i]

The classic example that is given is a farmer who has a fixed plot of land.  The increase in yield that plot of land produces get smaller and smaller as the farmer adds more and more laborers to work on that land.   That is, if you had 1 acre of land to farm, having 1 worker vs. 10 workers would likely make a big difference; but having 100 workers vs. 110 workers would not.

Fixed Field Problem

As in most principles in economics, the big (false?) underlying assumption is that the farmer only has this one plot of land.  What if the farmer has more plots of land – say 100 plots.  How should he distribute his 100 workers?  1 worker per plot?  2 workers each on 1 plot – thus neglecting 50 plots? This, of course, is where the principle becomes fuzzy.

Synergy: Increasing Returns

Modern day economists have improved upon the original law of diminishing returns by defining an initial zone of increasing returns.  That is adding more resources (workers, time, etc…) yields increasing returns.  The often over-lauded corporate word: synergy; that is, 1 + 1 is greater than 2.

To expand on the question posed in the fixed field problem section, up to a certain number of works, adding more workers per plot (e.g., 3 or 4 per plot) will achieve better yields versus putting 1 worker per plot despite letting a number of plots go unfarmed (due to limitation on number of workers).

There is also a zone after diminishing returns called negative returns, but we won’t treat that zone here.  Ideally you should never even get close to this zone if you’ve managed properly.

The figure below depicts the zones in a graphical way.

Corporate Setting

In a corporate setting, the X-axis can be a variety of factors: team size, number of hours spent, number of equipment, etc…  What we can conclude for sure is this:

Maximizing Output is an Inefficient Endeavor!

As much as this seems counter-intuitive, it is very much in line with another economic principle: the Pareto Principle.  More commonly known as the 80/20 rule, it states that for a large variety of events, roughly 80% of the effects come from 20% of the causes.[ii] Conversely, in order to attain the last 20% of effects, you need 80% of the causes.

Put simply, trying to squeeze out the last 20% of effects (or results) is very inefficient.  To put it in a real corporate context, let’s assume that there are 20 candidates projects (of similar size) that your company can undertake.  As in all real-world corporate settings, you are bound by how much time (effort) your employees can devote (no. of employees being fixed in the near term).  To take 1 project to 100%, you would need 100% of effort (cause); however, with that same 100% of effort, you could take 5 projects to 80%.

Exceptions to this are plentiful (e.g., regulatory compliance projects are typically very binary in outcome) but you shouldn’t let the exceptions guide your general direction.  Getting the most out of the limited resources you have should be the general goal.

Ending Thoughts

• Create a culture where 80% is good enough (it usually is).
• Executives should be aware that single project managers are typically focused on maximizing output of their project – make sure you monitor them.

Finally, don’t criticize me for having holes on this post.  I spent 20% effort to create a 80% post.

[i] Samuelson, Paul A.; Nordhaus, William D. (2001). Microeconomics (17th ed.). McGraw-Hill. p. 110. ISBN 0071180664.

[ii] Bunkley, Nick (March 3, 2008). “Joseph Juran, 103, Pioneer in Quality Control, Dies”. The New York Times