As you study for the AP® Microeconomics or AP® Macroeconomics exams, you’ll need to know the law of diminishing returns! In this post, you’ll learn what the law of diminishing is, why it is important, and you’ll get to work through a couple of practice questions – all of which is vital for your AP® Economics Review!

What is the Law of Diminishing Returns?

The law of diminishing returns, which you’ll also see called the law of diminishing marginal returns, says that – holding everything else constant – as a firm adds more factors of production, eventually each unit added won’t add as much to the production process as the unit before it did.

Let’s break this definition down. By factors of production, we’re referring to something like capital (think adding machines or computers) or more labor (hiring additional workers). So this definition is saying that if you hold everything else fixed, and you keep adding more and more workers, eventually you just aren’t going to get very much more production out of those workers.

Let’s build an intuitive example. Let’s say that you own a factory where you produce shirts. In this example, you can think of the starting point for the law of diminishing returns – holding everything else fixed – as a fixed amount of shirt producing machines in your factory. The first worker you hire may be able to produce three shirts with your available machines. And so may the next one. But eventually, you’re going to run out of machines, and the employees are likely just to get in each other’s way! Eventually, that next new worker may only add two shirts to your production. And further down the line, another worker may only produce one more shirt for you. In fact, it’s possible that you could have hired so many workers, that the next worker you hire just gets in everyone’s way. Even though you’ve hired another worker, you won’t produce any more shirts than before!

Building on this example, let’s think about what this would look like in a table. This will give us some definitive numbers to work with!

The last column, marginal shirts, refers to how many shirts the most recently hired worker produced. Since your first worker produced 3 shirts, there were 3 marginal shirts produced. After you hire the next worker, you’ll produce a total of 6 shirts, which means that the marginal shirts produced by the second worker were also 3.

So how can we read the law of diminishing returns on this chart? We can read it right off the marginal shirts column! The law of diminishing returns tells us is that, eventually, as you hire more workers and keep the number of machines in your factory fixed, the next worker just isn’t going to produce as much as the last worker! In our table, we see this start to happen when we hire the third worker. The second worker produced 3 more shirts for your company, just as the first worker did. However, when you hired the third worker, your factory was starting to get a little too full! The third worker only produced 2 more shirts for your company, compared to the 3 shirts that the second worker produced. That, in a nutshell, is the law of diminishing returns!

What’s so Important About the Law of Diminishing Returns?

As one of the most important concepts underpinning economics, it’s crucial that in your AP® economics review you study the law of diminishing returns. It is particularly useful for AP® Microeconomics because of how it relates to firms.

The law of diminishing returns will be vital to understanding how much a firm can produce, and why a firm chooses to produce as much as it does. In your AP® Economics review, you’ll eventually come across firms and their cost functions. Understanding the law of diminishing returns will be vital to understanding a firm’s cost functions and, hence, acing your AP® Econ exam!

The law of diminishing returns is also important because it is a basic economic concept that will put you in the right frame of mind as you continue your AP® Economics review. Since it works simply through firms, the law of diminishing marginal returns will be a concrete and helpful example as you encounter other important economic concepts such as diminishing marginal utility.

How Would the Law of Diminishing Returns be Tested?

To see how you could be tested on the law of diminishing returns, let’s work through a previous free response question. This example is taken from free response questions on the 2001 AP® Microeconomics exam. You’ll notice that the question looks a lot like the intuitive example we built for ourselves earlier in the post:

Sparkle Car Wash is a profit-maximizing firm with the following production information. With which worker is the marginal product maximized?

To approach a problem like this, you should first think about the intuitive and simple example that we built for the law of diminishing returns. Thinking back to our simple example, what’s missing here? The marginal cars washed by the next worker! So the first step for this free response question should be to build a table for the marginal cars washed.

To fill this in, note that the first worker washed 15 cars. Once the second worker is added, 35 cars are washed in total. To find the marginal cars washed by the second worker, you’ll subtract 15, the total before you added the second worker, from 35, the new total. This will reveal 20 as the marginal cars washed by the second worker. Then, you simply need to do this over and over again until you’ve run out of workers.

Here you can see the law of diminishing returns in action! Since you know about the law of diminishing returns, you know that in order to find the maximum marginal product, you would need to set up a table like the one we made before. After doing so, you see that the marginal product is maximized at 25 when you’ve added the third worker.

Next, the free response question asks you to identify and define the economic principle that explains why marginal production eventually decreases. But you already know the answer to that, the law of diminishing returns! Let’s repeat the definition here again, because there’s something important to keep in mind. The definition of the law of diminishing returns is that as more units of a variable input (labor in this example) are employed with a fixed input, the output will eventually increase at a decreasing rate.

So, what’s important to keep in mind here? When defining the law of diminishing returns, you should always remember that all else is held equal. One of your inputs, such as the machines in our example before or water hoses in this example, is held fixed, and you are only varying the other input – in this case, workers.

Further, the law of diminishing returns has also helped you figure out why the 6^th worker could never be hired. Namely, returns have fallen so much that adding the 6^th worker means that Sparkle Car Wash is actually washing fewer cars! Thinking back to our intuitive example, Sparkle Car Wash has added so many workers, that they’re just getting in each other’s way, making it so that fewer cars get washed than if Sparkle Car Wash had only hired five workers!

Conclusion

For the AP® Microeconomics and AP® Macroeconomics exams, it’s crucial that you know the law of diminishing returns. It’s an intuitive idea, but it will underpin all of your AP® Economics studies, particularly around firms. Understanding it will help you answer the questions it relates to, such as firms, but also because it gives you concrete examples where you can build your economic intuition. Economic intuition will be very important as you move onto less concrete diminishing properties, such as diminishing marginal utility. Try this page to get started. Can you think of some examples in your experiences where the law of diminishing returns seems to apply?

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