“DIMINISHING RETURNS DO NOT NECESSARILY MEAN ECONOMIC

INEFFICIENCY” EXPLAIN WITH APPROPRIATE DIAGRAM(S).

Diminishing returns is a production concept which occurs in the second stage of production in
the short run. Diminishing returns is the decrease in the marginal output of production. In the
short run at least one factor of production is held constant. This happens when there is an
addition to factors of production used whiles holding all other factor of production constant.
By the law of diminishing marginal returns, states “all other things being equal” as more units
of a variable factor (labour) is employed on a fixed factor (land), the change in total out
increases at first and thereafter diminishes. By implication total output increases at a decreasing
rate.

On the other hand, Economic efficiency can be explained in terms of cost incurred or prices
related to the factors of production. By economic efficiency, the interest lies in getting the
maximum profit for a given level of output at the minimum cost. By implication, it means
producing a given level of output at the lowest cost as possible. Where there is economic
inefficiency, a given output is not produced at the lowest cost even though cost can be reduced
further to produce the same level of output. i.e. the input combinations are at their lowest cost.

As indicated in the diagram below, diminishing returns sets in at the second stage (Stage II)
of production. In this stage, the total product and reaches its maximum and the total product
curve has a decreasing positive slope. The average product curve is at its a peak, where it is
equal to the marginal product at the onset of Stage II. The average product (AP) is positive but
has a negative slope. The marginal product curve has a negative slope but the marginal product
is positive in this stage.

The law of diminishing returns implies that marginal cost will rise as output increases. The
marginal cost of supplying an extra unit of output is linked with the marginal productivity of
labour. When diminishing returns set in the marginal cost curve starts to rise. Eventually, rising
marginal cost will lead to a rise in average total cost. Average total cost continues to fall until
the point where the rise in average variable cost equates with the fall in average fixed cost. This
is known as the output of productive efficiency.
 TP

TPL

0
L1 L2 Labour

MP
AP Stage II
Stage III
Stage I

APL

0 Labour
L1 L2

MPL

Since the marginal product is positive with each additional unit of labour employed, there is
no wasting of resources. All resources are fully utilized and this is inferred from the relation
(MP>0) in stage II. As more of the variable input is added to the fixed input, the marginal
product of the variable input decreases has a positive value. By implication additions to the
marginal product yield a positive impact to production. All units of labour employed adds to
production at this stage, such that no unit of labour is neutral in terms of addition to production.
In the face of diminishing returns given average product falling and total product rising, so far
as the marginal product remains positive, there is economic efficiency in production. For this
reason, diminishing returns do not necessarily mean economic inefficiency. Once there is
economic efficiency, any change that is made to assist any person is likely to harm others.
Again, there will be economic inefficiency when the marginal product of the additional unit of
labour is less than zero (MP < 0). Also, the marginal cost of production can be equated to the
marginal cost incurred (MC=MB) and this condition supports efficiency.

Reference:

Gans, J., King, S., & Mankiw, N. G. (2011). Principles of microeconomics. Cengage Learning.