Returns, Diminishing

BIBLIOGRAPHY

The French economist Anne-Robert-Jacques Turgot (1727–1781) is credited with introducing the concept of diminishing returns into economics. In production theory, it refers to the changes in output associated with changes in some inputs, called variable factors, while other inputs, called fixed factors, are held constant. The relation is stated as a law: with given production techniques, the increment to output associated with each additional unit of a variable factor applied to a given amount of a fixed factor will eventually diminish, which is why it is more properly called the Law of Eventually Diminishing Returns.

The short-run concept of diminishing returns is not to be confused with the long-run concept of returns to scale. The latter refers to changes in output when all inputs are altered in equal proportion. Diminishing returns caused by a hidden fixed factor has, however, been offered as one explanation of the observation of what appears to be diminishing returns to scale.

Diminishing returns provides a possible explanation of the eventual positive slope of cost curves in the short run (defined as a situation in which at least one key input is fixed). However, its most famous application was made in 1798 by the English economist Thomas Robert Malthus, who argued that increased population (and capital) applied to the given amount of a nation’s land would eventually encounter diminishing returns. Each new person added to the labor force would then add less and less to total production, until living standards are reduced to the subsistence level. It is non-controversial that, if techniques of production remain constant, increases in population (and all other inputs) with land held constant, must encounter diminishing returns to agricultural output and, hence, cause falling living standards. Malthus also noted that, if unchecked, populations tend to grow at a geometric progression. He then added the arbitrary assumption that the growth of productivity, due to the development of new technologies, would follow an arithmetic progression, which researchers today know to be incorrect. This theory produced two famous predictions. First, the growth of population and capital would eventually lead to continually falling living standards until bare subsistence is reached. Second, the growth of capital alone could raise living standards but at a falling rate (due to diminishing returns) until the arrival of the “stationary state” in which per capita income could not be raised further. These predictions led the Scottish historian Thomas Carlyle (1795–1881) to label economics “the dismal science.”

A related concept, called diminishing returns to income, is used in the economic theory of consumption. It holds that successive increments of income give decreasing amounts of satisfaction (what economists call utility) since people’s most pressing needs will be satisfied first and then as income rises further, along with the consumption that it permits, successively less and less pressing needs will be met. The concept was long regarded as an untested although plausible hypothesis. Research summarized by Richard Layard in 2005 has, however, succeeded in measuring satisfaction and has largely confirmed the hypothesis of diminishing returns to consumption— although not necessarily that of diminishing returns to income, since income may serve other purposes than permitting consumption, such as conferring power and prestige.

Physical diminishing returns is often appealed to by those who believe that sustained growth is impossible. They argue that when variable amounts of human capital and effort are applied to the world’s fixed amount of resources, diminishing returns must sooner or later be encountered, slowing and eventually halting growth. Modern students of the accumulation of knowledge, and the technological change that it allows, argue otherwise. They make two points. First, unlike most economic entities that are rivalrous—if one person uses a machine, another person cannot simultaneously use it—knowledge is nonrivalrous—if one invents a new technology, everyone can use that knowledge simultaneously. Second, there is no reason to believe that the accumulation of knowledge will encounter diminishing returns when acting through the new technologies that it enables. New knowledge occasionally generates new general purpose technologies (GPTs) such as the steam engine, electricity, and the computer. These in turn make possible a massive set of derivate technological applications. There is no law in physics or economics that suggests that the power of successive GPTs to generate derivative innovations will lessen over time. Indeed, it is clear that the dynamo brought with it a much richer implied research program than did the steam engine.

Knowledge accumulation is the historical process that has allowed humanity to overcome diminishing returns through the invention of new technologies, which have enabled bursts of economic growth throughout history. The accelerating creation of new technological knowledge since the first industrial revolution may well permit the circumvention of diminishing returns by being the source of sustainable improvements in living standards in the foreseeable future.

SEE ALSO Returns; Returns to a Fixed Factor; Returns to Scale; Returns to Scale, Asymmetric; Returns, Increasing

BIBLIOGRAPHY

Appleman, Philip, ed. 2004. An Essay on the Principle of Population: Influences on Malthus’ Work Nineteenth-Century Comment, Malthus in the Twenty-first Century. 2nd ed. New York: Norton.

Layard, Richard. 2005. Happiness: Lessons from a New Science. London: Penguin Books.

Lipsey, Richard G., Kenneth Carlaw, and Clifford Bekar. 2005. Economic Transformations: General Purpose Technologies and Long-Term Economic Growth. New York: Oxford University Press.

Malthus, Thomas Robert. 1798. An Essay on the Principle of Population, as It Affects the Future Improvement of Society with Remarks on the Speculations of Mr. Godwin, M. Condorcet, and Other Writers. London: J. Johnson.

Romer, Paul. 1993. Idea Gaps and Object Gaps in Economic Development. Journal of Monetary Economics 32: 543–573.

Kenneth I. Carlaw

Richard G. Lipsey