Please explain why the law of diminishing returns applies only in the short-term period.

The law of diminishing returns applies only in the short-term period because in the long term, a company can introduce major changes that lower its production cost base and enable it to boost production output and expand margins.

Expert Answers

An illustration of the letter 'A' in a speech bubbles

The law of diminishing returns states that, in the short term, the profit to be gained from a particular product or process decreases after a certain level of investment, either of money or energy. It refers to the point at which the money or energy (or both) invested into a given set of products or processes is greater than the amount that these things give back. This law sets a maximum amount that a given set of economic units is worth over a certain interval of time.

This law only applies in the short-term, or, to be more specific, over a definite period of time, but in the indefinite sense, it does not hold true. The classic example I have read in economic textbooks to demonstrate the law of diminishing returns in a common-sense kind of way is the "toothpaste" scenario. When you go out to the store to buy toothpaste, how many tubes do you buy? Most people buy one, or some might buy two so that they have an extra. It is quite unusual, however, for a person to purchase ten tubes of toothpaste all at once if they are only investing money into this commodity for personal use. The reason has to do with the law of diminishing returns. In the short run (say, in the span of a week), one will never be able to use more than one tube of toothpaste through personal consumption, so the purchase of more simply becomes increasingly superfluous and a bad investment choice. Over a longer time frame, however, say, one year, it is reasonable that a person may consume ten or more tubes of toothpaste, and so obviously they will need to invest in these over the course of the year. But to purchase all of them at once is not economically sound according to the law of diminishing returns.

In a real business scenario, this principle can be translated into the purchase of capital. Say a person owns a factory that produces car parts. Part of the capital that keeps their factory running is conveyor belts. In the short-term, that person would not want to purchase more conveyor belts than their current factory can handle. This is a calculation that must be made according to a number of different variables: their labor efficiency, market demand, how many conveyor belts the factory can actually support, and so on. In the short term, this businessperson will only want to purchase a set number of conveyor belts. However, over time, we may assume that the company will grow, the demand for car parts goes up, and this company will begin to sell more products and employ more people. At this point, the threshold maximum number of belts that can be economically purchased in the short-term will increase, and the older number that was set based on the law of diminishing returns will no longer be valid. In the long term the law of diminishing returns does not hold true.

Approved by eNotes Editorial Team
An illustration of the letter 'A' in a speech bubbles

The law of diminishing returns applies only in the short-term period because in the long term, a company can lower the costs of creating additional product and thereby improve returns.

For example, a company can add additional production capacity that produces higher volumes at lower costs. A company can also upgrade its manufacturing equipment to lower the per-unit costs of manufacturing product or make other changes, such as lowering electricity costs or automating aspects of the production process that were previously completed manually.

However, these are significant changes that take time to phase in and often require large capital expenditures. Thus, the company must plan for these changes, and that is why they are viewed as long-term modifications that can impact the law of diminishing returns in the long term.

In the short term, the company is limited in the number of changes it can introduce to improve the manufacturing costs. Thus, if a company sells its products to generate annual profits of $100 and the cost of producing more product remains flat, the company would continue to produce and sell more product, but this is not what occurs.

The cost of producing more product increases in the short term, reflecting several factors, including the added stress that manufacturing higher volumes places on production capacity and the need to add labor and/or additional shifts and greater use of electricity. Thus, the costs of production will increase, leading to the law of diminishing returns in the short-term period until the company can introduce major changes that alter its production cost base and improve returns at higher volumes of production output.

Last Updated by eNotes Editorial on