Marginal Product and Diminishing Returns

Even products feel marginalized sometimes.

Marginal product is basically looking at inputs and how they affect outputs in a business. When you add one-more-whatever of input, that doesn’t necessarily mean you’ll get a proportional output.

If you put yourself in the shoes of a “firm” (think: capitalist trying to max profits), then marginal product and diminishing returns is all of a sudden very interesting.

Let’s use Stacy, a six-year-old who’s selling lemonade to help with Granny’s medical bills. You might think, “The more cups, lemons, sugar, and water Stacy has, the more lemonade she has, proportionally.” Yes. Here, the inputs are proportional to the outputs. When we measure change in production costs to change in output, we’re looking at the marginal product.

But after Stacy’s story becomes national news, making Stacy the poster child of everything that's wrong with healthcare in America, she gets a flood of incoming business—so much business that she needs another table (a “fixed cost”), which costs money. That, plus all of her variable costs, make each cup of additional lemonade more and more expensive to produce. Stacy realizes that she’s facing diminishing returns on her lemonade, and that it’ll make sense to stop at the optimal level of production, when it’s no longer worth the cost to create and sell an additional cup of lemonade.

When you're running a business, you invest in your inputs: everything from large fixed costs to labor. In return for your inputs, you get your output. But how do you know if it's worth it or not to add more of an input?

Finding the marginal product of an input can help you answer this question. The marginal product of an input (whether physical inputs or labor) is the increase in output as a result of one additional unit of that input. To see what we mean, let's take a look at Blackbeard, who, for having a very short pirating career, is nonetheless known for being a decent manager of his crew.

At first, Blackbeard had a small crew. Because his crew was small, their, um...booty...was also pretty small. They couldn't battle big ships that were holding the most gold, and they could only carry so much of it. Blackbeard hired another pirate, which increased their total booty from 1,000 pieces of eight to 1,300 pieces of eight. Since the booty went from 1,000 to 1,300 thanks to the addition of the new employee, the marginal product of that new hire was 300 pieces of eight.

The results of another mate in the crew were so great that Blackbeard decided to hire another pirate. And then another, and another. Even though the marginal product with each new input of labor was less than the last, he kept hiring more pirates, since each new pirate was still contributing to a higher total output.

With a bigger crew, they were able to take on bigger ships, increasing their total output. All other inputs, like their pirate ship, stayed constant. As the crew's size increased, so did the amount of booty they were scoring. And who doesn’t like to score booty?

But...the law of diminishing returns has a way of making it rain on everyone’s parade. The law of diminishing returns pops up in many places in economics, including marginal product. While increasing a marginal product (such as labor, for instance) will increase total output for awhile, eventually additional units of that input will result in a stagnant or decreased total output.

After Blackbeard’s most recent pirate hire, a looting went terribly wrong. There were so many pirates on his ship that they couldn't loot effectively. They were bumping into each other, accidently shooting each other...and they were frustrated because of it. All of a sudden, their total output (their booty) dropped from 3,000 pieces of eight to 2,500 pieces of eight. Arrrrrhhhh.

In Blackbeard's case, his output was initially increasing as he grew his crew, but eventually decreased because of it. The last pirate he hired had a negative marginal product of 500 pieces of eight, since that last additional unit of labor input caused total output to go from 3,000 pieces of eight to 2,500 pieces of eight.

What’s a pirate to do? Well, he could get another ship and start a franchise...er, a fleet...or he could let that last pirate walk the plank, and stick with the one ship.

The more the merrier? Eh, up to a point. Ask any pirate.