Thursday, February 21, 2013

The Law of Diminishing Marginal Returns

This is due to the so-called law of diminishing marginal returns, with which we have to get acquainted now. It is a technical law. It is concerned with the technical productivity of one factor of production used in combination with another.
The law states that, given a certain amount of one factor—labor for instance—the addition of every further unit of the other factor—e.g. capital—increases the productivity of the first factor, but in a decreasing degree. The validity of this law will readily be understood if we consider that an amount of capital applied to labor, for instance in the form of a hammer, is likely to raise the productivity of labor much more than the same amount of capital used for the last refinement of a capitalistic process. This law of diminishing returns, or better diminishing marginal returns, means that the entrepreneurs will be able to pay less interest for every additional amount of capital.
We can now establish how much capital will be used in our stationary economy. Just as on every other market, the quantities borrowed and lent on the credit markets are determined by the intersection point of the demand and the supply curves. Capital will be saved and employed in production up to the point where the higher interest demanded for additional credits can no longer be paid by the entrepreneurs because the additional amounts of capital no longer increase productivity to a corresponding degree. The lending price for capital, the interest rate, is determined by the marginal supply of and the marginal demand for credits.
It should be noted in this connection that the question of combination of capital and labor is not identical with the question of the optimum size of the plant. Nor should either question be confused with the question of the optimum combination of so-called fixed and variable capital. These questions will be treated later on. They do not exist in a stationary economy, where we must assume that adjustments to the optimum size of plants and to the optimum combination of fixed and variable capital have already taken place.

Common Sense Economics

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