How the Law of Diminishing Returns Helps Explains the Contemporary Global Economy

What is the Law of Diminishing Returns and why we are Regressing Progressively?

Economics is a fascinating subject that helps us understand how modern societies work in economic terms.

More than a science and an art, Economics is also a discipline that blends theoretical depth with scientific rigour and most leading economists are also Avid Students of Life making them experts in fields beyond the Dismal Science, as some characterize the subject of economics.

In this context, a very important law in economics is the Law of Diminishing Returns which deals with returns on investment and capital according to specific conditions.

The Law of Diminishing Returns states that as more and more capital is invested in producing goods and services, there comes a point where the output from such activities or in other words, the returns from such investments diminish gradually leading to a situation where there is a need for more capital to generate the diminishing returns.

What this means is that all economic activities tend to Regress Progressively (to use an Oxymoron) wherein each unit of investment generates diminishing units of returns leading to economic activities being unsustainable in the longer term. We will discuss its implications and effects.

How Diminishing Returns from Capital Lead to Speculation and Rent Seeking Behaviour

To start with, some leading economists have repeatedly warned that contemporary economies worldwide are now entering the Law of Diminishing Returns stage wherein more investment is needed to generate the needed economic output.

Some French Economists have gone as far as to predict that each unit or percentage of GDP or Gross Domestic Product, the indicator that describes the rise and fall in economic growth, now needs Four or More Units of Investment/Capital meaning that economic activities, in turn, have become Guzzlers of Capital for Meagre Returns, thereby nullifying any gains from Innovation or Entrepreneurship.

Indeed, most of the nations in the Global Economy now are in a Cyclical Phase where Diminishing Returns to Capital have taken hold leading to Unproductive Capital and Dead Investments.

Any Entrepreneur or Businessperson would definitely not like to invest when returns are meagre or diminishing and this has led to Speculation rather than Investment in Physical Assets, which is why the Stock Markets are Booming and the Workers Suffering from reduced wages and lack of worthwhile job opportunities.

In other words, Capitalists worldwide are investing in speculative assets rather than hard assets that generate jobs as the returns from the former diminish over time.

Diminishing Returns Lead to a Doom Loop of Failed Stimulus Packages and Inequality

Let us now consider what the effects of the Law of Diminishing Returns are on the broader economy apart from Entrepreneurs. Say the government wants to Kick Start Economic Growth through Stimulus Packages.

For each unit of such stimulus, there is diminished impact on the outcomes or the outputs intended thereby creating a vicious loop in which more and more stimulus packages are needed for actualizing the same output as before.

This Self Defeating Cycle means that governments would be more interested in encouraging people to spend rather than save as the Glut of Savings reduces the capital needed for investments thereby feeding into the same Doom Loop.

This is the reason why the Division between the Owners of the Capital and the Workers is deepening leading to Inequality and Inequity since those with capital tend to invest more in speculation and less on investments and those dependent on such capitalists tend to see their wages and savings diminish.

The only way out of this Malaise that is causing so many societal problems is to ensure that those who speculate are made to at least contribute some of their earnings towards Direct Cash Transfers to those who are the Victims.

Overcoming Diminishing Returns through Innovations and Technological Revolutions

Having said that, it is not always the case that the Law of Diminishing Returns wins and through Technological Innovation and other Evolutionary Jumps, Modern Economies can be made productive.

For instance, the IT or the Information Technology Revolution was thought to have solved the problem of Law of Diminishing Returns in the 1970s and the 1980s and as the Boom covered the 1990s and the First Decade of the New Millennium, it contributed significantly to the Poverty Reduction and Productive use of Capital.

Similarly, the emerging Fourth Industrial Revolution is expected to be a contributor for negating the impact of Diminishing Returns.

On the other hand, the Covid Pandemic has made us realize how the Law of Diminishing Returns has led to differing reactions and responses to the crisis.

For instance, the Income and the Wealth Gap have dictated the Impacts on the people as Lockdowns have made those with enough wealth live comfortably whereas those with no savings or assets bear the brunt.

Of course, this does not mean that we must abandon Capitalist Economics. Just that we need to ensure that when there are Diminishing Returns, it is our collective responsibility to help those who need it.

Diminishing Returns and Entropy

Last, similar to the Thermodynamic Principle of Entropy which posits how Things Move from Order to Disorder, the Law of Diminishing Returns too points to how over time, the Graph becomes Flat.

Therefore, what we need is a new and innovative approach towards solving economic and societal problems and this can be achieved through a Just and Fair methods of Distribution of the Returns from Capital.

Instead of Speculation and Rent Seeking, what we need are more investments in Human and Social Capital so that those at the Bottom of the Pyramid benefit as well leading to a Paradigm Shift.



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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.


Managerial Economics