You may have noticed another feature of the production function from ***Figure 5.3 "A Graphical Illustration of the Aggregate Production Function" and ***Table 5.1 "A Numerical Example of a Production Function". Look at what happens as the amount of capital increases. Output increases, as we already noted—but by smaller and smaller amounts. Going from 1 unit of capital to 2 yields 26 extra units of output (= 126 − 100). Going from 2 to 3 units of capital yields 18 extra units of output (= 144 − 126). And going from 3 to 4 yields 15 extra units of output (= 159 − 144). The same is true of labor: each additional unit of labor yields less and less additional output. Graphically, we can see that the production function becomes more and more flat as we increase either capital or labor. Economists say that the production function we have drawn exhibits diminishing marginal product.
The more physical capital we have, the less additional output we obtain from additional physical capital. As we have more and more capital, other things being equal, additions to our capital stock contribute less and less to output. Economists call this idea diminishing marginal product of capital.
The more labor we have, the less additional output we obtain from additional labor.Analogously, this is called diminishing marginal product of labor. As we have more and more labor, we find that additions to our workforce contribute less and less to output.
Diminishing marginal products are a plausible feature for our production function. They are easiest to understand at the level of an individual firm. Suppose you are gradually introducing new state-of-the-art computers into a business. To start, you would want to give these new machines to the people who could get the most benefit from them—perhaps the scientists and engineers who are working in R&D. Then you might want to give computers to those working on production and logistics. These people would see a smaller increase in productivity. After that, you might give them to those working in the accounting department, who would see a still smaller increase in productivity. Only after those people have been equipped with new computers would you want to start supplying secretarial and administrative staff. And you might save the chief executive officer (CEO) until last.
The best order in which to supply people would, of course, depend on the business. The important point is that you should at all times give computers to those who would benefit from them the most in terms of increased productivity. As the technology penetrates the business, there is less and less additional gain from each new computer.
Diminishing marginal product of labor is also plausible. As firms hire more and more labor— holding fixed the amount of capital and other inputs—we expect that each hour of work will yield less in terms of output. Think of a production process—say, the manufacture of pizzas. Imagine that we have a fixed capital stock (a restaurant with a fixed number of pizza ovens). If we have only a few workers, then we get a lot of extra pizza from a little bit of extra work. As we increase the number of workers, however, we start to find that they begin to get in each others’ way. Moreover, we realize that the amount of pizza we can produce is also limited by the number of pizza ovens we have. Both of these mean that as we increase the hours worked, we should expect to see each additional hour contributing less and less in terms of additional output.
In contrast to capital and labor, we do not necessarily assume that there are diminishing returns to human capital, knowledge, natural resources, or social infrastructure. One reason is that we do not have a natural or obvious measure for human capital or technology, whereas we do for labor and capital (hours of work and capital usage).
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