I’m stumbling at the outset of my introductory study of Austrian economic theory. So far I have viewed a lecture or two and read most of the first volume of Man, Economy, and State, but most of it simply doesn’t make sense. I’ve recently started over with the Human Action study guide by Robert P. Murphy. Right now I’m on chapter 7 on “action within the world”, which covers among other things what is referred to as the Law of Returns.
"With full understanding of the technological processes
involved, one can compute the additional yield of output attributable
to successive units of input of a particular producer good,
holding the quantity of all other inputs fixed. At some finite
point, an “optimum” level will be reached, in the sense that the
quantity of output per unit of input (of the producer good that
is being varied) is maximized. Economists often describe this as
the point at which “diminishing returns” set in, meaning that
further increases in the input result in proportionally smaller
increases in output (Murphy)."
What is this “proportion”? What the heck does this mean?
To understand the proportion he’s talking about, it might be helpful to first think about “total physical product” (TPP). TPP is the quantity of a good produced for a given quantity of one of its variable factors of production (all other factors held constant).
For example, let’s say we know that if a kitchen has…
1 cook it can produce 10 dishes of a certain menu item per night.
If it has 2 cooks, it can produce 22 dishes.
3 cooks , 33 dishes.
4 cooks, 40 dishes.
5 cooks, 35 dishes.
“Wait a minute,” you might object, “Why would 5 cooks produce fewer dishes than 4?” Too many cooks in the kitchen, of course. It’s a small kitchen, so adding a 5th cook will actually make the work slower, as they stumble over each other.
If you plot these inputs and outputs on a graph, you have a “TPP curve”. The TPP curve serves to show at which point adding units of a factor of production hurts production in absolute terms. In this case, the 5th cook hurts production in absolute terms; that’s the point at which adding another cook makes the output absolutely smaller, the point at which Diminishing Total Returns sets in.
BUT the output gets proportionately smaller in relation to total input even sooner. To find the point at which output gets proportionately smaller, we must look at, not the TPP, but the APP ( “average physical product”). The APP of a variable input is the TPP divided by the quantity of its variable factor of production. In the above example, 1 cook would have an APP of 10 (10 units of output (dishes) divided by 1 unit of input (total # of cooks)), 2 cooks would have an APP of 11 (22 units of output (dishes) divided by 2 units of input (total # of cooks), 3 cooks would have an APP of 11 (33 divided by 3), 4 cooks would have an APP of 10 (40 divided by 4), and 5 cooks an APP of 7 (35 divided by 5).
If you plot these inputs and outputs on a graph, you have a “APP curve”. The APP curve serves to show at which point adding units of a factor of production makes total output smaller in proportion to total input. In this case, the 4th cook results in a lower APP. That’s the point of Diminishing Average Returns.
But the point at which the condition “diminishing returns” sets in is where “Marginal Physical Product” (MPP) gets lower.
The “marginal physical product” (MPP) of a factor of production is the additional amount of output divided by its corresponding additional amount of input. In the example above, adding the first cook gives an MPP of 10 (10 more dishes divided by 1 more cook). Adding the second cook gives an MPP of 12 (22 total dishes minus the 10 dishes that would have produced without the second cook divided by 1 more cook). Adding the third cook gives an MPP of 11 ((33-22)/1). Adding the 4th cook gives an MPP of 7 ((40-33)/1). And adding the fourth cook gives an MPP of -5 ((35-40)/1).
If you plot these inputs and outputs on a graph, you have a “MPP curve”. The MPP curve serves to show at which point adding units of a factor of production makes additional output smaller in proportion to the additional input.
In our “cooks in the kitchen” example, MPP starts getting lower with the 3rd cook. That’s the point of diminishing returns that Dr. Murphy is talking about (the point of Diminishing Marginal Returns); that’s the point at which the “additional dishes to additional cooks” ratio starts to get smaller.
If you’re having trouble with the basics, you might check out my 7-part comic series.
Sweet, man. That’s exactly the kind of no-nonsese, clearly-stated, example-intensive instruction I’m looking for. I know for a fact that Murray N. Rothbard explained the exact same terms (APP, TPP, MPP) in probably the same way, but I must have found his wording confusing.
I’m glad I could help. I first studied the Law of Returns via reading Rothbard as well. And, while Rothbard can be a great teacher, his exposition did not clear it up for me either. I had to google around before it finally clicked.