The law of diminishing returns indicates that the ratio of input and output is not constant. For example, the additional sales generated with a 20000$ advertising budget is not necessarily twice as much as for 10000$ advertising budget. In many instances, sales still increases, but at a lower rate. Decision makers need to consider this when optimizing their use of resources.
- You were just running 10K, and now you're thirsty. You pour yourself a glass of water and at this moment, this glass of water is everything you want. After you finish the first glass you pour yourself a second glass, still refreshing. So you go for a third glass. Now your body's less dehydrated, and you feel better. While you might still enjoy a fourth glass, the additional satisfaction you get from this fourth glass is clearly less than it was for the first glass. This is the law of diminishing returns.
It means that every additional unit of input generates less returns or benefits than the previous unit. In this case water. The law of diminishing returns is important because it has significant implications for managerial decisions. Let's look at the online campaign of an online fashion store. In order to have many customers landing on their webpage, they have basically two options which are often combined. The first option is to optimize the webpage so that potential customers easily find it on the search engine.
The second option is to pay for online advertising. Google, the largest online advertising company, asks how much the retailer is willing to pay for each click through to the website, and which key words should be associated with the store. Google then uses its big data and sophisticated algorithms to position the retailer in front of potential buyers. Because there are millions of potential buyers out there, but you don't have millions of dollars to advertise you have to set a daily limit.
Through experimenting, the fashion store finds out that with a daily click budget of $1,000, 1,420 customers landed on their site. If they doubled the budget to $2,000, the number of clicks to their webpage is 1,981. Notice that this is less than double the previous number, indicating the law of diminishing returns. The company has experimented different daily budgets.
With $500, they get 812 clicks. With $1,500, they get 1,792 click. And with $2,500, the result is 2,025 clicks. If we now connect the dots, what we see is a concave function, which is typical for describing the law of diminishing returns. Just looking at this graph we still cannot decide what the optimal budget is going to be.
What we know is that the higher the budget, the fewer additional clicks we get. What we also need to know to make a sound economic decision is the value of each click. Keep in mind that not every customer who clicks and lands on the retailer's website is actually buying. From experience, the company knows that the average gross margin per click equals one dollar. Therefore, 500 clicks would generate $500, 2,000 clicks will generate $2,000.
We can now draw a line in the diagram that shows how the gross margin is increasing in linear fashion. The question is now at which point is the difference between our gross margin and our advertising costs the highest? We can do a few calculations. If we invest $500, we get 812 clicks, which turns into $812, so that our profit is $312. If we invest $1,000, we get 1,420 clicks, which equals to $1,420, resulting in a profit of $420.
This means investing $1,000 is more profitable than investing $500. What happens if we invest $2,500? We receive 2,025 clicks, which equals $2,025, which is $475 less than our investment. In other words, with $2,500 budget we lose money, because the law of diminishing return does not justify this budget increase.
When looking at the chart, we see that the profit is the horizontal difference between our costs, the blue line, and the gross margin, the green line. As you probably know, economists love to draw charts. So what they do in order to define the optimal budget, is to draw a parallel line to the gross margin line that is tangential to the blue line. This line touches the blue line at $1,000, indicating that this is the optimal advertising budget.
Above this budget, the law of diminishing return kicks in and leads to a gross margin per click that is lower than the cost per click. Unfortunately, many of you don't have this type of data to make precise calculations, never mind. Precision is not important here. What is important here is that you understand that more is not always more. There is a point where you get less for more, and it's not critical that you know exactly where that point is.
It is completely sufficient if you get an idea where the optimal point could be. This helps you to optimize your decision for highest effectiveness.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
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- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action