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The Law of Diminishing Returns; How we Escaped Its Consequences  
Raymond Richman, 4/14/2016

Most of us do not understand the economic Law of Diminishing Returns. Parson Malthus, who gave economics its reputation as the dismal science, postulated that given the fact that the earth’s surface is limited, as population grows the product that each additional worker adds to land’s output of productive land would eventually begin to diminish and that if growth of population were left unchecked, earnings in agriculture per person would diminish to below the level needed to sustain the population. What Malthus and all the classical economists, including Karl Marx, failed to realize was that land was not the only resource employing labor. Most of our labor is employed in producing non-agricultural products and services, combining labor not with land alone but will growing amounts of physical capital. Since the time when Malthus wrote, the end of the 18^th century, the U.S. and Europe have experienced rising wage rates as capital per worker increased. But there is some evidence that we have begun to experience diminishing returns again, the result of forgetting that for wages to rise wage-increasing capital investment must grow relative to labor input.

Not many decades ago, after World War II, Japan began to experience rapid economic growth so rapid in fact that a colleague of mine at the University of Pittsburgh predicted it would catch up to the U.S., just as many have been predicting that China’s rapid growth would make it the number one economic power exceeding the U.S. But even economic growth is subject to the law of diminishing returns.ot surprising to economists familiar with the law of diminishing marginal productivity, China’s rate of growth slowed down just as Japan’s had before it. The returns to capital are high when there are lots of new investment opportunities. But new investment opportunities often grow slower that savings, the source of investment capital. Marx thought that savings would always rise faster than investment opportunities. Marx was the real economic pessimist. Marxism is the real dismal science.

Knowledgeable readers may have already guessed that the law of diminishing marginal productivity is merely an application of the economic Law of Supply and Demand. The supply of land being relatively fixed combining it with an ever-increasing supply of labor reduces the amount of product eventually that each additional unit of labor produces, hence the law of diminishing returns.  But Malthus did not anticipate the extensive growth of non-agricultural industries over the next two centuries. The production of new products increases the demand for labor causing wages to rise. He never expected the incredible rise in productivity in the industrial and commercial sectors.

Government actions have important effects on the supply and demand for labor and capital without increasing the productivity of labor.  The simple growth of government expenditures creates a demand for capital and labor which raise the prices of capital and labor but with no increase in labor productivity. Governments because of the absence of competition are inherently inefficient. Governments pick and choose industries which almost always turn out to be unproductive. An example is the industries it has chosen to subsidize in a futile effort to prevent global warming. The  billions spent by the federal and state governments on measures to prevent global warming made fortunes for those building unproductive wind and solar plants with huge government subsidies, making highly subsidized electric and hybrid vehicles, subsidies to business and homeowners to insulate their buildings, etc., none of which has had any effect on climate change.

Of course, some private investment is labor-saving, designed to economize on the cost of labor.  If it economizes on the cost of labor, it has the same effect as an increase in the supply or labor relative to demand for labor. But if full employment is maintained the increased productivity of labor raises wages in general.

But not all countries experience beneficial increase in labor productivity. China, Brazil, and Russia are examples of economies which were long hostile to free competitive enterprise. Therefore, they failed to experience the benefits of innovation that the countries of Europe and North America. The rapid growth of the Chinese economy when it ended its hostility to free competitive enterprise only a few decades ago is an incredible example of opening an economy to productive growth. Only recently has it experienced the law of diminishing returns to investment.

The growth of increasing private industrial and commercial growth has slowed in the U.S. as evidenced by the decline of manufacturing employment. Instead of increased investment in the U.S. private sector to produce more goods, we substituted increased imports of goods made abroad, often by American manufacturers producing their goods abroad.  In addition to growing international trade deficit, the U.S. meanwhile has been plagued by increasing hostility to private enterprise and growing government spending and inefficiency, and re-entered after a hiatus of 150 years into a period of Malthusian diminishing returns. We’ll eventually prove Marx, too, was right after all. Just wait for countries to unlearn what made them successful.  So it goes.