January 20, 2018 

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LAFFER CURVE: The graphical inverted-U relation between tax rates and total tax collections by government. Developed by economist Arthur Laffer, the Laffer curve formed a key theoretical foundation for supply-side economics of President Reagan during the 1980s. It is based on the notion that government collects zero revenue if the tax rate is 0% and if the tax rate is 100%. At a 100% tax rate no one has the incentive to work, produce, and earn income, so there is no income to tax. As such, the optimum tax rate, in which government revenue is maximized, lies somewhere between 0% and 100%. This generates a curve shaped like and inverted U, rising from zero to a peak, then falling back to zero. If the economy is operating to the right of the peak, then government revenue can be increased by decreasing the tax rate. This was used to justify supply-side economic policies during the Reagan Administration, especially the Economic Recovery Tax Act of 1981 (Kemp-Roth Act).

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The change in the quantity of total product resulting from a unit change in a variable input, holding all other inputs fixed. Marginal returns is an older and more generic term for marginal product. While marginal product has largely replaced marginal returns in most discussions of short-run production, the phrase does persist in a few terms like the law of diminishing marginal returns.
Marginal returns can either increase and decrease. Increasing marginal returns mean that marginal product is greater for each subsequent unit of a variable input than it was for the previous unit. Decreasing marginal returns, as such, mean that marginal product is less for each subsequent unit of a variable input than it was for the previous unit.

Two Returns

Marginal returns can either increase or decrease.
  • Increasing Marginal Returns: Increasing marginal returns occurs during the course of short-run production by a firm if an increase in the variable input results in an increase in the marginal product of the variable input. Increasing marginal returns typically surface when the first few quantities of a variable input are added to a fixed input.

  • Decreasing Marginal Returns: Decreasing marginal returns results with short-run production if an increase in the variable input results in a decrease in the marginal product of the variable input. Decreasing marginal returns usually emerge only after the first few quantities of a variable input are added to a fixed input and persist throughout production.

A Big, Empty Factory

How about an example to illustrate marginal returns? Suppose that OmniMotors is producing the wildly popular OmniMotors XL GT 9000 Sports Coupe in its two-million square foot OmniMotors assembly plant located on the outskirts of Shady Valley. This OmniMotors assembly plant is filled with the machinery, tools, and equipment needed to produce XL GT 9000 Sports Coupes. In the short run, this capital, the OmniMotors assembly plant and related equipment, is fixed. To produce cars, OmniMotors needs workers. The vast size of this plant, means that OmniMotors can easily provide separate productive tasks (installing engines, painting the exterior, checking the horn) for several thousand workers.

First, Increasing Marginal Returns

What happens when workers are added? The first few hundred workers hired by OmniMotors are bound to make increasingly more effective use of this enormous plant. If OmniMotors employs only a dozen or so workers, each performs a wide range of unrelated tasks using a wide range of capital equipment. On a given day, one worker might spend time at the engine installation work-station to install an engine, then move off to the painting room to paint the exterior, then amble over to the hood-ornament polishing position to polish the hood ornament, then dash off to horn-testing area to honk the horn.

A relatively small contingent of labor is not able to effectively use the fixed capital. This means that each additional worker employed can use the capital more effectively. Each worker can concentrate on a specific task. This gives rise to increasing marginal returns, increasing marginal product, and the upward-sloping segment of the marginal product curve.

Next, Decreasing Marginal Returns

However, as the workforce continues to expand, the capacity of the fixed capital is approached. Workers have to share the equipment and substitute for each other on lunch and coffee breaks. Some workers might do nothing but assist other workers. While the efforts of these extra workers does increase total production, the incremental increase declines for each one. This gives rise to decreasing marginal returns, decreasing marginal product, and the downward-sloping segment of the marginal product curve.

Most important, decreasing marginal returns is a reflection of the key principle underlying the study of short-run production--the law of diminishing marginal returns.


Recommended Citation:

MARGINAL RETURNS, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2018. [Accessed: January 20, 2018].

Check Out These Related Terms...

     | law of diminishing marginal returns | increasing marginal returns | decreasing marginal returns | production inputs | production function | production time periods | total product | average product | production stages |

Or For A Little Background...

     | short-run production analysis | marginal product | long run, microeconomics | short run, microeconomics | fixed input | variable input | product | production | production cost | variables | labor | capital | law of supply | supply | supply price | quantity supplied | principle | business | economic analysis | marginal analysis | factors of production | microeconomics | market |

And For Further Study...

     | long-run production analysis | law of diminishing marginal utility | marginal utility | division of labor | production possibilities | law of increasing opportunity cost | total product and marginal product | total product and average product | average product and marginal product | returns to scale |

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