Real Investment and Diminishing

returns
Definition
 Diminishing returns is a principle of economics. It says that in any
system of production, there comes a point where increasing the
quantities of one input while holding all other inputs constant
yields progressively smaller output results. This point is called the
"optimal result. Once you've reached the optimal result, the only
way to maintain your previous gains in output is by increasing the
size of the entire system.

In finance, as more investment in an area is made, overall return

on that investment increases at a declining rate, assuming that all
variables remain fixed. To continue to make an investment after
a certain point is to receive a decreasing return on that input.

Example of Diminishing Returns

Consider a store filled with shoppers. In this situation there's a

certain number of salespeople who will yield an optimal result for
sales. Below the optimal number of salespeople, customers are
frustrated. They have to wait for attention and may wander off. We
need to hire more salespeople. Since we have an excess of
customers, each salesperson hired can work full time and increase
sales by the same amount.
However, eventually we reach our optimal result where every
customer who wants a salesperson can find one immediately. Past
that point new salespeople don't lead to as many new sales. They
stand around idle. We're overstaffed and our sales per employee
drops. We have reached a point of diminishing returns.

What Is an Optimal Result?

The law of diminishing returns depends on the concept of an

optimal result. This is the idea that at a certain point all
productive elements of a system are working at peak efficiency.
You can't get any more efficiency from the system because
everything and everyone is working at 100%. Note that past this
point it may be possible to get more output from the system.
However, if so, you will see smaller and smaller gains for similar
units of input.

A system of production has three states surrounding the optimal

result:

1. Below Optimal
 Here, the system is underutilized. Certain elements of the
system are working inefficiently and could produce more
output if they had more materials to work with. By increasing
one or more inputs you can get more out of your system.

2. Optimal
The system is producing at full efficiency. This means that no
elements of the system are idle or under-utilized. Each given
unit of input is used as fully as possible to create a unit of
output.

3. Diminishing Marginal Productivity

The system might produce more than at optimal state, but
one or more elements are operating inefficiently. This means
that some unit of input has been oversupplied. The other
elements of your system can't use all of that input, and so
you see increasingly diminishing returns.

Past the point of optimal results, the only way to maintain your
system's efficiency while also increasing production is to expand
your system overall.

Example of Optimal Results 

Let's return to our shop to look at optimal results in action.

1. Below Optimal
Our store is understaffed. This makes the customer element of
our system operate inefficiently. They can't always find a
salesperson to speak with when they'd like to buy something.

In economic terms, our salespeople are operating at 100%

efficiency because each one spends all of his time speaking with a
customer and contributing to the output (sales). Our customers,
however, are operating at less than 100% efficiency because each
one spends time unable to find a salesperson and buy something.

2. Optimal

Our store has exactly the right amount of staff. Every customer
can find a salesperson with ease. Every salesperson is constantly
engaged with selling something.

Both inputs are now operating at 100% efficiency. Our

salespeople are always interacting with customers to close a sale,
our customers can always find a salesperson to buy something.

3. Diminishing Returns

Our store is overstaffed. Although every customer can always find a

salesperson, many of those salespeople go long stretches of time
without speaking with a customer.
Our salespeople have become less efficient. Each new hire increases
the employee-to-customer ratio and the amount of time those
salespeople spend just standing around. Our customers still operate
at 100% efficiency, but they have all the help they need. They've
got no use for the additional salespeople lingering around.

The only thing we can do now is to expand the entire store and get
more customers in.