I have added this entry to this blog's glossary, it being a myth within neoclassical economics.
Diminishing Returns and Marginalism
Few ideas have done more damage to the teaching of economics than “marginalism”, which is the belief that firms and individuals make decisions by balancing costs and benefits “at the margin”. It sounds technical, precise and scientific. In reality, it is little more than an elegant simplification that obscures how modern economies actually work.
Assumption
According to the textbooks, each firm expands output until the additional (or marginal) cost of producing one more unit equals the additional (or marginal) revenue earned from selling it. Beyond that point, costs supposedly rise faster than revenue because of “diminishing returns”. As more resources are used, productivity falls. The same logic is applied to individuals. We supposedly consume or work until the marginal benefit equals the marginal cost of effort. This “equilibrium on the margin” supposedly guarantees efficiency.
Reality
Real businesses rarely behave this way. In most modern industries, fixed costs, such as those of buildings, software, machinery, and intellectual property, dominate their cost structures, and once those costs are covered, the extra cost of each unit often falls rather than rises. For a tech company selling software downloads, the marginal cost of any sale is, in fact, as close to zero as makes no difference, but none is willing to sell at that price. Economies of scale, network effects, and increasing returns are the real forces shaping industrial structure. Moreover, firms make decisions under uncertainty: they plan, invest, and compete strategically over years, and do not and cannot make instant marginal adjustments, not least because they will not have the data to do so in a great many cases. The neat mathematical curves of marginalism bear no resemblance to boardroom reality.
Marginalism also struggles to describe sectors such as public services, where output cannot easily be measured and where efficiency is not the goal. Teachers, nurses and carers cannot “optimise” marginal productivity because their value lies in relationships, not outputs. Yet marginalist logic has been used to impose spurious efficiency targets across the public realm.
And as for real people, no one thinks in the way that neoclassical economics teaches. The idea it presents is alien to human experience.
Why It Matters
Marginalism creates the illusion that markets naturally find optimal outcomes, while masking the structural realities of scale, power and uncertainty. It treats investment and innovation, which depend on bold leaps and not incremental adjustments, as aberrations.
It has also legitimised austerity: if every activity must yield marginal returns, public spending appears wasteful whenever its benefits are not easily priced. Economics must abandon its obsession with the margin and return to thinking about systems, not points on curves.
Summary
Modern economies thrive on increasing returns and interdependence, not marginal perfection, and policy must reflect that.
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Helpful, thank you. My eyes were first opened by Mariana Mazzucato’s book ‘The value of everything’ – a book I read while furloughed as a result of hearing a Reith Lecture by Mark Carney. He has his uses!
Might the theories/propagandas of marginalism etc. be fundamentally faulty as they ingnore/externalise the effects of the theory on the host society as a whole?
Again, yes in a word.
This rings true for me. Steve Keen has pointed out incessantly the rather static view Neo-liberalism has of economic activity. The truth of the matter is in the concept of fractals.
What we actually have is a huge variety of ‘things to do’ which means lots and lots of little economies within economies within economies. This is the real dynamism of the economy. To say you can manage them all the same is complete bullshit.
I am not very familiar with the myth of marginalism so thanks for this post. I occurs to me that marginalism may be the precise opposite of what happens.
With a factory there is a lot of capital investment. Sometimes the owner will be lucky enough to achieve full production, but this will almost never happen. Either there will be too much demand for the products or too little.
With too much demand the producer may simply raise prices to reduce demand. They are unlikely to invest in a new factory in the short term, and even if they did there is likely to be a substantial lag before increased production is available. So too much demand is the classic cause of inflation, they raise prices “because they can”.
More likely in current times of austerity, there is more likely to be less than 100% demand for the products. In this case there are not, as you say, diminishing returns but the opposite. Marginal costs of production would likely be low below capacity.
The classical economics approach sounds (from my engineering background) like it assumes a linear system near equilibrium, with no lags. But, in fact, the system is highly non-linear and has substantial lags.
And all this matters because neoliberal economics assumes that creating money will invariably cause inflation and so must be avoided. In reality, money creation may not cause inflation until an inflection point, full productive capacity, is reached, when it does start to cause inflation. By avoiding money creation, because of a false fear of inflation, leads to an economy running below capacity and to austerity. So this principle of marginality does sound like a serious problem.
It’s interesting to think about the obvious differences between national economies in terms of the balance between fixed and variable costs. A couple of things that always strike Brits once they get out into ‘la France profonde’ (ie. outside touristy areas) are the survival of small family businesses even in busy high streets, and the frequency that they remain closed – most shops still close for a couple of hours at lunchtime, for example – many restaurants open only at lunchtime. All are quite likely to close unexpectedly simply for a nice day out with visiting family.
How can they afford not to ‘sweat their assets’ ? Part of the answer lies of course in deep and complicated cultural differences – but part also lies simply in the fact that the French economy remains (despite Macron’s disastrous and deeply unpopular meddling) much less financialised than the British. Fixed costs, especially premises costs, remain relatively low, and premises are still often family-owned rather than investment vehicles for property developers, and behind them the finance industry. Even quite large supermarkets are often franchised to families, not directly-run branches. But the cost of employing people is more expensive than the UK – staff wages are higher, as are employment protections and on-costs. Often, if the family want to eat lunch together, or have a day or a week off, it’s simply cheaper to close; ‘sweating your assets’ actually makes less sense.