Relevance of The Law of Diminishing Returns

The law of diminishing returns is important in that it is seen to operate in practical situations where its conditions are fulfilled.  Thus, in a number of developing countries with peasant agricultural economies populations are increasing rapidly on relatively fixed land, and with unchanging traditional methods of production.  Consequently, productivity in terms of output per head is declining, and in some cases total productivity is falling.

Also the law of diminishing returns is important in the short run.  The aim of the firm is to maximize profits.  This happens when the firm is in a state of least-cost-factor-combination.  This is achieved when the firm maximises the productivity of its most expensive factor of production.  Productivity is measured in terms of output per unit of the factor.  Thus, if the variable factor is the most expensive factor, the firm should employ the variable factor until APP is at the maximum.  If the fixed factor is most expensive the firm should employ the variable factor up to the level when TPP is at maximum.