Money and the Law of Diminishing Returns

Why there's only so much rich people can use money for

You’ve probably heard of the classic, even overused, archetypes of finance theory, of free market capitalism versus communism, where one maybe wonders what economists used to argue over, prior to the existence of communism.

Like the classic left-right divide in politics, it is a grave oversimplification of economics and there are a plethora of economic theories, with varying levels of validity and success.

I want to discuss arguably one of the most self-evident and obvious economic theories, one that is largely ignored in economics, and one that has implications in all economic domains.

The Law of Diminishing Returns

For those not familiar, the law of diminishing returns means, the more of something you do or have, the less you get from it.

For example, lets say I wanted to insulate my house, if I put the insulation in strategic areas where the most heat loss occurs, I get the best returns on retaining warmth for the money spent.

I could also add the insulation to areas where there is less heat loss, but still some heat being lost. It would still cost me the same amount of money to buy the insulation, and I would be saving less heat, but there’s still a return. A diminished return.

However, if I was to keep buying insulation and also adding it to areas of the house that don’t lose heat, I’d be wasting my money and getting little in return for it, as it wouldn’t be needed to prevent heat loss. This is what it means by a diminishing return: spending money and getting less and less, to the point there are no returns.

What This Says About Economics

What this tells us in economics is there is a saturation point, or a point where a business, government or person can either spend too much money for little in return, or people can own more money than they could ever possibly meaningfully use.

For example, lets say there’s a housing crisis (there is), and lets say there are people who own more than one home (there are). Let us pick John. John owns two houses. John can only ever physically be in one house at one given time.

At most, John can be in a house for 50% of the time if he owns two. In terms of diminishing returns this means a house is being under-utilised by 50%. There could be two people, one in each house, utilising both houses 100% of the time.

In the real world, John isn’t likely to spend all their time trapped indoors trying to maximise the use of two houses. It is more likely one house is the main house (used ~90% of the time) and the other is a vacation or short-stay house (used ~10% of the time).

This means there is a largely vacant, under-utilised house that is empty for 90% of the time, and the rise of AirBnB-style rentals show this isn’t an isolated trend. How can there be so many vacant, rentable houses, and yet not a single affordable property on the market for first time buyers?

In a short sentence: greed. In a longer sentence: terrible economic theories that allow wanton disregard on diminishing returns. Governments are okay with overseas oligarchs owning 20 or more homes so long as they have the cash to buy it. But that means 20 largely vacant properties. A horrible under-utilisation whilst first time buyers can’t afford to move out and homeless people freeze to death.

Communists would rub their hands with glee and demand tyrannical seizure of the properties. Free market capitalists would jump up and down and would say denying first time buyers and homeless people the dignity of homeownership is acceptable so long as you have vast wads of cash and the impoverished people should just, somehow, magically, earn more. Just go get born as a Saudi Arabian Shiek you pleb.

Is There A Solution?

Funnily enough the law of diminishing returns does indeed hint towards a solution, which hints towards an exponential cost relative to the under-utilitisation. So rather than buying a home for x1 each house, you would multiply by the under-utilisation factor the cost.

The idea being if your goal is to play monopoly and control the entire board, it becomes eyewateringly expensive to just keep hoarding multiple assets and depriving others. So if you have one home, it becomes a x1 cost, if you then seek to buy a second home, it becomes a x2 cost (half under-utilisation), 3 for x3 cost (third under-utilisation) and so on.

These additional costs can then be reinvested into building additional utility assets for others to be able to purchase and enjoy. Law of diminishing returns also solves another aspect: it shows the way for good fiscal responsibility, and it factors in supply availability.

Guns, Guns and More Guns

So we’ve only talked about diminishing returns when there is limited supply, such as houses, but what about when it is the opposite? When supply is overly abundant to the point it is affordable for nearly everyone to own, such as a gun, and a person buying several does not preclude other people the opportunity to also purchase?

Diminishing returns actually hints in the opposite direction. So, lets say you’ve got a large pile of potatoes. You’re a farmer, you made more potatoes than you could possibly imagine and you’ve fulfilled your supply contract, and you’ve got excess.

Well, diminishing returns tells us if you don’t either sell or give away those potatoes pronto, their returns will be lost. Hoarding the potatoes or allowing them to rot has practically zero returns. Ideally you want to sell them, but you don’t want to hold out to the point they go rotten and there’s nothing to sell or give.

Diminishing returns drops us another economic hint: if these potatoes are not given away as rapidly as possible, then value is lost. That means you kind of want people to take as many potatoes as possible, even if optimal modelling would mean a maximum utilisation distribution model: there is a time component, how long until the potatoes start rotting.

So even if there was a 1% utilisation of the potatoes (such as immediate composting with no eating inbetween), it is still better than a 0% utilisation where they simply rot in the open air. In-fact, the waste and smell would be a negative utilisation as it would cost you money on clean up.

The law of diminishing returns therefore tells us there are specific situations where you want people to use more; when there is an abundance of supply.

Okay, But Why Should I Care?

You should care because diminishing returns offers a very intuitive model for economic management that doesn’t have to be broken down over several books. It is a generalised rule that can be applied to any sort of situation. Whether that is personal finances or government scale contracts.

You would agree a government working well economically would ensure the under-utilised potatoes were distributed in a way that maximised their usefulness, and prevented under-utilisation of scarce resources such as housing.

Current economic theories try to strike at solving this issue without much success.

Free market capitalism argues government interference makes things worse and inefficient (read: under-utilised), which given the government tends not to have clear strategies, tends to be the case. However, free market capitalism often heavy under-utilises resources so long as it is profitable. Empty aircraft flying between destinations to maintain airport booking slots is a good example.

Communism tries to argue that exactly equal distribution is the only way to fix under-utilisation, but forgets that real life is naturally uneven, and the needs of people are variable. Not all houses are created equal in size, not all first time buyers have the same requirements. Some are single, some have families. You wouldn’t give half a cake to a child and the other half to an adult.

Law of diminishing returns is dynamic, and guides the way on how economic theory should be managed, with a gear towards utilisation maximisation. When free market maximises utility, leave it alone. When free market under-utilises or operates inefficiently (who designed the airport booking slot system such it requires a ghost flight anyway?) intercede.

Economics is a dynamic system. The economic theories used for it should be also.

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