Understanding the Law of Diminishing Returns

Insights from Michael Mauboussin with Real-World Examples

A few days ago, while watching a video by Sajal sir, I came across the concept of the ‘Law of Diminishing Returns’. It really stuck with me, and I’ve been exploring it ever since.

The law of diminishing returns is a fundamental concept in economics and business strategy, illustrating how adding more of a single input to a production process, while keeping other factors constant, eventually yields progressively smaller increases in output. Michael Mauboussin, a renowned strategist and thinker in finance, has often emphasized the importance of understanding such principles to evaluate companies and their operational efficiency. In this blog, we’ll explore the law of diminishing returns, visualize it with a graph featuring points A, B, and C, and apply it to two famous companies—one from the "Magnificent 7" (Mag7) tech giants and one from the Indian stock market—to see how this concept plays out in practice. We’ll then dive deep into how to spot these critical points, with a special focus on the elusive Point A.

The Law of Diminishing Returns: A Quick Overview

The law of diminishing returns states that after an optimal level of production capacity is reached, each additional unit of input (e.g., labor, capital, or resources) results in a smaller increase in output. This doesn’t mean total output decreases (that would be negative returns), but rather that the efficiency or marginal productivity declines. Mauboussin’s work often ties this concept to investment decisions, urging investors to assess when companies hit these critical thresholds, as they can signal shifts in profitability and growth potential.

To illustrate this, let’s visualize the law with a graph:

The Graph: Points A, B, and C

Imagine a graph where the x-axis represents the input (e.g., number of workers or capital invested) and the y-axis represents the output (e.g., units produced or revenue). The curve typically follows three key stages:

• Point A: Increasing Returns – At the start, adding inputs leads to disproportionately large increases in output. This is the phase of optimization where resources are underutilized, and efficiency rises rapidly.

• Point B: Optimal Returns – This is the peak of efficiency, where the system operates at its maximum capacity. Adding more inputs still increases output, but the marginal gains begin to shrink.

• Point C: Diminishing Returns – Beyond this point, each additional input contributes less to output than the previous one. Efficiency declines, and costs may rise faster than revenue.

Now, let’s apply this framework to two real-world examples: Apple (from the Mag7) and Reliance Industries (from the Indian stock market).

Example 1: Apple (Mag7) – The iPhone Boom and Beyond

Apple, one of the "Magnificent 7" tech giants, provides a compelling case study for the law of diminishing returns, particularly with its flagship iPhone product line.

• Point A: Early iPhone Era (2007–2012)
  When Apple launched the iPhone in 2007, it entered a phase of increasing returns. Each new model (e.g., iPhone 3G, 4, 4S) brought significant innovation—touchscreens, app ecosystems, and better cameras—driving explosive sales growth. The company scaled production, invested in supply chains, and saw output (revenue and units sold) soar with relatively modest increases in input (R&D, manufacturing capacity). This was the golden era of optimization.

• Point B: Peak Efficiency (2015–2018)
  By the mid-2010s, Apple hit its stride. The iPhone 6 and 6S series marked a sweet spot—massive global demand met a well-oiled production machine. Sales peaked in 2015 at over 231 million units annually, and profit margins were robust. Here, Apple operated at Point B, maximizing returns on its investments in design, marketing, and production.

• Point C: Diminishing Returns (2019–Present)
  Post-2018, iPhone sales growth slowed. Adding more inputs—new features (e.g., marginal camera upgrades), increased marketing spend, or expanded production—yielded smaller gains in unit sales. Consumers saw less need to upgrade annually, and competition from Android players intensified. While Apple’s total revenue grew (thanks to services and wearables), the iPhone’s marginal contribution per additional input declined, signaling Point C. Mauboussin might argue this is where investors should reassess growth expectations embedded in Apple’s valuation.

Example 2: Reliance Industries (Indian Stock Market) – The Jio Revolution

Reliance Industries, led by Mukesh Ambani, transformed India’s telecom and digital landscape with Jio. Its journey also mirrors the law of diminishing returns.

• Point A: Jio Launch (2016–2017)
  When Jio entered the market in 2016 with free data and ultra-low-cost plans, it was in the increasing returns phase. Massive capital investments in 4G infrastructure and spectrum licenses led to a subscriber boom—over 100 million users in just six months. Each rupee spent on network expansion translated into outsized gains in market share and revenue potential, disrupting competitors like Airtel and Vodafone.

• Point B: Market Dominance (2018–2020)
  By 2018, Jio reached Point B. It had captured nearly 35% of India’s telecom market, with 300 million subscribers. Investments in network coverage and data capacity were still paying off handsomely, and Jio turned profitable in 2019. This was the optimal phase where inputs (infrastructure, marketing) aligned perfectly with output (subscriber growth and revenue).

• Point C: Diminishing Returns (2021–Present)
  After dominating the market, Jio’s growth slowed. Adding more towers or offering deeper discounts brought smaller subscriber gains as the market saturated—India’s telecom penetration neared 90%. Costs rose (e.g., 5G rollout), but revenue per user (ARPU) remained stubbornly low due to price wars. Reliance shifted focus to Jio’s digital ecosystem (e.g., JioMart), but the core telecom business entered Point C, where marginal returns on additional inputs diminished. Investors, as Mauboussin might suggest, need to weigh this transition when valuing Reliance’s future cash flows.

How to Spot Points A, B, and C

Spotting Points A, B, and C on the law of diminishing returns curve involves analyzing a company’s operational and financial data over time, combined with qualitative insights about its industry and strategy. While Points B and C are often easier to identify through visible success or slowing growth, Point A—the phase of increasing returns—requires foresight and is critical for spotting undervalued opportunities. Here’s a detailed guide to identifying each:

General Approach

• Quantitative Metrics: Track output per input (e.g., revenue per dollar spent), marginal returns, growth rates, and cost trends.

• Qualitative Indicators: Assess innovation cycles, market dynamics, and management signals.

Spotting Point A (Increasing Returns)

Point A is the phase where adding inputs yields disproportionately large increases in output. It’s the "early growth" stage, often marked by underutilized resources and untapped market potential. Here’s how to spot it:

1. Rapid Output Growth with Modest Input Increases:

   • Look for a steep upward trajectory in sales, revenue, or user adoption with relatively small investments.

   • Example (Apple 2007–2012): iPhone sales skyrocketed from zero to tens of millions with initial R&D and production scaling, far outpacing the input costs.

2. Low Base Effect:

   • Point A often occurs when a company starts from a low baseline (e.g., new product launch, market entry). Small absolute increases in input lead to high percentage gains in output.

   • How to Spot: Compare early growth rates (e.g., 100%+ year-over-year) to later stages. For Apple, iPhone sales grew from 1.4 million in 2007 to 37 million by 2011—an exponential rise.

3. Innovation as a Catalyst:

   • New products, technologies, or business models often drive Point A by unlocking demand. Look for breakthroughs that competitors haven’t yet matched.

   • Signal: Patents filed, product launches, or buzz in industry reports. For Apple, the iPhone’s touchscreen and App Store were game-changers.

4. Underutilized Capacity:

   • Early on, companies often have excess capacity (e.g., factories, staff, or infrastructure) that’s not fully leveraged. As demand rises, output scales without proportional input hikes.

   • How to Spot: Low capital expenditure relative to revenue growth, or high operating leverage (fixed costs spread over growing sales).

5. Market Feedback:

   • Customer adoption accelerates, and market share grows rapidly. Look for early signs of “hockey stick” growth in user metrics or sales data.

   • Example: Apple’s iPhone gained traction as a status symbol and must-have device, driving demand beyond initial projections.
     Challenge: Point A is often only clear in hindsight. To spot it in real-time, focus on emerging companies or product lines with high growth potential but low current scale. Analyst reports, earnings calls, or industry trends hinting at “the next big thing” can help.

Spotting Point B (Peak Efficiency)

Point B is the sweet spot where inputs and outputs are optimally balanced. It’s easier to identify because it’s tied to visible success.

1. Maximum Marginal Returns:

   • Output growth is still strong, but the rate of increase starts to slow. Calculate the peak of marginal revenue per additional dollar spent.

   • Example (Apple 2015–2018): iPhone sales hit 231 million in 2015, with high margins, but growth rates began tapering.

2. Operational Maturity:

   • Supply chains, production, and marketing are fully optimized. Look for stable, high profit margins and efficient resource use.

   • Signal: Consistent earnings beats or record profitability.

3. Market Penetration Peaks:

   • The company captures a significant share of its addressable market, leaving less room for explosive growth.

   • How to Spot: Market share data or industry reports showing dominance (e.g., Apple’s 20%+ global smartphone share).

Spotting Point C (Diminishing Returns)

Point C is where additional inputs yield smaller gains, often due to saturation or rising costs. It’s the most obvious phase.

1. Flattening Growth:

   • Revenue or sales growth slows despite increased spending. Look for single-digit or declining growth rates.

   • Example (Apple 2019–Present): iPhone unit sales stagnated around 190–200 million annually, despite new features.

2. Rising Costs Outpace Revenue:

   • Incremental investments (e.g., marketing, R&D) don’t translate to proportional output. Check declining return on invested capital (ROIC).

   • Signal: Higher CapEx with flat or shrinking margins.

3. Market Saturation:

   • The product reaches most potential customers, reducing demand elasticity. Look for signs of customer fatigue or competition.

   • How to Spot: Surveys showing longer upgrade cycles (e.g., iPhone users waiting 3–4 years).

Practical Tips for Spotting Point A

Since Point A is the hardest to detect in real-time, here’s a focused strategy:

• Look for Disruption: Companies introducing novel solutions (e.g., Tesla’s early EVs, Jio’s cheap data) often start at Point A.

• Track Early Metrics: Monitor pre-profit startups or divisions with surging adoption (e.g., user growth, pilot success).

• Historical Analogy: Study past examples (like Apple’s iPhone) to recognize patterns—low initial scale, high innovation, and accelerating demand.

• Investor Lens (Mauboussin’s View): Michael Mauboussin might suggest focusing on firms with undervalued growth options—where the market hasn’t yet priced in the steep curve ahead.

Key Takeaways from Mauboussin’s Lens

Michael Mauboussin often emphasizes that understanding where a company sits on the diminishing returns curve is critical for investors. At Point A, firms are undervalued growth stories; at Point B, they’re cash cows; at Point C, they risk stagnation unless they pivot. Apple’s shift to services and Reliance’s push into digital platforms show how companies adapt when core products hit diminishing returns.

For the Mag7 and Indian market giants alike, the law of diminishing returns isn’t a death knell—it’s a signal to innovate or diversify. As Mauboussin might argue, the best investors spot these transitions early, adjusting their expectations before the market does.

Conclusion

The law of diminishing returns, visualized through points A, B, and C, offers a powerful framework to analyze corporate performance. Apple’s iPhone journey and Reliance’s Jio saga highlight how even the most successful companies encounter these phases. By blending economic theory with Mauboussin’s investment insights—and mastering how to spot these points—we can sharpen our understanding of value creation and its limits.