Costs of Production

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Chapter 5: Section 2

Pages 108-114

Labor and Output

• One of the basic questions any business owner must answer is how many workers should they hire.

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• They must consider how the number of workers hired will affect their total production.

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• Marginal Product of Labor – the change in output from hiring one more worker.

Case Study

• Let’s see how this works by using a company that produces beanbag chairs.
• Assumptions…

- The firm owns 1 sewing machine and 1 pair of scissors.

- The firm’s inputs are workers and materials.

- Each beanbag requires the same amount of materials.

Increasing Marginal Returns

• The marginal product of labor increases for the first three workers because there are three tasks involved in making a beanbag.

- Cutting, sewing, and stuffing.

• As these workers specialize in the task that they do the efficiency of the work is increased and more of the product can be produced.

Diminishing Marginal Returns

• The level of production in which the marginal product of labor decreases as the number of workers increases.
• This happens because the workers must work with a limited amount of capital.
• The problem will get worse as more workers are hired and they will be forced to wait to gain access to the capital used in creating the beanbags.

Negative Marginal Returns

• At some stage of the game the workers will simply get in each other’s way and disrupt the production.

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• The result will be an overall decrease in output.

Fast Fact

• To understand the diminishing marginal returns of capital, consider an Internet service provider (AOL) that mailed millions of free copies of its software on computer discs to people across America.
• The first discs sent out got customers interested in the product and provided a good return on investment.

• After consumers received several additional discs, however, the discs no longer caught their attention and more often than not they became coasters or ended up in the trash.

Production Costs

• Fixed Costs – a cost that does not change, no matter how much of a good is produced.

- examples include rent, machinery repairs, property taxes, salaries of workers, etc…

• Variable Costs – costs that rise or fall depending on the quantity produced.

- examples include raw materials, labor, electricity, etc…

Total Cost

• The fixed costs and variable costs are added together to find total cost of producing an item.

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• This total cost will vary as the output increases or decreases.

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Fixed Costs + Variable Costs = Total Cost

Marginal Cost

• The additional cost of producing one more unit of good.
• This rising marginal cost reflects diminishing returns from labor.
• As more and more workers share a fixed production facility the marginal costs will continue to increase.

Setting Output

• Behind all of this is the firm’s basic goal… to maximize profits!

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• Key Terms…

- Profit is the total revenue minus the total cost.

- Total Revenue is equal to the price of each good multiplied by the number of goods sold.

• To find the level of output with the highest profit, we look for the largest gap between total revenue and total cost.

• Another way to find the best level of output is to find the output level where marginal revenue is equal to marginal cost.

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• Marginal Revenue – the additional income from selling just one more unit of a good.

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• If a firm has no control over the market price, marginal revenue equals market price.

The Shutdown Decision

• When should a company pull the plug and shut down the operation?
• Operating Costs – the costs of operating the facility which includes the variable costs the owners must pay to keep the factory running, but not the fixed costs, which the owners must pay whether the factory is open or closed.

- Example: POTLATCH