Marginal Returns and Productivity

The marginal product of labour (MPL) is the change in the output of a firm that results from employing an added unit of labour. The Marginal Product of labour is also known as Marginal Return.

Example: 

Suppose a toy production firm used to produce 1200 toys/month when it employed 5 labourers. The firm decided to hire one more labourer and with this addition, the production shot up to 1500 toys/month. Then the marginal return/marginal product of labour will be given as:
  • Marginal Product of labour (MPL) = (1500-1200) / (6-5) = 300
  • Here, 300 will be the Marginal return on the addition of 6th labourer.
  • Initially, with the addition of each labour, the firm experiences increasing return/output. This is known as the phenomenon of Increasing Marginal Return. This increase in production/output is due to the ‘division of labour’ and ‘labour specialization’. In the initial phase, firms are short in staff and hence employees engage in multi-tasking and duty sharing. But as the number of staff increases, employees divide work among themselves, and this results in specialization which increases output.
  • Example: Consider a car production firm that has only 1 employee. Suppose, this firm develops cars in three phases which are car body production, seat production, and engine development. The employee will have to do all the three things on his own. Now suppose 2 more employees are added, then the 3 staff members can divide the work among them, i.e. one does car body production, the other does seat production and the third one does engine production. This way both divisions of labour and work specialization happens, which increases productivity. Hence Marginal Return increases initially.
  • But after a certain output level, the Marginal return/Marginal Product of labour eventually decreases because the fixed input restricts the output potential of additional workers. This is known as the phenomenon of Diminishing Marginal Return. This happens when a firm is already operating at its full capacity. Now the labour addition will not increase the output, but will only add to the labour cost. This will decrease the marginal return.
  • Example: Consider the firm which has the capacity to produce 1000 balloons/per month. The firm cannot increase it as it has material only to produce this much of balloons/month and with 5 employees it is able to do so. If the firm adds a sixth employee, his contribution to output will be nil. But the firm will have to pay his salary, which will add to labour cost and thereby decrease the marginal return.
  • Marginal Return is a feature of the production function and depends on the amounts of physical capital and labour already in use. Marginal return is directly related to input productivity, a measure of the output per unit of input.

Productivity: Relationship between Production and Cost

  • The cost of producing anything depends on a number of factors such as the cost of factors of production (land, labour, capital & entrepreneurship) and input prices. Employee hours, Machine hours, raw materials are examples of costs of production.
  • For simplicity, economists consider only two types of input costs: a) labour Costs b) Capital. The labour cost is expressed in terms of Employee time while capital is expressed in terms of Capital Input.
  • Employee time (L) is simply labour hours per time period. For example, if a firm employs 12 workers per week and workers work 40 hours/week. Then, the employee time will be (12*40) = 480 labour hours/week. labour hours per time period is denoted as L.
  • Capital Input (K) is defined as Machine Hours used per time period. For example, if a firm uses 3 machines which operate 40 hours in a week. Then, the capital input will be (3*40) =120 machine hours/ week. Machine hours per time period is denoted as K.
  • The Total Cost of Production (TC) is the sum total of Employee cost and Capital Cost. Employee Cost is Employee time(L) multiplied with the wage rate(w). The Capital Cost is Capital Input(K) multiplied with the rental rate of machines(r).
Total Cost of Production (TC) = (Employee Time) *(wage rate) + (Capital Input) *(Rental rate)
Total Cost of Production (TC) = (L*w) + (K*r)
  • The cost of production can be decreased by decreasing either Employee Time or Capital Input. Productivity helps a firm do Cost Minimization and Profit Maximization. The benefits from increased productivity are lower business costs, an increase in profits as well as an increase in labour rewards/compensation.
  • The productivity of a firm is determined by three parameters:
    • Total Product
    • Average Product
    • Marginal Product
In determining the above three parameters, it is assumed that only labour (Employee Time) is the input material. Here Capital Input is ignored for convenience.

Total Product (Q): 

  • It is defined as the aggregate sum of production for a firm for a particular time period. It provides superficial information about the productivity of the firm. It is denoted by Q.
  • Example: 
  • Suppose there are 3 car manufacturing firms A, B, and C which have production of 20,000, 1 lakh, and 45,000 cars respectively. Then among A, B & C, B is the most dominant company with a production share of 60.6 %.
  • The total product only provides information about a firm's production volume relative to the industry; it does not show how efficiently a firm is in producing its output.

Average Product (APL): 

  • It is defined as the total product (Q) divided by Employee Time (L). It is also known as the Average Product of labour (APL). It measures the average productivity of an input, which is Employee time in this case.
  • Example: A firm XYZ produces 12,00,000 units of products (Q) and employs 100 worker hours (L). Then the Average Product of labour will be given as 12,00,000 / 100 = 12,000.
  • Example: Suppose there are 3 car manufacturing firms A, B, and C which have the average product of labour as 1200, 800, 300. Then the most efficient firm will be A with maximum APL.

3) Marginal Product (MPL): 

It is defined as the productivity of each additional unit of input. It is the change in the output of a firm that results from employing an added unit of labour. It is also known as the Marginal Product of labour (MPL), or, Marginal Return.

Example: 

  • Suppose a toy production firm used to produce 2000 toys/month when it employed 15 labourers. The firm decided to hire one more labourer and with this addition, the production shot up to 2500 toys/month. Then the marginal return/marginal product of labour will be given as:
    • Marginal Product of labour (MPL) = (2500-2000) / (16-15) = 300
    • Here 500 will be the Marginal return on the addition of 16th labourer.
  • Consider the following chart to understand the difference between the three:

Labour Total Product Average Product Marginal Product
0 0 - -
1 100 100 100
  2 250 125 150
  3 360 120 110
  4 400 100 40
  5 375 75 -25
  • The total product increases with the addition of each labour hour until the 5th labour hour at which production falls by 25 units. This is an example of diminishing marginal return.
  • Average Product for 3 labours is given as 360/3 = 120
  • Marginal Product for 4th labour is given as: (400-360)/ (4-3) = 40

Marginal Return Curve:

  • Till Point A in the curve, with the addition of each labourer, the firm experiences increasing return/output. This is known as the phenomenon of Increasing Marginal Return.
  • From point A to point B, the output still increases with the addition of each labourer, but the increase in output is at a slower rate. This is known as Diminishing Marginal Return.
  • After point B, the addition of extra labourers only adds to the cost of production without any increase in output. This is known as Negative Marginal Return.
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