Firm’s cost of producing of a specific good or service depends of quantity of resources needed to produce that goods. Price is determined by resource supply and demand. To examine labor-output relationship we should know some terms:
- Total Product (TP) is the total quantity or total output of a specific good or service.
- Marginal Product (MP) is the extra output of a product associated with adding a unit of variable resource, in our case it is labor. Thus we can write the following formula:
- Average Product (AP) is output per unit of resource employed (labor in our case):
In the short run we can maximize “for a time” the output by adding labor to the fixed plant. But how much will output rise when a firm adds labor?
Law of Diminishing Returns
Law of diminishing returns also called low of diminishing marginal utility, states that as a successive unit of variable unit(let’s say labor) is added to a fixed resource(capital, land or firm), the marginal product (MP) will eventually decline. For example if additional workers are hired to work with a constant amount of machineries, the output will rise by smaller and smaller amounts.
Let’s say that a farmer has 100 hectares of planted tomatoes. If the farmer will cultivate this land once he will get 100kg per hectare, if he cultivates it twice he will get 150 kg per hectare, a third cultivation may result in 170 kg per hectare, the fourth one will rise the output only by 5 kg per hectare, so he will get 175 kg/hectare. So succeeding cultivations add less output. If there wouldn’t be like that then the world’s need for food could be fulfilled by intense cultivation of these 100 hectares. If diminishing returns wouldn’t occur the world could be fed from 1 m2. Just keep adding seeds, fertilizers and harvester.
Another example of law of diminishing returns could be taken from a firm for producing doors for cars. This firm has a fixed number of machineries. So if only 2 or 3 workers are hired then the total output would be very low. Because they will have to do many different jobs and advantage of specialization won’t occur. Workers will lose time for switching from one job to another and machineries may stay a lot of time idle. So the firm will be understaffed and there will be underproduction of goods.
This firm may hire more labor then the equipment will be used efficiently. There won’t be any time lost by switching the jobs. As we add more workers the production will be more efficient and the marginal product will rise.
The rise in marginal product won’t go indefinitely. If still more workers will be added, beyond a point, the firm may be overcrowded. Workers will have to wait to use machineries. Total output will increase at a diminishing rate, because since we have a firm fixed-sized firm, each additional worker will have less additional capital to work with, as more labor is hired. The marginal product will decline because there will be more labor than the amount of capital available. If we still add more labor then the quantity produced will decline, so the marginal product will get negative and at a point(extreme one) will fall to zero.
Law of diminishing returns assumes that all units of labor are with the same qualities, same innate abilities, education, training and work experience. Marginal product decreases not because the workers whom we add are inferior, but because more workers are used in comparison with the amount of firm and equipment.