- [Instructor] Let's say that we run ABC Watch Factory
and we want to understand the economics of our business.
So, what we have in this table
is some data that we've already been able
to estimate or measure based on how our business is running
and then we're gonna be able to figure out
some other things based on this data.
This first column is fixed costs,
our monthly fixed costs,
so these are the things that we can't really change
in the short run regardless of how many people we hire
or how many units we produce,
so that might be the rent on our facilities
or the cost of renting the equipment
and so, for us that's $5,000 a month.
Then you have your labor units
and for the sake for this model,
we'll say that a labor unit is a full-time employee
who's at the factory working every working day
in a month and so, you can see,
we can go from one person working full time
every working day in a month,
all the way up to six.
Now, this is the variable cost
and for simplicity, this is mainly driven
by the labor units and a real-world example
would be driven by the labor units,
it would be driven by how much material we're using
to produce the watches
but we have our variable cost right over here.
And then we have our total cost
which is just simply the fixed costs plus the variable cost
for any given level of labor units
and then we know how many watches we can produce in a month
based on our number of labor units
or you could view it as based on our total costs
or based on our fixed and variable cost.
Now, what we have here are other things
that we would wanna look at.
If we really wanna understand how our factory works.
So, this is the marginal product of labor,
MPL for short, then you have your marginal cost,
then you have your average variable cost,
then you have your average fixed costs
and then you have your average total costs,
so like always, pause this video
and try to fill what these values would be
for even one row of this table
and then I'll do it with you.
Now let's do it together.
Let's start with marginal product of labor.
Let's remind ourselves what that is.
That says for every incremental labor unit,
how much more are we able to produce?
And so, we'd have to start at the second one
'cause we have to think about it incremental labor unit.
So, as we go from one to labor units,
we were able to go from 10 to 25 total output,
so we were able to produce 15 more watches.
I could just type in 15
but it's even better to do it with a formula
so I can just scroll it down the rest of the rows.
So, in this formula,
I wanna find the difference in my total output,
so 25, that cell minus this cell,
that that's saying hey look,
I was able to grow 15 output
or increase my output by 15
when I increase labor by two minus one.
And then I got my marginal product of labor is 15
when I went from one employee to two
and then I can just figure that out
for the other rows, that's the value of using a spreadsheet.
My marginal product of labor
when I went from two employees to three employees
is 20, so that means by adding that third employee,
I'm able to produce 20 more watches per month
and so, you might be noticing two interesting trends here.
Initially my marginal product of labor seems
to be increasing and then it seems to be decreasing.
And that's consistent with the way a lot of businesses
or factories work
which is initially you're getting the benefits
of specialization where if you only have one person working
in your factory, they have to do everything,
they have to polish the glass
and bring in the boxes and talk to your suppliers
and fit the gears on your watches
and whatever and do the wiring
while as you add more people,
they can start to specialize.
One person can specialize on assembly.
Another person can specialize on bringing the boxes in
and so, initially you have these benefits of specialization
and so, people can focus on just one skill and do it well
but then you start getting diminishing returns,
the office starts getting crowded,
people are waiting for different supplies,
they have to get out of each other's way
and so, then you see this diminishing return trend
where the marginal product of labor starts going down
for those incremental labor units.
Next, we'll think about marginal cost
and as we'll see, the marginal cost trend's going
the other direction as the marginal product of labor.
So, marginal cost is just for every,
for a certain increment and output,
how much is that costing us?
So, for example, if we are going from 10 to 25 output,
for that 15 increment and output,
how much is that costing us
and I would say costing us on average
but I don't want you to get confused,
we're not talking about average variable cost
or average fixed cost or average total cost
but that would be, let's see our costs
went from 7,000 to 11,000,
so we'll do 11,000 minus 7,000.
That is our change in cost
divided by our change in total output.
So, that's going to be divided by the 25 minus the 10.
And we could just scroll this down,
we'll extend that formula
and you can see this trend
that is as the marginal product of labor
is increasing, your marginal cost is decreasing
and it makes sense, in some ways we're getting
more efficient through the specialization and what else
but then once you have diminishing returns,
diminishing marginal returns,
your marginal cost is going up.
And now we can do the, I guess you could say
the average cost.
So, first average of variable cost.
That's just taking your variable cost
and dividing it by your total output.
And so, for at least those first 25 units,
they cost on average or just the variable component,
you have to be careful is $240.
If you talk about the fixed component,
well, that's just gonna be our fixed cost
divided by our total units
and then our average total cost,
that's gonna be our total cost
divided by those 25 units
and so, you can see, our average total cost
for those first 25 units is $440
and then it can be broken up
between how much of that $440
is variable versus fixed
and then we can just extend these formulas down,
the magic of spreadsheets
and what's interesting here
and it's not gonna be going to be so obvious
just looking at this spreadsheet
is something interesting is happening
when marginal cost seems to intersect
either your average variable cost
or your average total cost
that at some point you're average variable cost,
you see that same trend,
it's trending down and then it starts to trend up again.
Average total cost is trending down
but then it trends up again
and as we'll see when we graph it,
the point at which marginal cost intersects
with the average variable cost,
that's when you have that change in direction
of average variable cost
and then same thing is true
of when marginal cost intersects with average total cost.
That's when you have that change in direction.
Average fixed cost just continues
to go down because those fixed costs
aren't going up as you have more and more output,
so you have those same fixed costs,
you could view it has spread amongst more and more output,
so that's just going to keep asymptoting downward.
In the next video, we'll actually graph that
and see these trends visually.