Just as every consumer has a common objective, maximizing happiness, every producer has a
common objective: producers want to maximize profits.
How do I know what profits are?
Well, all I have to do as a business owner is to look at how much money has come in (my
total revenue, determined by how many units have sold times the price tag I was able to
charge for each unit), and then deduct the total cost of production, or the amount of
money going out.
The problem is, that I don't really know much about costs, or how to figure them out.
Before I can figure out costs, I need to understand something about production, and what happens
as I pour more resources into the production process -- since it’s resources that cost
money.
Let’s look at an example: I want to promote economics, and how wonderful the subject is,
so I need to produce banners that say “I love economics,” and I’m going to post
them up everywhere.
However, I don't really want to do the work; I'm really better in a supervisory capacity.
So right now, I have zero employees, and with zero workers I get zero output.
To get some production, I'll need to hire some workers.
This is Lee, my first employee.
He can produce six banners in a given time.
Lee is good, giving me six units, but how can I get more output?
I'll need to hire a second employee.
This is Angelina, my second worker.
When Lee and Angelina work together as a team, 14 banners are produced.
The interesting thing here is that when I doubled my work force from one employee to
two, I more than doubled my output.
When this happens, that is, when I see increasing returns from my added resource, it actually
gets cheaper to produce each unit!
Just a little more of the resource adds a lot more output.
As a business owner, this is great for me.
Now I hire a third employee, Oliver.
Note that with the addition of Oliver to the team, I still get more output, but not as
large a boost as I got when I hired Angelina.
However, since my output’s still rising -- this time, half again as many employees
yield half again as much output, so I have constant returns -- I will continue to hire
workers.
An issue arises when the hire my fourth employee, Katie.
It doesn’t have so much to do with her as a worker, since she has the same skill set
as my other employees, but rather with the fact that I've been hiring more and more workers,
but I haven't acquired more of the non-labor resources -- like paper, ink, or computers.
Now that I've brought Katie in, there isn't enough equipment for each employee to have
his or her own supplies, so the employees will have to share.
This overcrowding tends to slow things down a bit.
I still end up with a bit more production, but if you think about it, I paid the extra
money for an additional worker, and don't have much extra output to show for it.
If I continue to add more workers, without purchasing any other resources, eventually
I'll get to the point where more workers actually leads to less total output.
This is NOT a good scenario for the business owner.
Cost per unit goes through the roof if I pay more wages to get less output!
Take a look at the data.
At first, each worker adds more to the output than the previous worker.
How is this possible, if each of the workers has the same skills to do the job?
Well, here's the way it typically works: at first, Lee is working alone, but when I add
Angelina, they form a team and split the job into specialized tasks.
When I conduct this experiment in class, most often I see one person take over the “I
love” part, and in the second person does the “economics” part.
This specialization and division of labor leads to increasing marginal product.
By definition marginal product, or MP for short, is the addition to the total product
when another unit of resource, in this case labor, is added.
While you'll see increasing marginal product in the early stages of adding the resource,
inevitably the Law of Diminishing Returns will set in: the marginal product will fall
as I add more and more of the same resource (workers, here), due to overcrowding and shortage
of other resources.
OK, here’s the visual on how production progresses when you add more and more of one
type of resource, without changing the other resources.
First, I hired Lee; my total product was 6, and he had added 6 to my product.
Next I hired Angelina.
She added 8 to my production, giving me a total output of 14.
Third, I bring Oliver to the team, bringing total product to 21.
This means that Oliver added 7 to my output.
Lastly, I hired Katie.
Total production did increase to 24, but this was only 3 additional units of output.
At this point, as the employer, I can see that my output is seriously slowing, and I
would be cautious about spending more on labor.
I would see very little increase in production, and quite likely output would even fall.
As a business owner, it would probably be wiser at this point to invest in more the
other kinds of resources before hiring more workers.
NEXT TIME: Accounting costs versus economic costs
TRANSCRIPT00(MICRO) EPISODE 20: PRODUCER THEORY