Total Output May Continue to Rise Even Though Marginal Physical Product is Negative
Short Run Production Process
To increase output in the short run, a firm must increase the amount used of a variable input. Three relationships are crucial in this period. (Assuming labor is the only variable input in the following discussion.)
Total Product (TP or Q) is the total amount of output produced.
Marginal Product (MP) of labor is the increase in output resulting from a one-unit increase in the amount of labor employed.
Average Product (AP) of labor equals total output divided by the amount of labor employed.
When the marginal product of labor curve rises, the firm experiences increasing marginal returns, that is the marginal product of an additional worker exceeds the marginal product of the previous worker. At this time, the rate of increase in total product is accelerating. When the marginal product of labor curve falls, the firm experiences diminishing marginal returns, that is, the marginal product of an additional worker falls short of the marginal product of the previous worker. This is when the total product grows at a diminishing rate. As the marginal product continues to decrease, it will eventually become zero, then negative. This is when the total product declines.
The law of diminishing returns states that as successive units of a variable resource are added to a fixed resource, the marginal product of the variable input eventually diminishes, assuming all units of variable inputs- workers in this case are of equal quality.
Marginal product diminishes not because successive workers are inferior but because more workers are being used relative to the amount of plant and equipment available. For example, a doctor�s office has only one doctor and several assistants. This office is getting very busy; so more assistants are hired. The number of patients served by this office cannot increase without limit. Eventually, the additional assistant will not be able to increase the number of patients in this office. It is not because this extra assistant is inferior, but because there is only one doctor in this office. Doctor may be considered as fixed resource, while assistants can be considered variable resources.
The average product increases when the marginal product exceeds the average product. The average product falls when the marginal product is smaller than the average product. The average product is at its maximum and does not change when the marginal product equals the average product. This is the usual relationship between average and marginal variables. If your GPA or grade point average is 3.0, by getting A (4.0) in this class, you can increase your GPA. GPA is the average variable; your grade of each class is the marginal variable. A marginal variable which is greater than the average variable will increase the average variable, a smaller than average marginal variable will lower the average variable.
Short Run Costs
Total Cost (TC) is the cost of all the productive resources used by the firm. It can be divided into two separate costs in the short run.
Total Fixed Cost (TFC) is costs of firm�s fixed resources; TFC does not vary with changes in short-run output.
Total Variable Cost ( TVC) are costs of firm�s variable resources, TVC does vary with changes in output.
TC = TFC + TVC
Average Total Cost (ATC) is the total cost per unit of output.
Average Fixed Cost (AFC) is the total fixed cost per unit of output.
Average Variable Cost (AVC) is the total variable cost per unit of output.
ATC = TC / Q; AFC = TFC / Q; AVC = TVC / Q.
ATC = TC / Q = (FC + VC) / Q = (FC / Q) + (VC/Q) = AFC + AVC
Marginal Cost (MC) is the increase in total cost resulting from a one-unit increase in output. Marginal decisions are very important in determining profit levels.
All curves are U-shaped, except the AFC curve. The AFC curve is downward sloping because the fixed costs are spread over output. As output increases, the AFC decreases. Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise. The MC is related to AVC and ATC. These costs will fall as long as the marginal cost is less than either average cost. As soon as the MC rises above the average, the average will begin to rise. Once again, you can think of the GPA example. MC curve cuts the ATC and AVC curves at their minimums.
Please use this practice problem to exercise the above relationship.
The shapes of a firm�s cost curves are determined by the technology it uses. MC is at its minimum at the same output for which MP is at its maximum; AVC is at its minimum at the same output for which AP is at its maximum. A technological advance that increases productivity shifts the product curves upward and cost curves downward. If a technological advance requires that more capital and less labor be used, at low levels of output the ATC curve shifts upward and at higher levels of output the ATC curve shifts downward. Cost curves will shift if the resources� prices changes. For example, an increase in minimum wage will shift the MC, AVC and ATC upward as labor is a variable resource. An increase in fixed cost shifts the AFC and ATC upward but does not shift MC and AVC.
Economic profits (EP) are defined as the difference between total costs (TC) and total revenue (TR). Total revenue (TR) is the price multiplied by the quantity sold. Total costs include both implicit and explicit costs. In another words: payments to owners (Normal profit) and non-owners for their resources are both included in the total cost. Economic profit is different from accounting profit because accounting profit does not account for implicit costs.
TC = explicit cost + implicit cost = FC + VC (in the short run period)
TR = Price X Quantity
Source: https://staffwww.fullcoll.edu/fchan/micro/3short_run.htm
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