Page 113 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes
Table 7.2: Stages of Production
Total Physical Marginal Physical Average Physical Additional
Product Product Product Information
Stage I
Increases at an Increases and reaches Increases (but Fixed inputs grossly under
increasing rate its maximum slower than MPP) utilised, specialisation and
team work cause APP to
increase when additional
input is used
Stage II
Increases at a Starts diminishing Starts diminishing Specialisation and teamwork
diminishing rate and becomes equal to continue and result in
and becomes zero greater output when
maximum additional input is used,
fixed input is being properly
utilised
Stage III
Reaches its Keeps on declining continues to Fixed inputs capacity is
maximum, and becomes negative diminish but must reached, additional input
becomes constant always be greater causes output to fall
and then starts than zero
declining

7.1.2 Optimal use of Variable Input

It is important for the firm to decide how much labour it should use in order to maximize
profits. The firm should employ an additional unit of labour as long as the extra revenue
generated from the sale of the output produced exceeds the extra cost of hiring the unit of labour,
i.e., until the extra revenue equals the extra cost.

Thus, if an additional unit of labour generates 300/- in extra revenue and costs an extra 200
then it pays for the firm to hire this unit of labour as its total profit increases. This is an example
of application of the general optimization principle.

The extra revenue generated by the use of an additional unit of labour is called the Marginal
Revenue Product of Labour (MRP ). This equals the Marginal Product of Labour (MP ) times the
L L
Marginal Revenue (MR) from the sale of the extra output produced. Thus,
MRP = (MP ) (MR)
L L
The extra cost of hiring an additional unit of labour or Marginal Resource Cost of Labour
(MRC ) is equal to the increase in the total cost to the firm resulting from hiring the additional
L
unit of labour. Thus,

A firm should continue to hire labour as long as MRP > MRC and until
L L
MRP = MRC
L L
This is applicable to any variable input and not just labour.

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