The effect of the price reduction beyond £75 has a greater negative effect on total revenue than the effect of increasing quantity demanded.

Firm revenue is just one component in the profit-maximizing decision of the firm. The next relevant component is output.

4.3.3FIRM OUTPUT (PRODUCT): MARGINAL AND AVERAGE OUTPUT

What a firm can produce depends on the inputs available to it, both in terms of the quantity and quality of those inputs. At its simplest, what comes out of a firm depends on what goes in. The exact relationship between inputs and output will be different for each firm since different firms are in different lines of business and will have very different input requirements, different resources, both capital and human. Even for firms within the same industry or line of business, the relationship between inputs and outputs will vary as firms will have different inputs available to them and different strengths and weaknesses in successfully converting their inputs into output. A general relationship between inputs and output, however, can be graphed, as shown in Figure 4.2.

Putting one input (labour) on one axis, total output, also referred to as total product, can be drawn. If we consider the output of a firm in the short run, we assume that its capital input is fixed while its labour input can be varied. This is the simplest case that we can use to display the relationship between output and factors of production.

The S-shape of the total product curve represents the general relationship between variable input(s) and output for any firm, where L1, L2 and L3 represent different numbers of workers. In the short run, the more workers a firm employs, the higher its total output up to a point. Beyond that point (C), additional workers just get in each other’s way and total output begins to fall.

The relationship between output and labour input is not a simple linear relationship, as the S-shape indicates. Up to a certain number of workers – L1 – total output rises more and more with each additional worker. This is reflected in an increase in the slope of the total output curve up to point A in Figure 4.2. This is the portion of the total product curve that reflects increasing marginal physical product of labour (the MPPL was discussed in Chapter 2).

Marginal physical product of labour: the change in the quantity of output produced by each additional worker: Q /L.

When L1 workers are employed, MPPL is at its maximum, as seen in Figure 4.3. After point A, the MPPL declines implying that although total output still increases as the quantity of workers increases, its rate of increase slows down. This is reflected in a decrease or flattening of the slope of the total output curve beyond point A in Figure 4.2.

The pattern in the average product of labour can also be considered with reference to Figures 4.2 and 4.3.

Average product of labour: total output divided by the number of workers: Q /L.

For example, with L2 workers, the firm shown in Figure 4.2 produces Q2 output – at point B on the total product curve. If this output corresponds to 200 tables, produced by 160 workers, each worker produces 1.25 tables on average. For all values of total output below Q2 (and the corresponding number of workers below L2) the average product of labour is less than at point B. For example, at L1 120 workers produce 140 tables, a lower average of 1.2 tables each. For all values of total output above Q2, and the corresponding number of workers above L2, average

Labour

F I G U R E 4 . 3 M A R G I N A L A N D A V E R A G E O U T P U T ( P R O D U C T ) O F L A B O U R

product of labour is lower than at point B. (At any point apart from B on the total product/output curve, the slope of a line drawn between zero and that point on the total product curve is lower than at point B. The slope expresses the vertical distance between zero and the output quantity relative to the horizontal distance between zero and the quantity of labour, i.e. the measure of average output per worker: Q /L.) At L3 with 260 workers, output is 240 tables, or 0.92 of a table.

This explains why in Figure 4.3, point b is the highest point on the average product of labour curve. From this figure we see that:

•When the marginal physical product of labour lies above the average product of labour, hiring one extra worker leads to an increase in the average product of labour.

•When the marginal physical product of labour lies below the average product of labour, hiring one extra worker leads to a fall in the average product of labour.

•The marginal physical product of labour curve intersects the average product of labour curve from above at the highest point on the average product of labour curve.

The shape of the marginal product curve can be understood from the analysis of the labour market and the discussion of the law of diminishing marginal returns discussed in Chapter 2.

M A R G I N A L A N D A V E R A G E R E L A T I O N S H I P S

Linda is taking a course with five continuous assessment exercises, each counting for 20% of the overall course mark. Linda would like to do well in all exams but her key objective is to score 50% overall so she can pass the course and move on to the next year of her studies.

Linda scores as follows in the exams:

Linda’s average mark after the first exam was 60%.

Her average mark over the first two exams is [60 + 65]/2 = 62.5%.

Her average mark over the first three exams is [60 + 65 + 52]/3 = 59.0%. Her average mark over the first four exams is [60 + 65 + 52 + 60]/4 = 59.25%. Her average mark over the five exams is [60 + 65 + 52 + 60 + 64]/5 = 60.2%.

The marks received in each exam correspond to the definition of marginal marks – the change in total marks for each extra exam completed: the change in marks after the second exam is the total marks 125 minus the marks for the first exam or 125 − 60 = 65.

You can see that:

•When the marginal mark rose (eg. 60% to 65%), the average also rose (from 60% to 62.5%).

•When the marginal mark fell (eg. 65% to 52%), the average also fell (from 62.5% to 59%).

•When the marginal mark was greater than the average, the average increased (look at exams #1 and #2).

•When the marginal mark was less than the average, the average declined (consider exams #2 and #3).

4.3.4FIRM COSTS

Firms must pay a range of different costs, depending on their circumstances and line of business – costs for rent, rates, insurance, taxes, wages, salaries, production inputs, machinery, computers, refuse collection, accountants’ fees, etc. A firm’s total costs are the sum of variable and fixed costs.

Total costs (TC) are the sum of variable costs and fixed costs.

Variable costs (VC) or total variable costs (TVC) depend directly on the amount of output the firm produces, such as the costs for production inputs and workers. The higher the quantity produced the higher the variable costs.

Other costs such as rent and rates must be paid even if the firm produces no output and these costs are called fixed costs (FC) or total fixed costs (TFC).

TC = TVC + TFC

Total fixed costs can be graphed easily, as shown in Figure 4.4, since they do not change as output changes. If when adding up all a firm’s fixed costs, total fixed costs are £2750 per week, then these costs must be paid by the firm if output is zero or not.

In panel B of the figure, average fixed costs are shown. The average fixed cost of the first unit of output is £2750/1 = £2750; for the second unit it is £2750/2 = £1375;

for the third unit it is £917 and so on, so the more the firm produces the lower its average fixed cost as the fixed costs can be spread across a greater amount of output. The average fixed costs of 1000 units of output would be £27.5 while the average fixed cost for 3000 units would be £0.92.

Variable costs change with output, which was shown above as total output. The total variable costs curve for any firm follows an inverted S-shape since it is related to the total output curve. It is drawn based on available information on the price of inputs and knowledge about the best available techniques (technology) for converting inputs into output. In short-run analysis, technology is assumed to be fixed so the cost curves are drawn assuming a certain level of technology.

The best technique for transforming inputs into output can depend on the amount of output produced. It may make sense for a large car producer to invest in robotic technology because of the quantity produced but this technology would be too expensive and make no economic sense for a small-scale car producer. Large dairy companies use large container vats for cheese-making; such investment in equipment would be unsuitable and too expensive for smaller homemade cheese producers.

The general shape of any firm’s total variable cost curve (TVC) is shown in Figure 4.5. The first units of output generate high initial costs for a firm – the first worker is hired, initial inputs must be bought (often in bulk) and the most efficient ways to produce output are yet to be learned by the workforce – often it is only from working on-the-job (learning by doing) that the best ways to produce efficiently are understood and put into practice. Hence, in the initial stages of production, until point a on the TVC curve, total costs rise proportionately faster than output. Once efficiencies are realized, production costs still increase but not as quickly as output. Beyond point b, there is no point in producing extra output as costs rise significantly faster than output.