Section 2 Costs of Production
Preview
Objectives
After studying this section you will be able to:
- Explain how firms decide how much labor to hire to produce a certain level of output.
- Analyze the production costs of a firm.
- Understand how a firm chooses to set output.
- Explain how a firm decides to shut down an unprofitable business.
Section Focus
Entrepreneurs consider marginal benefits and costs when deciding how much output to produce. Ordinarily, firms earn their highest profits when the cost of making one more unit is the same as the market price of the good.
Key Terms
- marginal product of labor
- increasing marginal returns
- diminishing marginal returns
- fixed cost
- variable cost
- total cost
- marginal cost
- marginal revenue
- operating cost
In Section 1, we identified how producers respond to a change in price. The law of supply states that producers will offer more goods as the price goes up and fewer as the price falls. In this section, we will explain how a supplier decides how much to produce.
Consider a firm that produces beanbags. The firm's factory has one sewing machine and one pair of scissors. The firm's inputs are workers and materials, including cloth, thread, and beans. Assume that each beanbag requires the same amount of materials. As the number of workers increases, what happens to the quantity of beanbags produced?
The supply of beanbag chairs in the market depends on several factors, including the cost of labor and capital.
Labor and Output
One of the basic questions any business owner has to answer is how many workers to hire. To answer this question, owners have to consider how the number of workers they hire will affect their total production. For example, at the beanbag factory, one worker can produce four beanbags per hour. Two workers can make a total of ten bags per hour, and three can make a total of seventeen beanbags an hour. As new workers join the company, total output increases. After the seventh worker is hired, production peaks at 32 beanbags per hour. When the firm hires the eighth worker, however, total output drops to 31 bags per hour.
Figure 5.6 shows the relationship between labor, measured by the number of workers in the factory, and the number of beanbags produced.
| Labor (number of workers) | Output (beanbags per hour) | Marginal product of labor |
|---|---|---|
| 0 | 0 | — |
| 1 | 4 | 4 |
| 2 | 10 | 6 |
| 3 | 17 | 7 |
| 4 | 23 | 6 |
| 5 | 28 | 5 |
| 6 | 31 | 3 |
| 7 | 32 | 1 |
| 8 | 31 | –1 |
Marginal Product of Labor
The third column of Figure 5.6 shows the marginal product of labor, or the change in output from hiring one more worker. This is called the marginal product because it measures the change in output at the margin, where the last worker has been hired or fired.
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