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Output Optimization: Marginal Revenue Product

Output Optimization: Marginal Revenue Product

Author: Kate Eskra

This lesson will explain Output Optimization: Marginal Revenue Product

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Source: Image of Total Product graph created by Kate Eskra, Image of Marginal Product graph created by Kate Eskra

Video Transcription

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Hi, welcome to economics. This is Kate. This tutorial is called Output Optimization. And we'll be looking at marginal revenue product.

In this tutorial, we'll be defining marginal revenue product. And you'll see how diminishing marginal returns applies to labor. We'll talk about how a firm is going to use marginal revenue product to determine how much labor and capital to hire.

So we know that all firms have to decide how to produce their good or service. And most firms can employ a combination of labor and capital. So, how many workers should we hire, how many machines should we purchase are questions that they need to ask themselves.

The key idea is that people they will hire the combination of labor and capital that will optimize their output. And so the subject of this tutorial is using a marginal revenue product to figure out what combination that is. We know that the point of owning a business is to make a profit and profit our revenues minus cost. But marginal revenue product combines the concepts of revenue with the cost of the capital or labor to figure out what will maximize profits. So we're looking at both sides of this.

So just as a refresher here, total products is the total amount that can be produced as we have either employees or machines would be capital here. And you can see the shape of the curve. And the marginal product looks at the additional amount each worker or each machine would bring in to the business. And if we graphed it, it would look something like that. So this in this example is the marginal product of labor since we're looking at how much each employee adds to total production.

One of the things that we can talk about is the concept of diminishing marginal returns. You can see how adding more workers definitely increases total production at least up until the fifth employee. But at kind of a slowing rate. Workers can specialize in the beginning and so the second employee is even better than the first in terms of what he or she adds, because there's so much for them to do when they can divide and conquer and specialize on devoted tasks.

But at some point, even though total product is increasing, it begins to diminish in terms of how much additionally they're producing. And that's because there's a fixed input in the short run. And so there just isn't quite as much for them to do.

Most people are under the impression that we should just continue hiring as many employees as we possibly can. But each employee is costly. And so now what we need to look at is what are they generating for the firm? Because if it doesn't justify it-- for example, the sixth employee here, no matter how little they might cost, it's probably not going to be beneficial to hire them since they generate actually no additional product. So how many workers should the firm higher to optimize output? That's what we're going to be looking at here.

How they use all this information is like as I was saying, we need to link this to the revenue that they can actually generate, and to the cost. How much is it costing us to hire these workers or to purchase these machines, or use these machines? So we'll be looking at the price of the product and the cost of labor or capital.

So here we have a chart that has the total marginal product and now marginal revenue product. Marginal revenue product is just the additional amount of revenue that one more unit of labor or capital generates for the firm. So if the price of the product was $10, we take our marginal product and we multiply it times the price.

So the second worker, for example, generated 15 additional units. And if we can sell them for $10 each, that would give us an additional $150 of revenue. But the fifth worker only generates $20 worth of revenue for the firm because they're only helping to contribute two additional products.

So now we have to compare that to how much each worker is costing us. In this example, let's say that the workers are costing us $80. So should we hire a third worker? Well, that third worker is going to cost us $80. But they're generating $100 worth of product or revenue for us.

So is that worth it? Yes, that will add $20 to profit. Because again, their MRP is $100, their cost is only $80. Should we hire a fourth worker? Well again, they cost us $80.

The additional revenue they bring in for us in terms of their production is only $50. That would not be a good decision because their profit would fall by $30. So that's how we use this to optimize our output or optimize how many workers we should hire.

What if the cost of labor went up? What if wages went up and now it's going to cost us $100 to hire each worker. So should we hire the third worker? We would go up to the third worker now. Because the third worker will generate $100 of revenue for us and they're costing us $100.

If we stop back here, we could actually get more out of it by continuing to hire. But we would never want to go down in here where it's costing us more than what they're generating in revenue. As long as we equate the marginal revenue product of each input with the cost of that input, the firm will be optimizing their output.

So I've been focusing on employees, so this is with labor. The firm would do this with their labor and they would do the same thing with things like machines or their capital. They would equate their marginal revenue product of capital with the cost of that capital. As long as they do that with both, that would be optimizing their output.

In this tutorial, we looked at the different ways of looking at production; the total marginal and average product. And we talked about how the firm uses the marginal product of labor and capital and marginal revenue product to determine how much labor and capital to hire to optimize their output. Thank you so much for listening. Have a great day.