Product: Total, Marginal and Average

Video Transcription

Hi. Welcome to economics. This is Kate. This tutorial is called "Product, Total, Marginal, and Average." As always, my key terms are in red, and my examples are in green. In this tutorial, we'll be talking about and graphing different ways of looking at production-- overall or total product, marginal product, and average product. We'll talk about how a firm uses all of these to determine how much labor and capital, or their inputs, that they need to hire. We'll look at two terms called the marginal product of labor and the marginal product of capital, and then we'll end by discussing marginal revenue product.

So we know that all firms have to decide how it is that they're going to produce their good and service. And most firms can use a combination of workers and machines. And so what they need to do is figure out the combination of labor and capital that's going to minimize their costs and optimize how much they're producing, or their output. So let's start with total product. Total products is just the quantity of goods and services produced overall.

So here I'm using labor, not capital. I'm talking about number of employees. And here you can see the relationship between the number of employees that a firm hires and the overall production that corresponds to how many employees they have. It makes sense that as the firm hires more employees, they're able to produce more. With more people, you can get more done.

And if we were to graph it, with total product on the y-axis and the number of workers here-- I just simply plot at those points-- and the curve would look something like this. I'll be talking in a couple of slides why it actually is shaped the way that it is here. Why it's shaped the way that it is actually has something to do with marginal product, our next key term. And it's the output produced when we add one additional unit of input. Remember, the word marginal means additional.

So here, I'm just adding a marginal product column to the same chart that we had before. So marginal, again, meaning additional. So when we go from 0 to 1 employees, how much additional product does that one person generate? 10. The second employee generates an additional 15, raising it from 10 up to 25. And then, the third employee, an additional 10, and then an additional 5, an additional 2. And the sixth employee, you'll notice, actually doesn't contribute anything additionally to the firm's overall production. And again, we'll talk about why that is in a little bit.

So if I were to graph marginal product this time on the y-axis, with number of workers on the x-axis, it would go up at first and then begin to diminish. And you can see here, at worker number 6, that's where it hits 0. And just to keep in mind that right here, this would be what's called the marginal product of labor, or the MPL, since I'm talking about what each additional employee adds in terms of overall production.

The MPK is actually how we would abbreviate Marginal Product of Capital. And that would look at, if we were to have number of machines here, what each additional machine contributes additionally to the firm's production. So the marginal product of labor, then, is defined as just additional output generated by adding one more unit of labor, and that's what we saw on the previous slide. And then I said to you, if we changed it to number of machines, that would make it MPK, or Marginal Product of Capital, which is the additional output generated by adding one more unit of capital. All right.

Now we need to look at the production on average. So any average is a total divided by the number of something, right? So average product is total output divided by the quantity of inputs. So really, we can talk about it as the average product of labor, or the average product of capital. Just as we had the marginal of both of those things, as well. So here, again, I'm sticking with the employees. So we're looking at labor. And so we've already seen total and marginal, now I'm just adding an average column here. And all I've done is I've taken total and divided by the quantity, or the number of employees.

So this tells us that, for example, let's say we have three employees, that on average each employee is producing 11.7 units. If we were to graph it-- again, your average is this curve right here-- it goes up at first and then falls, just as marginal went up and then fell like that.

Let's talk about actually these two curves and how they're related to one another. So here, where the marginal lies above the average, that would be from here to the left. OK? The marginal is up above the average. Notice how it's pulling the average up. If I were to use a sports analogy-- I think that actually helps before I go into this specific example-- If I were to use a sports analogy, let's say that a quarterback has a certain average. Let's say we're talking about his average touchdown passes per game. And let's say that his average right now is, on average, he's passing two.

So he has two average touchdown passes per game. That would be, obviously, this curve-- his average. The marginal represents his next game, his next performance. Right? Because marginal means your additional thing. So if, in the next game, he has a really great game and he has, let's say, five touchdown passes, won't that bring his average of two up? That's what's going on here.

So with marginal and average product of labor, when we're here, to the left of this spot, adding another worker, one more, will add more than the average to output. OK? So we'll pull that average up. As soon as that quarterback now has a really bad game, his marginal performance let's say is 0 touchdown passes, that's going to pull his average down. And that's where the marginal lies below the average.

So where a marginal lies below the average, it's going to pull it down. And that would mean that adding another worker will add less than the average to output. It doesn't mean necessarily that they're going to bring overall output down, it just means that they're going to add less than the average to output.

And that brings us to a concept called diminishing marginal product, which says that the marginal product of capital or labor will begin to fall at some point, holding everything else constant. So right here-- I said I would be talking to you about why the curves were shaped the way that they are. Notice how total product is increasing except when we hire the sixth employee. But it's increasing at different rates, and that's what marginal product measures. It measures the rate at which total product is changing.

And at first-- look at how the second employee, what he adds to the firm. He adds actually more than even the first worker. Why would that be? Well if you think about it, specialization can kind of explain that. With two people, can't you get so much more done than with just one person? But remember, in the short run, there's a fixed input. And so there's fixed amount of stuff for these workers to work with.

So at some point-- I just have it set in pretty quickly here to prove my point-- but at some point, specialization kind of runs out. And yeah, hiring more workers is still going to help you produce more. But the next worker won't be as good as the one before. Because there's just not enough stuff for them all to do, all to have specialized devoted tasks.

So here, I'm drawing an arrow to where diminishing marginal product sets in, at the third worker. Total product is still increasing. Hiring another worker or investing in a new machine for capital would still help to increase your numbers, just not as much as the one before. And that's what diminishing marginal product is all about. OK?

Here we would never want to hire a seventh employee. Because more than likely, that would be where they would actually bring down production. That's at the point where they're getting in each other's way, and it's actually less productive to have another employee. That's not what diminishing marginal product is, though.

So how is it that a firm uses all of this information? OK, now we need to bring everything together. And we need to link it to the revenue that they can generate and how much it's going to cost us to hire these inputs.

So we need to look at the price of the product that they're selling and the cost of labor or capital to the firm. And that's where the marginal revenue product is going to come in. So marginal revenue product is the additional sales revenue received from employing one more unit of labor, or capital. And again, I'm sticking with the labor example.

So marginal revenue product is simply taking the marginal product that we found and multiplying times the price of the product. So I'm saying in this example, let's say we can sell it for $10. So here would be our marginal revenue product.

Let's say that is going to cost us $80 to hire a worker. Should we hire a third worker? Yeah, we should. Because they're generating $100 of extra revenue for the firm, and it's only costing us $80. So it'll add $20 to profit.

But should we hire a fourth worker? Absolutely not. The costs would be an additional $80, and they're only generating another $50 of revenue for the firm. So that would actually have our profit fall by $30.

That's how we use marginal revenue product to make our decision. So in this tutorial, we looked at total, marginal, and average product. And finally, I just showed you how a firm uses these to determine how much labor and capital to hire. We need to the marginal product of labor and the marginal product of capital, and then we look at the marginal revenue product that each is contributing.

Thank you so much for listening. Have a great day.