Use of marginal revenue and marginal cost in 3.

3 determining work force

Meaning of Marginal analysis
Life involves a series of decisions. Consumers and businesses face questions--such as whether to put in a few extra hours at work, save a little extra each month, buy a new computer, or build an additional production facility--everyday. A central tool of economic research known as marginal analysis can provide decision makers with the tools for making decisions that will achieve the greatest benefit. Marginal analysis examines how the costs and benefits change in response to incremental changes in actions. Any additional action by an individual or a firm, such as buying an additional pair of shoes or increasing production of a product by an additional unit, brings additional cost. The central question in marginal analysis is whether the expected benefits of that action exceed the added cost. Differential calculus provides mathematical tools by which economists and business experts conduct marginal analysis. Differential functions in calculus look at an outcome or dependent variable (often expressed as the letter "y") as a function of one or more independent variables (expressed with the letter "x"). The equation examines the change in the value of y for each increase in the value of x. In economic terms, y can signify benefits and x can signify costs. Thus, calculus helps economists quantify the change in benefits resulting from a one-unit increase in costs. Individuals and businesses want to achieve the highest level of satisfaction possible. Economists call this maximizing utility. Individuals want to maximize their satisfaction and happiness, while businesses want to maximize profit. Marginal analysis helps businesses and individuals balance the costs and benefits of additional actions---whether to produce more, consume more, or other decisions---and determine whether the benefits will exceed costs, thus increasing utility. Marginal analysis benefits government policy makers, as well. Weighing the costs and benefits can help government officials determine if allocating additional resources to a particular public program will generate additional benefits for the general public. From an economist's perspective, making choices involves making decisions 'at the margin' - that is, making decisions based on small changes in resources: How should I spend the next hour? How should I spend the next dollar? On the surface, this seems like a strange way of considering the choices made by people and firms. It is rare that someone would consciously ask themselves - 'How will I spend dollar number 24,387?', 'How will I spend dollar number 24,388?'. Treating the problem in this matter does have some distinct advantages: Doing so leads to the optimal decisions being made, subject to preferences, resources and informational constraints. It makes the problem less messy from an analytic point of view, as we are not trying to analyze a million decisions at once. While this does not exactly mimic conscious decision making processes, it does provide results similar to the decisions people actually make. That is, people may not think using this method, but the decisions they make are as if they do.

Use of marginal revenue and marginal cost in 3.3 determining work force
Marginal Analysis - An Example
Consider the decision on how many hours to work, as given by the following chart: Hour Hour Hour Hour Hour Hour Hour Hour Hour Hour Hour Hour Hour 1 2 3 4 5 6 7 8 9 10 11 12 Hourly Wage $10 $10 $10 $10 $10 $10 $10 $10 $15 $15 $15 $15 Value of Time $2 $2 $3 $3 $4 $5 $6 $8 $9 $12 $18 $20

The hourly wage represents what an employee earn for working an extra hour - it is the marginal gain or the marginal benefit. The value of time is essentially an opportunity cost - it is how much value s/he having that hour off. In this example it represents a marginal cost - what it costs her/his by working an additional hour. The increase in marginal costs is a common phenomenon; S/he does not mind working a few hours since there are 24 hours in a day. S/he still has plenty of time to do other things. However, as s/he starts to work more hours it reduces the number of hours S/he has for other activities. S/he has to start giving up more and more valuable opportunities to work those extra hours. It is clear that s/he should work the first hour, as s/he gain $10 in marginal benefits and lose only $2 in marginal costs, for a net gain of $8. By the same logic s/he should work the second and third hours as well. S/he will want to work until which time the marginal cost exceeds the marginal benefit. S/he will want to work the 10th hour as s/he receive a net benefit of #3 (marginal benefit of $15, marginal cost of $12). However, s/he will not want to work the 11th hour, as the marginal cost ($18) exceeds the marginal benefit ($15) by three dollars. Thus marginal analysis suggests that rational maximizing behavior is to work for 10 hours.

Use of marginal revenue and marginal cost in 3.3 determining work force
Profit maximization & Demand for labor
Economists assume that firms attempt to maximize their profits. One question that might be asked is whether the employment of an additional unit of labor raises or lowers a firm's profits. To analyze this, recall that: economic profits = total revenue - total costs When an additional worker is hired, total revenue will rise (under most practical situations). On the other hand, total costs rise as well. The increase in revenue results in an increase in profits while the increase in costs lowers the level of profits. Thus, the addition of an additional worker will increase profits only if the additional revenue resulting from this labor is greater than the additional costs. Profits will decline if costs increase by more than revenue. To examine this issue, economists rely on two measures: o the marginal revenue product (MRP) of labor, and o the marginal factor cost (MFC) of labor. The marginal revenue product of labor is defined to be the additional revenue that results from the use of an additional unit of labor. In a similar manner, the marginal factor cost of labor is defined to be the additional cost associated with the use of an additional unit of labor. (Some textbook defines this using the somewhat less conventional term of marginal expense (ME) of labor.) In this course, we'll use the term "marginal factor cost". A little bit of reflection should convince you that a profit-maximizing firm will: o increase the use of labor if MRP > MFC, and o reduce the use of labor if MRP < MFC.

Marginal revenue product

The marginal revenue product of labor can also be expressed as: MRP = MR x MP where MR (marginal revenue) equals the additional revenue resulting from the sale of an additional unit of output and MP (marginal product, also known as marginal physical product or MPP in many micro principles texts) is the additional output resulting from the use of an additional unit of labor, holding the use of other inputs constant. Suppose, for example, that you wished to compute the marginal revenue product of labor when MR = 4 and MPP = 5. In this case, the employment of an additional worker results in a 5 unit increase in output (holding other inputs constant) while revenue increases by tk. 4 when an additional unit of output is sold. In this case, the marginal revenue product of labor will equal tk.20 (= tk. 4 x 5 unit). Using a little bit of algebra, the marginal revenue product can be defined as:

Similarly, marginal revenue and marginal product are defined as:

Use of marginal revenue and marginal cost in 3.3 determining work force

and:

The relationship among MRP, MR, and MP can also be seen quite clearly in an algebraic manner:

Since MRP is equal to the product of MR and MP, to determine the relationship between MRP and the level of labor use, we need to understand how MR and MP change when the level of labor changes. According to the law of diminishing returns, it can be stated thatas additional units of a variable input are added to a production process in which other inputs are fixed, the marginal product of the variable input will ultimately decline. While it is possible that MP may initially increase, a profit-maximizing firm will never hire workers in the range in which this occurs. (To see this, note that if it is profitable to hire the second worker and the third worker has a higher marginal product, it will always be optimal to hire the 3rd worker. A profit-maximizing firm would never hire only two workers in this case.) Thus, marginal product declines over the range of labor use that will be considered by a firm. The diagram illustrates the relationship between marginal product and the level of labor use.

As this become have to workers

diagram indicates, it is possible that the marginal product of labor will negative beyond some level of labor use. Once again, though, we do not worry about this because profit-maximizing firms will never hire additional if the additional labor results in a decrease in the level of output!

Use of marginal revenue and marginal cost in 3.3 determining work force
If the firm is operating in a perfectly competitive output market, marginal revenue is constant and is equal to the market price. In an imperfectly competitive output market (such as a monopoly or monopolistically competitive market), the firm faces a downward sloping demand curve and marginal revenue is less than the price. The relationship between output and marginal revenue under both perfect competition and imperfect competition is summarized in the diagram below.

Let's examine the shape of the MRP curve. We know that MP declines as labor use rises. In the case of a perfectly competitive output market, MR is constant. If the output market is imperfectly competitive, MR declines as labor use rises. Thus, we can safely predict that the MRP curve will be downward sloping, as illustrated in the diagram below (since MRP is the product of two terms, one of which always declines and the other is either constant or declining when labor use rises).

Use of marginal revenue and marginal cost in 3.3 determining work force
Marginal factor cost in perfectly competitive labor markets
If the labor market is perfectly competitive, each buyer and seller of labor is a price taker. In this case, the firm faces a perfectly elastic labor supply curve Since the wage is constant at all levels of labor use in this market structure, the marginal factor cost of labor is just the market wage. If workers are paid tk.7 an hour, the marginal factor cost of an additional hour of labor is tk.7. The relationship between marginal factor cost and the level of labor use is illustrated below.

Labor demand in perfectly competitive labor markets The diagram below combines the MRP and MFC curves for a firm in a perfectly competitive labor market. Notice that the MRP curve will be downward sloping and have this same basic shape regardless of whether the output market is perfectly or imperfectly competitive. The only difference is that MRP will be lower when the output market is imperfectly competitive (since MR < P in this case).

Use of marginal revenue and marginal cost in 3.3 determining work force
The diagram above can be used to determine the profit-maximizing level of labor use. Suppose that the firm chooses to employ Lo workers. At this level of labor use, MRP > MFC. The firm can increase its profits in this case by increasing the level of employment (since the additional revenue generated by an additional unit of labor exceeds the cost of this additional labor). If it hires L' workers, however, the additional cost of the last unit of labor exceeds the additional revenue generated by this labor. In this case, the firm could increase its profits by hiring fewer workers. Profits are maximized at a level of labor use equal to L*. Profits would be lower at any alternative level of labor use. Labor demand curve for a firm operating in a perfectly competitive labor market The analysis above may be used to derive a labor demand curve. Consider the diagram below. From this diagram, we can see that the optimal level of employment at a wage of Wo is Lo. When the wage rises to W', the profit-maximizing level of employment falls to L'. At a wage of W", the profit maximizing level of employment us L". A careful examination of this diagram indicates that for any given wage, the MRP curve provides a measure of the optimal quantity of labor demanded by the firm. Since the MRP curve tells us the quantity of labor demanded at each and every possible wage rate in the short run, it is the firm's short-run labor demand curve. This will be the case for any profit-maximizing firm that operates in a perfectly competitive labor market (regardless of the degree of competition on the output market).