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.

1
 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 Hourly Value of

Wage Time
Hour 1 $10 $2
Hour 2 $10 $2
Hour 3 $10 $3
Hour 4 $10 $3
Hour 5 $10 $4
Hour 6 $10 $5
Hour 7 $10 $6
Hour 8 $10 $8
Hour 9 $15 $9
Hour 10 $15 $12
Hour 11 $15 $18
Hour 12 $15 $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.

2
 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:

3
 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 that-

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

4
 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).

5
 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).

6
 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).