QUESTION TWO

A. Define and explain how a manager can use Average and Marginal analysis in deciding on
the optimal labour demand for any firm. [8 Marks]

Average and marginal analysis a decision-making tool used to examine the additional
benefit of an activity contrasted with the extra cost incurred by the same activity. It is mostly
used by companies to maximize efficiency and improve their decision-making processes.

Marginal analysis is the comparison of marginal benefits to marginal costs to determine the
net benefits of that additional unit. If positive, the consumer or business would pursue that
additional unit. If negative, they would not.

Marginal refers to the focus on the cost or benefit of the next unit or individual, for example,
the cost to produce one more product or the profit earned by adding one more worker.

A firm must have labour to produce goods and services. But how much labour will the firm
employ? A profit-maximizing firm will base its decision to hire additional units of labour on
the marginal decision rule: If the extra output that is produced by hiring one more unit of
labour adds more to total revenue than it adds to total cost, the firm will increase profit by
increasing its use of labour. It will continue to hire more and more labour up to the point that
the extra revenue generated by the additional labour no longer exceeds the extra cost of the
labour. This relationship is also called the marginal product of labor (MPL) in the economics
community.

The primary takeaway of marginal analysis is to operate until marginal benefit equals
marginal cost; this is often the most efficient use of resources. Using the average and
marginal analysis the manager can be able to decide on the optimal labour demand of the
firm.
B. Table 1. Shows the quantity of labour in relation to the total output and the price of output
is K 100 per unit. Fill in the blanks in the following table: [17 Marks]

Number of Total Output Marginal Average Value of

variable inputs (Q) Product of product of Marginal
variable input Variable input Product
3 90 18 30 1800
4 110 20 27.5 2000
5 130 20 26 2000
6 135 5 22.5 500
7 136.5 1.5 19.5 150

Total Output (Q) = Average product of variable input × number of variable input
Marginal product of variable input (MP) = Change in Total output/change in number of
variable inputs
Average product of variable input (AV) = Total output/number of variable input
Value of marginal product (VMP) = Marginal product × price

1. Q = AV × number of variable inputs

Q = 30 × 3
Q = 90

2. VMP = MP × price
VMP = 18 × 100
VMP = 1800

3. Q = Previous Q + MP
Q = 90 + 20
Q = 110

4. AV = Q/number of variable inputs

AV = 110/4
AV = 27.5
 5. VMP = MP × price
VMP = 20 × 100
VMP = 2000

6. MP = Change in Q/change in variable inputs

MP = (130 – 110)/(5 – 1)
MP = 20

7. AV = Q/variable inputs
AV = 130/5
AV = 26

8. VMP = MP × price
VMP = 20 × 100
VMP = 2000

9. Q = Previous Q + MP
Q = 130 + 5
Q = 135
10. AV = Q/variable inputs
AV = 135/6
AV = 22.5

11. VMP = MP × price

VMP = 5 × 100
VMP = 500

12. Q = AV × variable inputs

Q = 19.5 × 7
Q = 136.5

13. MP = Change in Q/change in variable inputs

MP = (136.5 – 135)/(7 – 6)
MP = 1.5

14. VMP = MP × price

VMP = 1.5 × 100
VMP = 150

This production process exhibits diminishing returns to input variables/ The marginal product
of variable inputs diminishes as inputs are added, and begin when the 6 th input variable in
added.