No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 159 “Q,” here, stands for the amount of goods she is able to produce with labor (L)and capital (K), which means that there is a positive relationship to capital and/or labor with output. So increasing either capital or labor (or both) will increase output, while decreasing either input (or both) will reduce output. The right hand side of the equation simply means that the product is a function (f) of the amount of labor (L) and capital (K). Let’s say Megan’s business is a new competitor to SUBWAY, where she can employ workers (L) and/or purchase machinery (K) to make sandwiches. We don’t need to be specific on what type of capital; in her world it could include toasters, electric knives, perhaps a moving sandwich line which automatically adds condiments. Let’s simply assume that she currently has five units of capital and three workers, and therefore she is able to produce 300 sandwiches per day. If Megan wants to increase her production, she can hire more workers, buy more efficient machinery, or some combination of both options. If she hires another worker, she might be able to produce 125 more sandwiches, for a total of 425. Hiring a fifth might yield 75 more sandwiches, and a sixth an additional 25. Can you think why subsequent workers don’t produce as many additional sandwiches as earlier workers? Production is subject to the law of diminishing returns, where adding more of one input while keeping others fixed will ultimately lead to increased output at a diminishing rate. The law of diminishing returns is operative over the short run, when at least one productive input is fixed. When an entrepreneur adds more labor to the sandwich line without more equipment, the workers have to share both the equipment and the work space to operate. Additional workers lead to more sandwiches, but less additional sandwiches with each additional worker. At some point, there may be so many workers behind the counter that they are simply in each other’s way, and each marginal (additional) worker actually causes a decrease in production output. We call this the diminishing marginal product of labor (MP L ) . The same thing will happen with capital. Initially adding more capital will result in increased production, perhaps at an increasing rate because of the gains from specialization as the capital may allow each worker to concentrate on a specific task. But eventually, without adding more workers to Figure 7.5, The Production Function. The curve above shows that if you fix all productive inputs except one, then as you increase that input (either capital or labor), the total product will increase. Notice that the total product initially rises with each increase in the productive input at an increasing rate but that eventually the output gains get smaller. This illustrates Diminishing Returns to each factor input. Labor or Capital Specialization Gains from Returns Diminishing Output Law of diminishing returns: the increase in production from increasing one factor of production (while holding the other factors constant—ceteris paribus) will eventually decrease. Marginal product of labor (MPL): the incremental (additional) output created by adding one unit of labor to the production process while keeping all other factors fixed.