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

Chapter Seven: Production: Man at Work 160 operate the machines, the returns will begin to decrease and we will see diminishing marginal product of capital (MP K ) . Graphically we can see how this operates in Figure 7.5 . As Megan increases the number of workers (or alternatively capital), while holding all other production inputs fixed, we see that the total product (sandwich output) increases. Adding more and more workers initially leads to output gains at an increasing rate due to gains from specialization as shown by the curve rising at an increasing rate. Eventually, however, successive gains begin to get smaller and smaller due to the law of diminishing returns, as shown by the increase growing at a slower rate (the curve flattens out). How does Megan know whether it would be more profitable to add another unit of machinery or another worker? She would need to compare the marginal product (additional output from adding one more unit of labor or capital) of each, divided by the cost of one more unit. This provides a way to compare each of the two inputs; you can think of it as the best “bang for the buck.” For example, an additional worker may cost $1,500 per month, while creating 500 sandwiches per month. A new automated condiment dispenser may have a cost of $5,000 per month but allow an additional 2,000 sandwiches per month in production. So the marginal product of labor divided by its price is less than the marginal product of capital divided by its price. MP L / P L = 500 sandwiches / $1500 = .33 sandwiches / $ MP K / P K = 2000 sandwiches / $5000 = .4 sandwiches / $ The relative price of capital is less than the relative price of labor since the output per dollar is higher with an investment in capital. Megan should therefore expand with capital rather than labor. The important point here is not necessarily the calculation itself, but rather that you understand that the various inputs to the production process can often be substitutes for one another. The relative price of each will determine the demand for each factor. MINIMUM WAGE REDUX: Given employers can trade off one productive input for another, if relative prices change, what would happen to the demand for capital if labor rates rise with an increase in the minimum wage? As this chapter’s analysis predicts, many labor intensive jobs will be automated via capital—eliminating the opportunity for low-skilled workers to climb the economic ladder. Marginal product of capital (MP K ): the incremental (additional) output created by adding one unit of capital to the production process while keeping all other factors fixed. FACTOR DEMAND IS DERIVED FROM: • demand for the factor’s output • relative prices of related factors of production