Marginal Returns and Productivity | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Welcome back as we shift our study from demand analysis to supply analysis. In this lesson, we shall learn the law of diminishing marginal returns.

Factors of Production

Imagine you are running a cafe. The product of your cafe is serving coffee, and obviously, you need several inputs to make that happen. In economics terms, we call these inputs the factors of production, which can include:

• Land – which, in this case, is the physical space you own or rent to house your cafe.
• Labour – this includes all workers that you hire, from unskilled to top management.
• Physical capital – sometimes called plant and equipment. In your case, this includes the coffee machine, tables, chairs, and kitchen equipment. Note that this does not include financial capital.
• Materials – which refers to the inputs that make the production possible. This should include the coffee beans, milk, water, and electricity.

For simplicity, economists typically concentrate on just two of these, labor and physical capital, denoted by letters L and K.

Short Run vs. Long Run

It is important at this juncture that we learn the economics perspective of short run versus long run for a firm:

• Short run refers to the time period over which some factors of production are fixed. Typically, we assume that capital (K) is fixed in the short run because a firm takes time to change its scale of operations. This is usually valid because leases are fixed and need to be fulfilled, and physical expansion of operations takes time.
• Long run, however, all factors of production are variable. The firm can let its leases expire and sell its equipment, and raise new financial capital to expand operations.

Productivity Measures

For your cafe, the total production should be a function of the labor and capital input. In the short run, we assume that capital is fixed as it is hard to expand given the constraints of the space and funding. The quantity of labor is the only variable that affects the total production in the short run.

Before we proceed, let’s first define 3 terms:

• Total product (Q) is simply the total output in a period. In this case, we define it as the number of cups of coffee served in a day.
• Average product (AP) is the total output per unit of input. In this case, it is the number of coffee served per unit of labour.
• Marginal product (MP) is the amount of additional product resulting from using one more unit of input. In this case, this is measured by the change in the number of coffee served, divided by the change in the quantity of labour.

Diminishing Marginal Productivity of Labour

When analyzing the marginal productivity of labor, there are three distinct stages:

1. When the labor input is smaller, marginal productivity is increasing. The slope of the output curve increases at this stage.
2. When the labor input gets larger, the marginal productivity is decreasing. The slope of the output curve decreases at this stage.
3. For some companies, marginal productivity can become zero, or even negative. The output curve hits a maximum and starts to dip beyond that.

Let’s observe how these 3 measures change when we vary the amount of labor input:

1. When you don’t hire any workers, there’s unlikely to be any coffee served.

2. When you hire just 1 employee for a start, this employee is overwhelmed by taking all 3 roles of cooking, serving, and cleaning. The production suffers, and the cafe can only serve 20 cups of coffee a day.

3. If you employ a second employee, productivity is improved. The cafe serves 50 cups a day, and the average product increases to 25 cups per employee. The marginal product is 30 cups because the output has increased by 30 cups from hiring one additional employee.

4. If you employ a third employee, productivity is improved further as each employee has their specialized role. The cafe serves 90 cups a day, and the average product is now 30 cups per employee. Marginal product is 40 cups. So far, you should be quite pleased as hiring more employees has been improving productivity, with the average product and marginal product both increasing.

5. However, if you hire the fourth, fifth, and sixth employees, you will find that the increase in output starts to slow. This means that the benefit from hiring gets progressively lesser, as can be seen by the declining average product and marginal product.

6. And when you add the seventh employee, you may find that the output remains the same, so the marginal product is zero. This may be due to the cafe reaching its maximum capacity.

7. In some cases, adding even more employees may result in a drop in output, giving us a negative marginal product. This may be due to your cafe becoming so crowded with employees that productivity is reduced.

So as you can see, this is the main takeaway for this lesson. This is what is known as the diminishing marginal productivity of labor, where in the short run, the additional output from each additional worker decreases progressively.