Marginal Returns To Labor

Look at the vertical arrows in Figure 4, which measure the marginal product of labor, and you may notice something interesting. As more and more workers are hired, the MPL first increases (the vertical arrows get longer) and then decreases (the arrows get shorter). This pattern is believed to be typical at many types of firms, so it's worth exploring.

Increasing Returns to Labor. When the marginal product of labor increases as employment rises, we say there are increasing marginal returns to labor. Each time a worker is hired, total output rises by more than it did when the previous worker was hired. Why does this happen? One reason is that additional workers may allow production to become more specialized. Another reason is that at very low levels of employment, there may not be enough workers to properly operate the available capital. In either case, the additional worker not only produces some additional output as an individual, but also makes all other workers more productive.

At Spotless Car Wash, increasing returns to labor are observed up to the hiring of the second worker. Why? While one worker could operate the car wash alone, he or she would have to do everything: drive the cars on and off the line, towel them down, and deal with customers. Much of this worker's time would be spent switching from one task to another. The result, as we see in Table 1, is that one worker can wash only 30 cars each day. Add a second worker, though, and now specialization is possible. One worker can collect money and drive the cars onto the line, and the other can drive them off and towel them down. Thus, with two workers, output rises all the way to 90 car washes per day; the second worker adds more to production (60 car washes) than the first (30 car washes) by making both workers more productive.

Diminishing Returns to Labor. When the marginal product of labor is decreasing, we say there are diminishing marginal returns to labor: Output rises when another worker is added, but the rise is smaller and smaller with each successive worker. Why does this happen? For one thing, as we keep adding workers, additional gains from specialization will be harder and harder to come by. Moreover, each worker will have less and less of the fixed inputs with which to work.

This last point is worth stressing. It applies not just to labor but to any variable input. In all kinds of production, if we keep increasing the quantity of any one input, while holding the others fixed, diminishing marginal returns will eventually set in. If a farmer keeps adding additional pounds of fertilizer to a fixed amount of land, the yield may continually increase, but eventually the size of the increase—the marginal product of fertilizer—will begin to come down. If a small bakery continues to acquire additional ovens without hiring any workers or enlarging its floor space, eventually the additional output of bread—the marginal product of ovens— will decline. This tendency is so pervasive and widespread that it has the force of a law, and economists have given that law a name:

Diminishing marginal returns to labor The marginal product of labor decreases as more labor is hired.

The law of diminishing (marginal) returns states that as we continue to add more of any one input (holding the other inputs constant), its marginal product will eventually decline.

The law of diminishing returns is a physical law, not an economic one. It is based on the nature of production—on the physical relationship between inputs and outputs with a given technology. At Spotless, diminishing returns set in after two workers have been hired. Beyond this point, the firm is crowding more and more workers into a car wash with just one automated line. Output continues to increase—since there is usually something an additional worker can do to move the cars through the line more quickly—but the increase is less dramatic each time.

This section has been concerned with production—the physical relationship between inputs and outputs. But a more critical concern for a firm is: What will it cost to produce any level of output? Cost is measured in dollars and cents, not in physical units of inputs or outputs. But as you are about to see, what you've learned about production will help you understand the behavior of costs.

Law of diminishing marginal returns As more and more of any input is added to a fixed amount of other inputs, its marginal product will eventually decline.

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