UNIT 3:

Cost Concepts
a) Accounting Cost v/s Economic Cost
b) Money Copt v/s Real Cost
c) Private and Social Costs
d) Fixed Cost v/s Variable Cost
e) Opportunity Cost
f) Sunk Cost

Production Function
a) Law of variable production function
b) Returns to Scale
c) Economies of scale. External economies and diseconomies

Cost of Production in Short Run

a) Average Fixed Cost, Average Variable Cost, and Marginal Cost
b) Relationship between Marginal Cost and Average Cost

Cost of Production in Long run

Long run Marginal Cost (LMC) and Long run Average cost (LAC)

Revenue Concepts –
Average Revenue, Marginal Revenue and Total Revenue.

Productivity Concept-
Total, Average and Managerial Productivity
  COST CONCEPTS:
Accounting Cost and Economic Cost

Accounting Cost includes all such business expenses that are recorded in the
book of accounts of a business firm as acceptable business expenses. Such
expenses include expenses like Cost of Raw Material, Wages and Salaries,
Various Direct and Indirect business Overheads, Depreciation, Taxes etc. When
such business expenses or accounting expenses are deducted from the Sales
income of any firm the accounting profit is obtained. Such Accounting/Business
expenses or costs are also termed as Explicit Costs.

 Accounting Cost: Various allowed business expenses. Such as Cost of

Raw Material, Salaries and Wages, Electricity Bill, Telephone Charges,
Various Administrative Expenses, Selling and Distribution Expenses,
Production Overhead Expenses, Other Indirect Overhead Expenses etc.
 Accounting Profit = Sales Income - Accounting Cost

Economic Cost on the other hand includes all the accounting expenses as well
as the Opportunity cost of a business firm. Economic Cost and Economic Profit
is thus calculated as follows:

 Economic Cost = Accounting Cost (Explicit Costs) + Opportunity Cost

 Economic Profit = Total Revenues - (Accounting Cost + Opportunity
Cost)

Money cost and Real cost:

Money Cost of production is the actual monetary expenditure made by

company in the production process. Money cost thus includes all the business
expenses which involve outlay of money to support business operations. For
example the monetary expenditure on purchase of raw material, payment of
wages and salaries, payment of rent and other charges of business etc. can be
termed as Money Cost.

Real Cost of production or business operation on the other hand includes all
such expenses/costs of business which may or may not involve actual monetary
expenditure. For example if owner of a business venture uses his personal land
and building for running the business venture and he/she does not charge any
rent for the same then such head will not be considered/included while
computing the Money Cost but this head will be part of Real Cost computation.
Here the cost involved is the Opportunity Cost of the land and building. If the
promoter of the company had not used the land and building for the business
venture then the land and building could have been used elsewhere for some
other venture and could have generated some income for the promoter. This
income/rent which could have been earned under the next best investment
option is the opportunity cost which needs to be considered while calculating
the Real Cost for the firm.

Case study:

 A company 'Arizona Textiles limited' is producing cotton textiles.

Various business expenses on per annum basis are as follows: Power
Charges - Rs. 5, 00, 00, Cost of Yarn - Rs. 10, 00, 000, Salaries and
Wages - Rs. 8, 00, 000, Various Direct and Indirect Overhead Expenses -
Rs. 10, 00, 000. The company is not paying any rent for the building from
where it is operating as the building is owned by the promoter of the
company. If this building had been rented out by the promoter in the
market then it could have earned a rent of Rs. 2,00,000 per annum.

In the above case Money Cost is Rs. 33, 00,000, obtained after adding the
following: Power Charges, Cost of Yarn, Salaries and Wages, Various Direct
and Indirect Overhead Expenses.

On the other hand Real Cost is Rs. 35, 00,000, which has been obtained after
adding the following: Money Cost plus the rent which the building belonging to
the promoter could have earned in outside market.

Private and social cost

The actual expenses of individuals/ firms which are borne or paid out by the
individual or a firm can be termed as Private Cost. Thus for a business firm this
may include expenses like Cost of Raw Material, Salaries and Wages, Rent,
Various Overhead Expenses etc.

On the other hand Private Cost for an individual will be his or her private
expenses such as expense on food, rent of house, expenses on clothing,
expenses on travel, expenses on entertainment etc.

Social Cost on the other hand includes Private Cost and also such costs which
are not borne by the firm but by the society at large. For example the cost of
damage or disutility caused by the operations of a firm in an economy may not
be borne by the firm in question but it impacts the society at large and thus such
cost is added to the Private Cost to find the Social Cost of producing the
product. Such Cost (that is cost not borne or paid out by the firm) is also known
as External Cost. Another example of external cost can be the cost of providing
the basic infrastructure facilities like good roads, sewage system or network,
street lights etc. Cost of such facilities is not borne by a business firm even
though the firm is benefits from such facilities. Such costs (External Costs) are
thus added to the Private Cost to find the Social Cost of producing a product or
good.

Above can be understood by following example: If a Tannery firm (A firm

processing animal skins) releases its toxic wastes in the river flowing nearby its
factory premises then this act of the Tannery firm results in water pollution and
environmental damage. The Cost of such damage/loss (also known as External
Cost) is added to the private costs of the tannery firm to get fair idea of Social
cost involved in the production of the product in question.

Social Cost of an individual will include his private cost and the cost of damage
on account of his actions (that has resulted in doing harm/damage to the
environment/society at large).

Case study

 A Company, 'Giga Dyes and Chemicals limited' is producing chemical

dyes that are being used in various industrial activities. Various
production expenses are as follows: Cost of Raw Material - 5, 00, 000,
Salaries and Wages - Rs. 9, 00, 000, Various Direct and Indirect
Overhead Expenses - Rs. 12, 00, 000, Selling and Distribution Expenses -
Rs. 4, 00, 000. The by-product of the production process of chemical dyes
produced by Giga Dye are certain toxic chemicals which are being
released by 'Giga Dye and Chemicals' directly into a river flowing near
the Dye manufacturing plant. This is polluting the river and killing the
organic life thriving in as well as near the river. The cost of loss to the
environment caused by Giga is estimated to be Rs. 20, 00, 000 per
annum.

In the above case, the Private Cost for 'Giga Dye and Chemicals Limited is Rs.
30,00, 000. This is sum total of various business expenses of Giga such as Cost
of Raw Material, Salaries and Wages Overhead Expenses and Selling and
Distribution Expenses.
On the other hand Social Cost is Rs. 50, 00, 000. This includes the cost of
damage to the environment caused by the activities of the firm. Thus Social cost
is Private Cost + External cost. In this case this is = 30, 00, 000 + 20, 00, 000

Fixed cost, variable cost, average cost and marginal cost.

Fixed Cost is that cost which does not change (that is either goes up or goes
down) irrespective of whether the firm is operating or not. For example on
account of Strike on account of Lockout in Maruti-Suzuki’s Manesar plant the
production process stands still. Even when the plant is not operating the Firm
still has to bear such expenses which are indirect in nature. For Example Rent of
the factory premises, Wages of administrative employees etc. In other Fixed
cost is not related direct production/manufacturing expenses.

Variable Cost on the Other hand is directly proportional to the production

operations. As the size of production at any business grows, along with that
grow the variable expenses. As the name suggests, the variable expenses vary
with the business operations. When the firm is not operating on account of
Strike/Lockout etc, then the variable cost of the firm is Zero

Average Cost is the cost that is obtained after dividing Total Cost with the
number of units produced.

 Total Cost = Fixed Cost + Variable Cost

 Average Cost = Total Cost / Units of Good produced

Marginal Cost is the change in the Total cost when an additional unit of good
is produced. In other words Marginal Cost is difference between total Cost of
producing ‘N + 1’ units of good and ‘N’ units of good.

 Marginal Cost = TC (n) - TC(n-1)

Following table can help in understanding the cost concepts like Total Cost
(TC), Average Cost (AC), and Marginal Cost (MC) etc.

Understanding Fixed, Variable, Total, Average and Marginal Cost

Number
Fixed Variable Total Average Marginal
of Units
Cost Cost Cost Cost Cost
Produced

1 10 5 15 15 15

2 10 10 20 10 5

3 10 17 27 9 7

4 10 30 40 10 13

5 10 45 55 11 15

In the above table, it is clearly visible that Fixed cost (which is 10) remains
same irrespective of the number of units of the good being produced. On the
other hand the Variable Cost is increasing as the number of units of good being
produced is increasing. Thus, Variable Cost is going up from 5 to 10 and from
10 to 17 etc as the number of units of good being produced is increasing.

Again it can be seen from the above table that Total Cost is the sum total of
Fixed Cost and Variable Cost. Thus Total Cost is 15 for the first unit (where 10
is Fixed Cost and 5 is Variable Cost). Again for producing 2 units, the Total
Cost is 20 (where 10 is Fixed Cost and remaining 10 is the Variable Cost).

Above Table also clearly indicates that the Average Cost is being obtained by
dividing Total Cost with the number of units of good being produced. Thus for
the first unit of good being produced it is 15. This value has been obtained by
dividing Total Cost (15) with the number of units of good produced (1).
Similarly, the Average Cost of producing two units is 10, which is obtained by
dividing Total Cost (20) with number of units produced (2).
On the other hand Marginal Cost is the change in the total cost when an
additional unit of good is being produced. Thus for the first unit of good being
produced, it is 15. This value is obtained by deducting from the Total Cost of
producing 'One' unit of good (15) the Total Cost of producing 'Zero' units of
good. For producing the second unit, the marginal cost is 5. This is obtained by
deducting from the Total Cost of producing 'two' units of good (20) the Total
Cost of producing 'one' unit of good (15).

Opportunity cost

The resources of any firm operating in the market are limited and investment
options are many. The firm therefore has to decide or select only those
investment opportunities/options which provide the firm with the best return or
best income on investment. This means that if a firm can invest money/
resources only in one investment option then the firm will select that investment
option which promises best return on investment to the firm. In other words
while doing so the firm gives up/rejects the next best option for investing the
funds. The opportunity cost of a company is thus this income/ return which the
firm could have earned on the next best investment alternative.

This can also be understood by a simple example - Let us assume that an

individual has two job offers in hand. One job offer is promising him a salary of
Rs. 30, 000 per month while the other job offer will ensure salary of Rs. 25, 000
per month. If the job profile and other factors related to the job offers are more
or less same then it can be easily expected that the individual will select the job
offer which will provide him with higher salary that is salary of Rs. 30, 000 per
month. Thus, in this case, the opportunity cost is the return involved in the next
best alternative i.e; Salary of Rs. 25, 000 in the next best job offer.

Concept of opportunity cost is closely related to the concept of Economic profit

or Economic Rent. A firm earns or makes Economic profit only when besides
covering various costs of operation, a firm is also able to earn more than its
opportunity cost (or its possible earnings under the next best investment
alternative). Opportunity Cost is also termed as Implicit Cost.

Economic Profit is thus earned only when following is true for the Firm:

Income of a Firm > Various Costs of Operations + Opportunity Cost

OR Economic Profit = Earnings or Revenue of Firm - Economic Costs. Here

Economic Cost is various expenses of the business plus the opportunity cost
Some simple examples of Opportunity Cost and Economic Profit are discussed
in following three brief case studies.

Sunk cost

Sunk costs cannot be recovered if a business decides to leave an industry.

Examples include:
* Capital inputs that are specific to an industry and which have little or no resale
value.
* Money spent on advertising, marketing and research and development
projects which cannot be carried forward into another market or industry.
When sunk costs are high, a market becomes less contestable. High sunk costs
act as a barrier to entry of new firms because they risk making huge losses if
they decide to leave a market. In contrast, markets such as fast-food restaurants,
sandwich bars, hairdressing salons and local antiques markets have low sunk
costs so the barriers to exit are low.

Asset-write-offs – e.g. the expense associated with writing-off items of plant

and machinery, stocks and the goodwill of a brand Closure or project
cancellation costs including redundancy costs, contract contingencies with
suppliers and the penalty costs from ending leasing arrangements for property.

The loss of business reputation and goodwill - a decision to leave a market can
seriously affect goodwill among previous customers, not least those who have
bought a product which is then withdrawn and for which replacement parts
become difficult or impossible to obtain.
A market downturn may be perceived as temporary and could be overcome
when the economic or business cycle turns and conditions become more
favorable.

Average variable cost and average fix cost and marginal cost

Average variable cost

The average variable cost (AVC) is the total variable cost per unit of output.
This is found by dividing total variable cost (TVC) by total output (Q). Total
variable cost (TVC) is all the costs that vary with output, such as materials and
labor. The easiest way to determine if a cost is variable is if the output changes,
the cost changes as well.
Profit-maximizing firms will use the AVC to determine at what point they
should shut down production in the short run. If the price they are receiving for
the good is more than the AVC given the output they are producing, then they
are at least covering all variable costs and some fixed costs. Fixed costs are
those costs incurred that do not vary with production; they are fixed at a certain
price no matter how much is produced. The best example is rent on the space
used to produce the good or provide the service. It doesn't matter how many
units you produce or customers you serve, the rent will always remain the same.
Therefore even if you are producing zero, as would be the case if you shut down
production, you will still have to pay the fixed costs.

As long as price is above the AVC and covering some of the fixed costs, you
are better off continuing production. If the price falls below the AVC, then the
firm may decide to shut down production in the short run because the price is no
longer covering any portion of the fixed costs or all of the variable costs.
Therefore the firm would rather not incur any variable costs and just pay the
fixed costs.

Average fix cost

Average fixed cost is the total fixed cost per unit of output incurred when a firm
engages in short-run production. It can be found in two ways. Because average
fixed cost is total fixed cost per unit of output, it can be found by dividing total
fixed cost by the quantity of output. Alternatively, because total fixed cost is the
difference between total cost and total variable cost, average fixed cost can be
derived by subtracting average variable cost from average total cost.

Average fixed cost decreases with additional production. The logic behind this
relation is relatively simple. Because fixed cost is FIXED and does not change
with the quantity of output, a given cost is spread more thinly per unit as
quantity increases. A thousand dollars of fixed cost averages out to $10 per unit
if only 100 units are produced. But if 10,000 units are produced, then the
average shrinks to a mere 10 cents per unit.

Average fixed cost, when combined with price, indicates whether or not a firm
should shut down production in the short run. If price is greater than average
fixed cost, then the firm is able to pay, at least, fixed cost. Even though it might
be incurring an economic loss, it will lose less by producing than by shutting
down production. If, however, price is less than average fixed cost, then the
firm is better off shutting down production.
Calculating Average Fixed Cost
The standard method of calculating average fixed cost is to divide total fixed
cost by the quantity of output, illustrated by this equation:
total fixed cost
average fixed cost =
quantity of output

An alternative specification for average fixed cost is found by subtracting

average variable cost from average fixed cost:

Relationship between marginal cost and average cost of production in long

run

The relationship between the marginal cost and average cost is the same as that
between any other marginal-average quantities. When marginal cost is less than
average cost, average cost falls and when marginal cost is greater than average
cost, average cost rises. Suppose that a cricket player’s batting average is 50. If
in his next innings he scores less than 50, say 45, then his average score will fall
because his marginal (additional) score is less than his average score.

If instead of 45, he scores more than 50, say 55, in his next innings, then his
average score will increase because now the marginal score is greater than his
previous average score. Again, with his present average runs of 50, if he scores
50 also in his next innings, then his average score will remain the same because
now the marginal score is just equal to the average score.

Likewise, suppose a producer is producing a certain number of units of a

product and his average cost is Rs. 20. Now, if he produces one unit more and
his average cost falls, it means that the additional unit must have cost him less
than Rs. 20. On the other hand, if the production of the additional unit raises his
average cast, then the marginal unit must have cost him more than Rs. 20.

And finally, if as a result of production of an additional unit, the average cost

remains the same, then marginal unit must have cost him exactly Rs. 20, that is,
marginal cost and average cost would be equal in this case.

The relationship between average and marginal cost can be easily remembered
with the help of Fig. 19.4. It is illustrated in this figure that when marginal cost
(MC) is above average cost (AC), the average cost rises, that is, the marginal
cost (MC) pulls the average cost (AC) upwards.

On the other hand, if the marginal cost (MC) is below the average cost (AC);
average cost falls, that is, the marginal cost pulls the average cost downwards.
When marginal cost (MC) stands equal to the average cost (AC), the average
cost remains the same, that is, the marginal cost pulls the average cost
horizontally.

Now, take Fig. 19.5 where short-run average cost curve AC and marginal cost
curve MC are drawn. As long as short-run marginal cost curve MC lies below
short-run average cost curve, the average cost curve AC is falling. When
marginal cost curve MC lies above the average cost curve AC, the latter is
rising.
At the point of intersection L where MC is equal to AC, AC is neither falling
nor rising, that is, at point L, AC has just ceased to fall but has not yet begun to
rise. It follows that point L, at which the MC curve crosses the AC curve to lie
above the AC curve is the minimum point of the AC curve. Thus, marginal cost
curve cuts the average cost curve at the latter’s minimum point.

It is important to note that we cannot

generalise about the direction in which
marginal cost is moving from the way
average cost is changing, that is, when
average cost is falling we cannot say that
marginal cost will be falling too. When
average cost is falling, what we can say
definitely is only that the marginal cost will be below it but the marginal cost
itself may be either rising or falling.

Likewise, when average cost is rising, we cannot deduce that marginal cost will
be rising too. When average cost is rising, the marginal cost must be above it
but the marginal cost itself may be either rising or falling. Consider Fig. 19.5
where up to the point K, marginal cost is falling as well as below the average
cost.

As a result, the average cost is falling. But beyond point K and up to point L
marginal cost curve lies below the average cost curve with the result that the
average cost curve is falling. But it will seen that between K and L where the
marginal cost is rising, the average cost is falling.

This is because though MC is rising between K and L, it is below AC. It is

therefore clear that when the average cost 4 is falling, marginal cost may be
falling or rising. This can also be easily illustrated by the example of batting
average.

Suppose a cricket player’s present batting average is 50. If in his next innings he
scores less than 50, say 45, his batting average will fall. But his marginal score
of 45, though less than the average score may itself have risen.

For instance, he might have scored 40 in his previous innings so that his present
marginal score of 45 is greater than his previous marginal score. Thus one
cannot deduce about marginal cost as to whether it will be falling or rising when
average cost is falling or rising

Long run Marginal Cost (LMC) and Long run Average cost (LAC)

Since marginal cost curve is important both from the viewpoint of the short run
and the long run, it will be useful to know how the long-run marginal cost curve
is derived.

The long-run marginal cost curve can be directly derived from the long-run total
cost curve, since the long-run marginal cost at a level of output is given by the
slope of the total cost curve at the point corresponding to that level of output.

Besides, the long-ran marginal cost curve can be derived from the long-run
average cost curve, because the long-ran marginal cost curve is related to the
long-run average cost curve in the same way as the short-ran marginal cost
curve is related to short-run average cost curve. In Fig. 19.12, it is depicted that
how the long-run marginal cost curve LMC is derived from a long-run average
cost curve LAC enveloping a family of short-run average and marginal cost
curves.
 If the output OA is too
produced in the long ran,
then it must be produced on
the long-run average cost
curve LAC at point H which
is a tangency point with the
short-run average cost curve
SAC1. Thus, when output
OA is to be produced in the
long run, it will be produced
with the plant corresponding to the short-run average cost curve SAC1 and the
short-run marginal cost curve SMC1.

Corresponding to the tangency point H between the short-run average cost

curve SAC1 and the long-run average cost curve LAC, there is a point N on the
short run marginal cost curve SMC. This means that the production of output
OA in the long run involves the marginal cost AN. Therefore point N must lie
on the long-run marginal cost curve corresponding to output OA. If output OB
is to be produced in the long run, it will be produced at point Q which is the
tangency point between LAC and SAC2.

Q is also the point on the short-run marginal cost curve SMC2, corresponding to
output OB. (Q is the common point between SAC 2 and SMC2 because Q is the
minimum point of SAC2, at which the SMC2, cuts it from below). Thus Q must
also lie on the long-run marginal cost curve corresponding to output OB.
Similarly, if output OC is to be produced in the long run, it will be produced at
point M which is the tangency point between LAC and SAC 3 Corresponding to
point M, the relevant point on the SMC3 is K which means that the long-run
marginal cost of producing OC is CK.
Thus point K must lie on the long-run marginal cost curve corresponding to
output OC. By connecting points N, Q and K we obtain the long-run marginal
cost curve LMC. It will be seen from Fig. 19.12 that the long-run marginal cost
curves is flatter than the short-run marginal cost curves.

It should also be remembered that the relationship between the long-run

marginal cost curve LMC and the long-run average cost curve LAC is the same
as that between the short-run marginal cost curve and the short -run average
cost curve.

Thus, when the long-run marginal cost curve LMC lies below the long-run
average cost curve, the latter will be falling, and when the long-run marginal
cost curve lies above the long-run average cost, the latter will be rising. When
the long- run marginal cost is equal to the long- run average cost, the latter will
be neither rising nor falling.

Total, Average and Marginal Revenue

The term revenue refers to the income obtained by a firm through the sale of
goods at different prices. In the words of Dooley, ‘the revenue of a firm is its
sales, receipts or income’.

The revenue concepts are concerned with Total Revenue, Average Revenue and
Marginal Revenue.

1. Total Revenue:

The income earned by a seller or producer after selling the output is called the
total revenue. In fact, total revenue is the multiple of price and output. The
behavior of total revenue depends on the market where the firm produces or
sells.

“Total revenue is the sum of all sales, receipts or income of a firm.” Dooley
Total revenue may be defined as the “product of planned sales (output) and
expected selling price.” Clower and Due

“Total revenue at any output is equal to price per unit multiplied by quantity
sold.” Stonier and Hague

2. Average Revenue:

Average revenue refers to the revenue obtained by the seller by selling the per
unit commodity. It is obtained by dividing the total revenue by total output.

“The average revenue curve shows that the price of the firm’s product is the
same at each level of output.” Stonier and Hague

3. Marginal Revenue:

Marginal revenue is the net revenue obtained by selling an additional unit of the
commodity. “Marginal revenue is the change in total revenue which results
from the sale of one more or one less unit of output.” Ferguson. Thus, marginal
revenue is the addition made to the total revenue by selling one more unit of the
good. In algebraic terms, marginal revenue is the net addition to the total
revenue by selling n units of a commodity instead of n – 1.

Therefore,

Total, Average and Managerial Productivity

Total Product:
Total product of a factor is the amount of total output produced by a given
amount of the factor, other factors held constant. As the amount of a factor
increases, the total output increases. It will be seen from Table 16.1 that when
with a fixed quantity of capital (K), more units of labour are employed total
product is increasing in the beginning.

Thus, when one unit of labour is used with a given quantity of capital 80 units
of output are produced. With two units of labour 170 units of output are
produced, and with three units of labour total product of labour increases to 270
units and so on.

After 8 units of employment of labour total output declines with further increase
in labour input. But the rate of increase in total product varies at different levels
of employment of a factor. Graphically the total product curve is shown by TP
curve in Fig. 16.1. It will be seen that in the beginning total product curve rises
at an increasing rate, that is, the slope of the TP curve is rising in the beginning.

After a point total product curve starts rising at a diminishing rate as the
employment of the variable factor is increased. The fact that ultimately total
product increases at a diminishing rate has been proved by empirical evidence,
as shall be seen later in our discussion of the law of diminishing returns.

2. Average Product:

Average product of a factor is the total output produced per unit of the factor
employed. Thus,

Average Product = Total Product/Number of units of a factor employed

If Q stands for total product, L for the number of a variable factor

employed, then average product (AP) is given by:
AP = Q/L

We can measure the average product from the total product data given in Table
16.1. Thus when two units of labour are employed, the average product is Q/L =
170/2 = 85. Similarly, when three units of labour are employed, average product
is 270/3 = 90 and so on.

From a total product curve TP in Fig. 16.1, we can measure the average product
of labour. Thus, when OL1 units of labour are employed, total product is equal
to L1A and therefore average product of labour equals L1A/OL1 which would be
equal to the slope of the ray OA. Similarly, when OL2 units of labour are
employed, total product (TP) is L2B
which would give us average product to
be equal to L2A/OL2 the slope of the
ray OB. Further, with the employment
of labour equal to OL1 the average
product will be measured by the slope
of the ray OC.

It has been generally found that as more

units of a factor are employed for
producing a commodity, the average product first rises and then falls. As shall
be seen from Table 16.1 and the Fig. 16.1, the average product curve of a
variable factor first rises and then it declines. That is, the average product curve
has an inverted U-shape.

3. Marginal Product:

Marginal product of a factor is the addition to the total production by the

employment of an extra unit of a factor. Suppose when two workers are
employed to produce wheat in an agricultural farm and they produce 170
quintals of wheat per year.

Now, if instead of two workers, three workers are employed and as a result total
product increases to 270 quintals, then the third worker has added 100 quintals
of wheat to the total production. Thus 100 quintals is the marginal product of
the third worker.

It will be seen from Table 16.1 that marginal product of labour increases in the
beginning and then diminishes. Marginal product of 8th unit of labour is zero
and beyond that it becomes negative.

Mathematically, if employment of labour increases by ∆L units which yield an

increase in total output by ∆Q units, the marginal physical product of labour is
given by ∆Q/∆L. That is,

MPL = ∆Q/∆L

The marginal physical product curve of a variable factor can also be derived
from the total physical product curve of labour. At any given level of
employment of labour, the marginal product of labour can be obtained by
measuring the slope of the total product curve at a given level of labour
employment. For example, in Fig. 16.2 when OL1 units of labour are employed,
the marginal physical product of labour is given by the slope of the tangent
drawn at point A to the total product curve TP.

Again, when OL2 units of labour are employed, the marginal physical product
of labour is obtained by measuring the slope of the tangent drawn to the total
product curve TP at point B which corresponds to OL2 level of labour
employment and so on for further units of labour employed.
 The marginal product of a factor
will change at different levels of
employment of the factor. It has
been found that marginal product
of a factor rises in the beginning
and then ultimately falls as more
of it is used for production, other
factors remaining the same.

That is why in Fig. 16.2 marginal

product (MP) of labour as measured by the slopes of the tangents drawn to the
total product curve TP at various points has been shown to be rising in the
beginning and then diminishing till it becomes zero at the maximum point G of
the total product curve.

Thereafter, the marginal product of labor becomes negative. The relationship

between average product and marginal product and how both of them are
related to the total product will be explained in detail in our analysis of the law
of variable proportions.