Q.
Differentiate between fixed cost and variable cost.
(5 marks, 2012 Q3b)
How are they inter-play with the law of diminishing marginal return in various production stages?
A.
Fixed costs are costs that are independent of output. These remain constant throughout the relevant range and are usually considered sunk for the relevant range (not relevant to output decisions). Fixed costs often include rent, buildings, machinery, etc.
Variable costs are costs that vary with output. Generally variable costs increase at a constant rate relative to labor and capital. Variable costs may include wages, utilities, materials used in production, etc.
When a worker is able to produce 10 units of output, increasing the number of workers and assuming other resources are not limiting, the production will increase more than double - i.e. two workers would produce output of more than 2x10=20, may be 30. This is because they can specialise or work in team.
Hence, this is increasing marginal output - from 0 to 1 worker, output was 10, but from 1-2 worker, output increased by 20 (30-10). The marginal product (MP) has increased. This is a scenario in the Stage I of the production stage.
[In economics and in particular neoclassical economics, the marginal product or marginal physical product of an input (factor of production) is the extra output that can be produced by using one more unit of the input (for instance, the difference in output when a firm's labor usage is increased from five to six units), assuming that the quantities of no other inputs to production change. [1]]
As more and more workers are employed, variable costs increases and marginal product increases even more up to a maximum point where other fixed costs (land, machinery) or variable costs (raw material, electricity) become limiting. From this point onwards, marginal gain became restricted. This is the maximum of Marginal Product (MPmax).
If even more workers are being added to the production, their productivity in fact become impaired. They have limited space to move, limited tools to use and inhibit each other for carrying out their normal function. This is the beginning of 'diminishing marginal return'. As such, it can become negative as the work place becomes dysfunctional. They can even produce less than the initial stage as a smaller work force could easily manage the space and reach to their tools, hence producing at a higher efficiency. At this negative marginal return stage 10 workers can't even produce what previously 1 worker could produce.
Let's give an example, 10 workers may only product 80 units of output. This means average of 8 units per worker (AP = 8), which is although less than 10 (the production capacity of the first worker), still a positive figure.
However, let's say we increase the workers to 12 persons, the Total Product (TP) is now 90, the marginal increase is 10 units of output with two new workers, ie 5 per worker. Now, the marginal gain has become less than Average Product (AP) by 3 (-3), and less than the normal production capacity of 10 per worker when first worker was employed, ie a negative 5 (-5) marginal gain. Thus, the MP line crossed to the negative range.
At this point, Average Product output is still positive, but the marginal product output has become negative! Total product output (TP) has declined!
Variable Costs and Fixed Costs from Economics.fundamentalfinance.com at http://economics.fundamentalfinance.com/micro_costs.php
Own account for discussion on inter-play with Production Stages and Diminishing Marginal Return.
Marginal Product definition from Wikipedia at http://en.m.wikipedia.org/wiki/Marginal_product