Say you’re a weakling who can only do one push-up rep. You don’t want to do more because you don’t care about your health or your physique at this time in your life. So there’s no incentive for you to do more.
Now say I came along and offered to pay you for each push-up rep you can do by the end of the year. This would be an incentive, and the size of the incentive will determine how hard you’ll be willing to train.
If I were to pay you one penny for each push-up, you wouldn’t do much. Instead, you’d go where you could make more money for your efforts; beg in the streets for example. If I paid you ten dollars for each push-up, you’ll be more willing to practice. You’ll do maybe two, five or ten more push-ups. It won’t make you a lot of money; but it’s enough to motivate you to train when you have free time. If I paid you $1000 for each push-up however, you would quit your job. You will train hard so you can do at least 100 push-ups by the end of the year. The conclusion from this thought experiment is: the more money I’m willing to pay you per push-up, the more motivated you are to make the sacrifices needed to do each additional one.
Firms have a similar mentality. The more money consumers are willing to pay them per unit-of-a-good, the more motivated they are to pay the costs to produce each additional unit.
There are two types of costs: variable and fixed.
Variable costs increase when a producer makes more of a good. For example, as I make more rice, I need to buy more raw rice grains.
Fixed costs are constant regardless of production volume. No matter how much rice I make, the rent for my store will cost $1000 a month.
A businessman has the ability to reduce average fixed costs per product. If I make 1,000 grains of rice in a month, then the average cost coming from rent for each grain would be one dollar (1000 dollars of rent divided by 1000 grains equals 1 dollar of rent per grain). If I make 1,000,000 grains in a month however, then the average cost of rent would just be .1 cents per grain. By making the most out of a fixed cost, businesses can save a lot of money!
Here are more general examples of variable and fixed costs:
In the long run, fixed costs can be considered variable because firms can adjust them according to how much they want to produce. They can buy more machines or open a new location for example, to supply more of their product.
This usually doesn’t happen in the short run because buying fixed costs requires money and risk. I wouldn’t buy a new stove or open a new location unless I knew I could make a lot out of those fixed costs in the long-run.
Businessmen want to make the most out of fixed costs, but there’s a limit to how much they can make. In a given day, there’s a limited amount of people a building can hold. There’s a limited amount of material a machine can convert. There’s a limited amount of energy a person can use. Despite how much they would like to, businessmen can’t make an unlimited amount of product out a single fixed input. Eventually, productivity decreases.
Say you want to build a brick wall. If you work by yourself, you can add 12 bricks, every hour. When you get a partner, you two can add 24 bricks per hour (that’s 12 bricks each person). When you get another worker, you all add 36 bricks per hour (that’s still 12 bricks each). When you get a fourth person though, you guys only add 44 bricks per hour (11 bricks each). When you add a fifth person, you only add 50 bricks per hour (10 bricks each).
What happened? Why did the production rate start to go down as you added more workers? The marginal product of the first three workers was a consistent 12 bricks per hour, but the marginal product of the fourth was 8 bricks (going from 36 to 44) and the fifth was 6 bricks (from 44 to 50). Why did they slow down?
It’s because the fixed space was limited. Eventually, as you add more workers, they start to block and bump into each other more often, and they thus prevent their co-workers from being fully productive.
This is known as The Law of Diminishing Returns. To put it into words: as you add a single factor of production, when every other factor is constant, production will eventually experience diminishing returns (in the form of less product per additional input).
A businessman usually stops adding an input when the last additional one gives a return equal to the cost of the input. For example, if you pay your workers 20 dollars an hour, and the tenth worker has a marginal product of 20 dollars an hour, then assuming you’re at diminishing returns, you won’t hire an eleventh worker because he will make you 19.99 or less. This means the cost of the additional worker would exceed the value he’s creating.
When starting my (fake) store, I knew that in order to produce more rice, I would have to either take a risk by buying more fixed capital, or add variable inputs while experiencing diminishing returns. With this in mind, I decided that if I was going to produce more rice per customer, then I would have to be compensated by a higher retail price.
If I had to make 250 grains of rice per customer, I wanted to be paid at least one cent per grain. If I had to make 500 per customer, I wanted at least 2 cents per grain. If I had to make 750 per customer, I wanted at least 3 cents per grain. Through this, I learned about the law of supply.
The Law of Supply states: as the price of a product increases, the quantity producers are willing to supply increases [and vice versa]. This is partly because a high price is an incentive to work harder. But it’s also because a high price covers the increasings costs and risks of high production.
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