 Land, labour, capital, entrepreneurship, supplies, or intermediate goods, everything that gets used to make this product will refer to as inputs, and the garden ornaments that get produced will refer to as outputs. For the Blakka marker, these inputs are the buildings, the machines, iron rods, the workers, even the lights and water. The output is the range of garden ornaments they produce. The process that changes inputs into outputs is called the production process. And to describe this process, we're going to make use of something called the production function. The production function shows us the maximum amount, the maximum output, a firm can produce with different combinations of inputs. The total output of a business, everything it produces, is called the total product or TP. Inputs can be classified as either fixed inputs or variable inputs. Things like the buildings and the capital, that's all the heavy equipment and machinery, are what we call fixed inputs. They can't be changed overnight, quickly or easily. These fixed inputs generate the fixed cost of production that we looked at earlier. Costs like rent, rates, interest payments on loans and so on. Other inputs, like the iron rods and the labourers employed, are called variable inputs, because they can change fairly quickly and easily. It's these inputs that are behind the variable costs. The difference between these two types of inputs is important, because the amount of fixed inputs affects the firm's freedom to make quick or flexible production decisions in the short run. The difference between a fixed and a variable input is really the difference in the speed at which a firm can change that input. OK, so now we know that firms can change variable inputs quickly. If Blarkermarker wants to produce more ornaments, they need to buy more iron rods and employ more workers. They can pick up the phone, order them and probably have them available the very next day. Fixed inputs, however, are not so easy to change. They could build a new factory, but that could take some time. They might have to secure new loans and investment, arrange to sell this factory, find and buy a new piece of land, contract an architect, then a builder, and then, well, you get the idea. It could take months or even years, and that's why when we look at production, we consider two different time periods. The short run is any period of time in which at least one of our fixed input factors cannot be changed. For instance, the size of the building or the capital equipment. The long run is any period of time in which the firm can change any of the inputs, including the fixed inputs. Decisions a firm makes about the long run are called planning decisions. In the real world, production functions are very complicated things. And to try and understand these complexities, we're going to use some of that old economist magic and make some simplifying assumptions. For now, we'll only deal with the short run. In other words, we will assume the fixed inputs do not change and ignore them for the time being. Now, the law of diminishing returns. This law was one of the first and is still today one of the most important tools we can use to understand and plan the production function for any type of business. To understand the production function, we first need to understand the law of diminishing returns. This famous law was established by a Frenchman, Anne Robert Jacques Turgot, who lived between 1727 and 1780. We'll just call him Turgot. He was one of the pre-eminent economists of the 18th century, a French Adam Smith, if you like, although his work preceded Smith's wealth of nations by about ten years. Many historians believe that if the French King Louis XVI had listened to Turgot instead of firing him, the French Revolution may never have happened and the King might have avoided his abrupt comeuppance. The law of diminishing returns states that as more of a variable input is used in the production process, while the fixed inputs stay the same. Each additional unit of the variable input will eventually produce less and less additional output. In economic language, the marginal product of the variable input declines. Many of the gloomy predictions made by economists during the 20th century were based on this law. They thought, well, agricultural land is a fixed variable, but the population keeps growing, more and more labour is working this fixed limited land, and because of the law of diminishing returns, the additional food produced by each new farm worker is going to get less and less. Oh, my word. Starvation will follow. Life will be brutal and shot. It wasn't a very hopeful picture. Fortunately, these predictions did not materialise due to new methods and innovations in technology in the agricultural sector. Let's see what this law means for Blakomarka. To keep things simple, we will assume that labour is our only variable input. So what is the contribution that each additional worker makes to total product? In other words, what is the marginal product of labour to total production? Column 1 in our table shows the number of workers. By employing the first worker, they can now produce 500 ornaments, so total product is 500. The contribution the first worker makes to total product is therefore 500. This is called the marginal product, which will list in column 3. By adding a second worker, total production increases to 1,500 ornaments. The marginal contribution of the second worker, his addition to total product, is therefore 1,000 units. Now, why is the second worker adding so much more product than the first worker, who only produced 500 units? What we're seeing here is the benefit of specialisation. Before the second worker was employed, worker number one had to do everything, from fetching the rods, bending them, welding them, painting them, and everything else in between. But now, two workers, the tasks are divided between them. Specialisation takes place, we have better efficiency, and the productivity of each worker improves. Now, if we add a third worker, average productivity might increase even more. The USA output increases to 3,000 ornaments. The marginal contribution of the third worker, is therefore 1,500 units. Up to this point, we're seeing increasing returns with each new worker. Adding a fourth worker pushes total production up to 4,000 units. The marginal product of worker number four is 1,000 additional units. Do you see what's happening? The marginal product of the fourth worker is less than the marginal product of the third worker. Diminishing returns are setting in. Using more workers in a limited space like this, we will become inefficient, falling over each other, and it's dangerous. And, as the law says, if we keep adding more of a variable input to the fixed inputs, a point will be reached, where each additional unit of the variable input will eventually produce less and less additional output. In our example, this happened when we added the fourth worker. His marginal product of 1,000 units was less than that of worker three, who added 1,500 units to the company's total production. Why is that? Additional labour only gets more productive when there's enough space, equipment, and raw materials to work with. But in the short run, the blocker marker cannot change the amount of space and equipment it has. These inputs are fixed. All it can change is the number of workers. Adding a fifth worker still increases output up to 4,500 units. But the marginal product of the fifth worker is now only 500 units. And adding a sixth only increases total product to 4,750 units. So the marginal product of the sixth worker is a fairly pathetic 250 units. While the factory is still producing a little bit more, this increase in output is happening at an ever diminishing rate. If they keep on adding workers, they'll eventually reach a point where the additional worker contributes nothing to production. In our example, this happens when worker number seven is employed. This blocker marker persists in employing more and more workers. When they add number eight, they'll see total production actually start to decline. In this case, total output drops to 4,500 units. The marginal contribution of the eighth worker is therefore a negative 250. And we can illustrate this with the help of a graph or diagram. On the horizontal axis, the number of workers is measured. In vertical axis, total output or total product. As more workers are employed, output increases, but only up to a point, after which it starts to decrease. Drawing a smooth curve through these points illustrates this. Adding more of a variable input, labour in our case, to a fixed input, increases total output more and more up to a certain point. And that increases output less and less till it reaches a peak, after which output will start to fall. Let's see what the marginal product curve is telling us. Using the figures from this table, we can compile the following graph. Marginal product first increases, it reaches an optimal point and then starts to decrease and finally becomes negative. This is very clearly demonstrated by the marginal product curve. With this information, we can now also calculate the average product per worker and this will give us some measure of productivity. The average product per worker is simply calculated by dividing the total product by the number of workers employed. In the case of one worker, the average product is 500 divided by 1. Well, that's 500. The average product when there's two workers is 1500 divided by 2, which gives us 750 and so on. These figures are given in column 3. Looking at average product in graphic form, we see that average product first increases, reaches a maximum and then decreases. And if we compare total product with marginal product, we can see three definite phases of production. Phase one is up until point B. The marginal product grows at an increasing rate and the marginal product of each additional worker also keeps rising. Phase two lies between point B and point A. Total product is still growing but at a slowing rate. The marginal product of labour is getting less and less with each additional worker, but the total output is still growing a little. Phase three is everything after point A. Total product is now falling and the marginal product of labour is now actually negative. Looking at these three phases, where would the company ideally like to be in phase one, two or three? Well, definitely not in phase three. In this phase, production declines and the additional workers have a negative contribution. That leaves us with phase one or two. The general principle for most businesses is that as long as total production is growing even if it's only slightly it's fine to keep adding labour. In the short run anyway, that's all the firm can do if it wants to increase output. It's only when extra labour doesn't add any more output that it becomes a real problem. Exactly where in phase two the best position for the firm is will depend on the price of the product and the cost of production.