The marginal product is the change in the production output resulting from a change in a production input. When companies calculate the marginal product, they must hold all factors, with the exception of the increase in units of labor, constant. This means that only the units of labor change and other factors such as property, plants and equipment available for production remain the same.
Calculating the marginal product allows companies to see the increase in the number of items produced per one unit of labor added. The definition of one labor unit can vary by company, but typically, one employee is one labor unit. The goal for the company is to find the number of employees it must hire to achieve maximum production and maximum revenue. Too few employees means you won't have enough to be productive. Too many employees means you'll spend more than you're bringing in. Both are a problem for any growing business.
Marginal Product Formula
The marginal product formula is the change in quantity (Q) of items produced divided by the change in one unit of labor (L) added (change in Q divided by change in L). The denominator in this equation is always one because the formula is based on each one unit of increase in labor. Companies can just as easily find the marginal product by subtracting the previous quantity of items produced from the current quantity of items produced.
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Marginal Product Example
A hat maker finds that he can produce five hats a day. After hiring an employee, he finds that his shop can produce a total of eight hats a day. The change in labor units is one. The change in the quantity of times produced is three (8 – 5 = 3). This is the numerator of the equation. The denominator is one. The marginal product in this example is 3/1 = 3.
Marginal Costs and Revenue
As a company hires each new employee, it incurs increased labor costs, called marginal costs. At the same time, the company is increasing its marginal product. This translates into an increase in revenue, called marginal revenue productivity. When marginal costs and marginal revenue productivity are equal, the company stops hiring new employees. If the company continues to hire employees after this point, its marginal product and revenue decrease while the cost of daily operations increases. Economists refer to this as the law of diminishing returns.