Politics & Society

Economics 101: What Is Marginal Product? Learn How To Calculate Marginal Product and Its Impact on Business

Written by MasterClass

Aug 8, 2019 • 4 min read

When business owners invest in their company by hiring new workers, purchasing new equipment, or ordering more raw materials, they aren’t just doing this for amusement. They are looking for a return on their investment. Specifically, they are looking for increased output, which should theoretically increase the net income of their company. The relationship between increased investment and increased output can be represented through the concept of marginal product.

Close

What Is Marginal Product?

The marginal product of a business is the additional output created as a result of additional input placed into the company. It is also referred to as marginal physical product, or MPP.

In practical terms, this might mean the additional donuts produced at a donut shop once they hire an extra employee. Or it might mean the additional number of strawberries harvested by a farmer who plants additional seeds. Or the additional revenue a bowling alley receives if it builds extra lanes.

How Is Marginal Product Calculated?

To accurately measure marginal product, one must isolate a specific change in a business and track how that change increases output. As such, there are multiple ways to calculate marginal product:

  • The marginal product of capital is the additional output that results from adding one unit of capital—typically cash. This metric often applies to start-ups, who rely on private investment to get their business off the ground.
  • The marginal product of labor is the additional output resulting from hiring another worker. This tends to apply to established businesses, like an automobile factory that adds a new worker to the production line.
  • The marginal product of land is the additional output gained from adding another unit of land. This might apply to a farmer who purchases a field adjacent to her existing property, or a factory owner who increases the square footage of her facility.
  • The marginal product of raw materials is the additional output gained from increasing a unit of material supply. Think of a rechargeable battery manufacturer who purchases a cache of lithium or cobalt (essential materials in manufacturing the leading model of battery).

Most businesses enjoy a variable input—the business’s managers may choose to increase or decrease the amount of labor, raw materials, and raw capital placed into the business. Their choice to vary this input usually comes back to balancing marginal cost with marginal product, with a goal of maximizing profit. As factors of production change, marginal productivity also changes, and so a business's total production and total profit may fluctuate as a result.

3 Examples of Marginal Product

Marginal product is most commonly measured in physical units.

  1. This means that a donut shop measures the number of donuts it can produce. Likewise, a cement manufacturer measures the number of cubic yards of cement it can produce.
  2. In service industries, such as tutoring or hairstyling, marginal product might refer to the number of services provided—such as individual lessons or haircuts.
  3. In the financial world, marginal product may simply refer to money. Since hedge funds and venture capital firms do not actually produce goods or services for the general public, they would measure their marginal product in the amount of wealth they can amass for themselves.

How Does Marginal Product Relate to Total Product?

The total product of a business represents the sum total of what it produces, while the marginal product represents additional output stemming from the increase of a single input. As a general rule:

  • When total output is low, increasing input will yield a positive marginal product. In other words, investing more into a business’s capital, land, labor force, or a trove of raw materials will likely lead to increased product.
  • As a business grows, increased input may produce slower rates of increased total product. As such the marginal product will start to reduce, although it may remain positive.
  • A business may reach a point where increasing the input actually decreases the total output. At this juncture, marginal productivity becomes negative.

What Is the Law of Diminishing Returns?

The law of diminishing returns states that, in the short run, investment in a production input (while keeping all other production factors in a fixed state) will yield increased marginal product, but that as the business scales up each additional increase of a production input will yield progressively lower increases in output.

Eventually, businesses will reach a point where increased input will hurt, not help, the marginal product. For instance, a car company’s production will be capped by the number of consumers who are financially positioned to purchase a car. If they make more cars than there are car buyers, their marginal product will be negative and the business will lose money.

What Is the Difference Between Marginal Product and Marginal Cost?

While marginal product concerns changes in output, marginal cost is a representation of the costs incurred when additional units of a product are produced. When physical products (such as a steel nail) are produced, the primary cost factors are:

  • Labor (the workers who make the nails)
  • Physical goods (the raw materials that are turned into nails, plus the machinery required)
  • Real estate (expenses involving the factory where the nails are made)
  • Transportation (costs incurred for transporting both raw goods and finished products)

Some of these costs are static no matter how many nails are produced. In particular, the cost of physical space is unlikely to change whether the factory produces one nail or one million nails. Manufacturing equipment, once purchased, also becomes a fixed cost, notwithstanding long-term wear-and-tear plus the extra electricity needed to keep the machines running.

Other cost factors will fluctuate based on how many units of a product are produced. If you make more nails, you need more raw iron and that iron needs to be shipped to the factory. The completed nails also need to be shipped to hardware stores. Labor costs may go up as well if more worker hours are required to produce the extra nails.

Learn more about economics and society in Paul Krugman’s MasterClass.