CHAPTER 2 THEORETICAL TOOLS OF PUBLIC FINANCE 47

costs of production, TC, are determined by TC rK wL, where r is the

price of capital (the rental rate) and w is the price of labor (the wage rate). For
day-to-day decisions by the firm, the amount of capital is fixed, while the amount
of labor can be varied. Given this assumption, we can define the marginal cost, marginal cost The incremental
or the incremental cost to producing one more unit, as the wage rate times the cost to a firm of producing one
more unit of a good.
amount of labor needed to produce one more unit.
For example, consider the production function just described, and suppose
that the firm is producing 2 movies using 1 unit of capital and 4 units of labor.
Now, holding the amount of capital fixed, it wants to produce 3 movies. To do
so, it will have to increase its use of labor by 5 units (to 9 total units). If the
wage rate is $1 per unit, then the marginal cost of raising production from 2 to
3 movies is $5.
The key point of this discussion is that diminishing marginal productivity gener-
ally implies rising marginal costs. To produce a fourth movie would require an
increase in labor of 7 units, at a cost of $7; to produce a fifth movie would cost
$9. Since each additional unit of production means calling forth labor that is
less and less productive, at the same wage rate, the costs of that production are
rising.
Recall that the goal of the firm is to maximize its profit, the difference profits The difference between
a firms revenues and costs,
between revenues and costs. Profit is maximized when the revenue from the
maximized when marginal rev-
next unit, or the marginal revenue, equals the cost of producing that next unit, enues equal marginal costs.
the marginal cost. In a competitive industry, the revenue from any unit is the
price the firm obtains in the market. Thus, the firms profit maximization rule
is to produce until price equals marginal cost.
We can see this through the type of hill-climbing exercise proposed in
the Quick Hint on pages 3435. Suppose the price of movies in the market
is $8, the cost of capital is $1 per unit, the cost of labor is $1 per unit, and the
firm has 1 unit of capital. Then, if the firm produces 1 movie, it will need to
use 1 unit of labor, so that total costs are $2. Because revenues on that first unit
are $8, it should clearly produce that first movie. To produce a second movie,
the firm will need to use 4 units of labor, or an increase of 3 units of labor.
Thus, the marginal cost of that second unit is $3, but the marginal revenue
(price) is $8, so the second movie should be produced. For the third movie,
the marginal cost is $5, as just noted, which remains below price.
But now imagine the firm is producing 4 movies and is deciding whether
to produce a fifth. Producing the fifth movie will require an increase in labor
input from 16 to 25 units, or an increase of 9 units. This will cost $9. But the
price that the producer gets for this movie is only $8. As a result, producing
that fifth unit will be a money loser, and the firm will not do it. Thus, profit
maximization dictates that the firm produce until its marginal costs (which are
rising by assumption of diminishing marginal productivity) reach the price.
Profit maximization is the source of the supply curve, the relationship
between the price and how much producers will supply to the market. At any
price, we now know that producers will supply a quantity such that the mar-
ginal cost equals that price. Thus, the marginal cost curve is the firms supply curve,
showing the relationship between price and quantity. As quantity rises, and