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Throughout the history of micro and managerial economic thought a firm's revenue and cost functions have been based on the idea that both revenue and cost are clearly dependent on the volume of production or demand. Both revenue and cost functions have been regarded as non-linear functions of volume with the Law of Declining Marginal Utility causing revenue curves to rise at a declining rate, and the Law of Diminishing Returns causing cost curves to rise at an increasing rate. With such functions, profit maximization occurs at that volume (output) where the greatest difference exists between revenues (R) and costs (C), which is where the slopes, or the marginal values, of the two functions are equal - where MR = MC.1 See Figure 1.
Consumer impact on volume has long been recognized. Consumers make the decision to buy more of a product at a lower per unit product price; this explains why revenue curves rise at a declining rate. But the employees ' decision to produce more at higher work unit prices has largely been ignored. Employees' motivation to produce depends (often to a considerable degree) on financial incentive magnitude - a marginal cost (price) per unit of work - just as the consumer's motivation to buy depends on marginal revenue, or price per unit sold.
The monetary (financial) rewards received by employees for producing are costs of production incurred by the company. The magnitude of the slope of the employees' perceived financial reward function - that is, the size of the marginal financial reward (a marginal cost to the firm), or the size of the incentive per work unit - affects how much they are willing to produce. Management determines, at least in part, how much employees will produce by adjusting the slope of this employee monetary reward (company cost) curve. The slope impacts motivation which in turn impacts output (volume), or amount produced. Management does not choose an output level directly and expect employees to produce at that level. Rather management decides the slope of the reward curve which indirectly affects the employees' decision on how much to produce.
Recognizing that output (volume) is dependent on reward (cost to the firm) function slope leads to a whole new dynamic in determining the...