Questions:

– What determines how much is produced?

– Who gets what portion of income from production?

– What determines how much output consumers, businesses and government buy?

– How do we reach an equilibrium?

**Production**

Factors of Production are inputs used to produce goods and services. They are consist of Capital and Labor.

– Capital (K): tools, machines, plants used in production

– Labor (L): time people spend for working

For now, assume there are fixed levels of these Capital and Labor. Available production technology will turn these K and L into output.

Production function = Y = F(K,L)

– It could exhibit constant returns to scale, meaning that zY = F(zK,zL). If we double the amounts of capital and labor used, we produce twice as much output

*Return to Scale*

Suppose Y1 = F (K1 ,L1 ) initially. Scale all inputs by the same factor z so that K2 = zK1 and L2 = zL1. For example, if z = 1.25, then all inputs are increased by 25%

What happens to output, Y2 = F (K2 ,L2 ) ?

– If constant returns to scale , Y2 = zY1

– If increasing returns to scale , Y2 > zY1

– If decreasing returns to scale , Y2 < zY1

**Distribution**

How will the proceeds of production be distributed?

Factor prices is how much K and L get paid. Workers will get wage while owners of capital will get rent

– Factor prices are prices per unit that firms pay for the factors of production

– Wage is the price of L

– Rental rate is the price of K

These price, of course, are determined by factor demand and supply

Suppose factor supply is fixed, what affects factor demand?

Assume a firm is competitive: a small part of the market, takes prices as given. The firm’s objective is maximize profit. Then,

– Profit = Revenue – Labor Costs – Capital costs or Profit= PY – WL – RK

What is Marginal Product of Labor (MPL)? Marginal Product of Labor (MPL) is the extra amount of output firm gets from one extra unit of labor

MPL = F(K, L+1) – F(K,L)

– Most production functions have diminishing MPL.

– How to decide whether hiring one more unit of labor or not? The answer is by comparing how much extra revenue it adds (P x MPL) vs. extra cost of hiring it (W). If extra revenue > extra cost, then hire another unit of labor

Demand for labor will be based on P x MPL = W or rewrite as MPL = W/P

– Example: the price of burger is $1. Worker’s wage is $6 per hour. Real wage would be = W/P = 6/1 or 6 burgers per hour

– So, we can hire workers until the additional worker contributes 6 burgers an hour.

This works for capital as well

– MPK = F(K+1,L) – F(K,L)

– Hire capital until MPK = R/P

Real Economic Profit = Y – (MPL x L) – (MPK x K)

– When the production function has constant returns to scale, profit = 0

– There is nothing left over after factors of production are paid

– F(K,L) = (MPK x K) + (MPL x L)

*What is Diminishing Marginal Returns?*

As a factor input is increased, its marginal product falls (other things equal).

If L goes up, while holding K fixed. Then:

– fewer machines per worker

– lower productivity

Next page, Goods Market Equilibrium