Intermediate Macroeconomics Heman Das Lohano

Handout based on Mankiw (sections 3.1 and 3.2) and Froyen Ch. 3

Q:
Suppose the production function in Pakistan economy is as follows:

𝑌 = 𝐴𝐾 𝛼 𝐿1−𝛼

𝑌 = 10𝐾 0.5 𝐿0.5

where
Y is real GDP
K is the amount of capital input
L is the amount of labor input
A denotes overall productivity or total factor productivity (TFP)

 Find the marginal product of capital. Show that it is positive and diminishing.

 Find the marginal product of labor. Show that it is positive and diminishing

 Find the degree of returns to scale.

 Find the elasticity of output with respect to capital. (It is equal to power coefficient on K).

 Find the elasticity of output with respect to labor. (It is equal to power coefficient on L).

 Solve the firm’s profit maximization problem. Assume that the country possesses 400 units
of capital: K = 400. Assume P = 1 and W = 5. Find the optimal quantity of labor.

 Find the optimal quantity of labor if W = 10.

 Find the optimal quantity of labor if W = 20.

 Draw the labor demand curve using the answers to above three questions.

Solved in the class.

Q:
Suppose the production function in Pakistan economy is as follows:

𝑌 = 10𝐾 0.5 𝐿0.5

where Y is the real GDP, K is the amount of capital, and L is the amount of labor. Assume that
the country possesses 400 units of capital.

(a) For the above production function, solve the profit maximization problem of the
representative firm and find the labor demand function for given level of capital stock: K
= 400.

(b) Suppose the supply of labor is fixed: 100 units. Find the equilibrium in the labor market:
real wages (W/P), nominal wages at P = 1, and quantity of labor in the market. Also,
compute marginal production of labor at the optimal quantity of labor. Compute real GDP
and nominal GDP.
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(c) Find the labor income in real and nominal terms. Compute the share of laborers in GDP.
How does it compare with the output elasticity of labor input? Prove they are equal.

(d) Suppose, output price (inflation index) increases to P = 2. Find the equilibrium in the labor
market: real wages (W/P), nominal wages at P = 2, and quantity of labor in the market.
Also, find real GDP and nominal GDP.

(e) Find the labor income in real and nominal terms. Compute the share of labor in GDP.

(f) Draw the aggregate supply curve of real GDP as well as nominal GDP.

Key:
(a)
Given production function is: 𝑌 = 10𝐾 0.5 𝐿0.5

When K=400, the production function is: 𝑌 = 200𝐿0.5

Define profit as total revenue minus total costs:

Profit = TR – TC

π = P*Y – RK – WL

π = P*200L0.5 – R*400 – WL

max 𝜋 = 𝑃 ∗ 200𝐿0.5 − 𝑅400 − 𝑊𝐿

𝐿

First order necessary condition for profit maximization:

𝜕𝜋 100
= 𝑃 ∗ 𝐿0.5 − 𝑊 = 0
𝜕𝐿

100
where 𝐿0.5 is marginal product of labor (MPL) and the above equation shows: P*MPL = W, or

MPL = W/P

Solving for L yields the labor demand function:

100𝑃 2
𝐿𝐷 = ( )
𝑊
(b)
Labor supply function is:
𝐿𝑆 = 100

Market clearing condition is:

𝐿𝐷 = 𝐿𝑆

100𝑃 2
( ) = 100
𝑊

Solving for W/P gives real wages:

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 𝑊
= 10
𝑃
Nominal wages at P=1:
𝑊 = 10

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

100
𝑀𝑃𝐿 == 10
𝐿0.5
Note that marginal product of labor is equal to real wage at the equilibrium:

𝑊
𝑀𝑃𝐿 = = 10
𝑃

Real GDP: 𝑌 = 200𝐿∗ 0.5 = 2000

Nominal GDP: PY = 1*2000 = 2000

(c)
Real labor income = (W/P)*L* = 10*100 = 1000

Nominal labor income = W*L* = 10*100 = 1000

Share of labor = (W/P)*L/Y = 1000/2000 = 0.5

Share of labor = (WL)/(PY) = 1000/2000 = 0.5

Prove that: Share of labor income = 0.5 (power coefficient on labor, which is also equal to
output elasticity with respect to labor)

Share of labor = (W/P)*L/Y

From profit maximization condition: MPL = W/P. So, we have:

Share of labor = (MPL)*L/Y

0.510𝐾0.5 𝐿−0.5 𝐿
Share of labor = = 0.5
10𝐾0.5 𝐿0.5

(d)
Solving the profit maximization problem for any given level of P and W, we have labor demand
function as given in part (a):
100𝑃 2
𝐿𝐷 = ( )
𝑊

Labor supply function is:

𝐿𝑆 = 100

Market clearing condition is:

𝐿𝐷 = 𝐿𝑆

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 100𝑃 2
( ) = 100
𝑊

Solving for W/P gives real wages:

𝑊
= 10
𝑃
Nominal wages at P=2:
𝑊
= 10
2

𝑊 = 20

Note that we can put P = 2 initially in profit, before solving it, and still get the same answer.

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

Real GDP: 𝑌 = 200𝐿∗ 0.5 = 2000

Nominal GDP: PY = 2*2000 = 4000

(e)
Real labor income = (W/P)*L* = 10*100 = 1000

Nominal labor income = W*L* = 20*100 = 2000

Share of labor = (W/P)*L/Y = 1000/2000 = 0.5

Share of labor = (WL)/(PY) = 2000/4000 = 0.5

(f)
Aggregate supply curve of real GDP:

2000 Y

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Aggregate supply curve of nominal GDP:

2000 4000 P*Y

Q:
(a) Suppose the production function in Pakistan economy is as follows:

𝑌 = 10𝐾 0.5 𝐿0.5

where Y is the real GDP, K is the amount of capital, and L is the amount of labor. Assume
that the country possesses 400 units of capital. Solve the profit maximization problem of
the representative firm and find the labor demand function for given level of capital stock.

(b) The labor supply function is:

𝑊
𝐿𝑆 = 10
𝑃
Find the equilibrium in the labor market: real wages (W/P), nominal wages at P = 1, and
quantity of labor in the market. Also, compute real GDP.

(c) Suppose, output price (inflation index) increases to P = 2. Find the equilibrium in the labor
market: real wages (W/P), nominal wages at P = 2, and quantity of labor in the market.
Also, compute real GDP.

(d) Draw the aggregate supply curve of real GDP using the answers to parts (b) and (c).

(e) What are the possible shifters of the aggregate supply curve? Also, report the direction of
the shift for each.

Key:

(a)
Define profit as total revenue minus total costs:

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

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 𝜋 = 𝑃𝑌 − 𝑅𝐾 − 𝑊𝐿

𝜋 = 𝑃𝐹(𝐾, 𝐿) − 𝑅𝐾 − 𝑊𝐿

For given K:

̅ , 𝐿) − 𝑅𝐾
𝜋 = 𝑃𝐹(𝐾 ̅ − 𝑊𝐿

Representative firm’s problem:

̅ , 𝐿) − 𝑅𝐾
max 𝜋 = 𝑃𝐹(𝐾 ̅ − 𝑊𝐿
𝐿

First order necessary condition for profit maximization:

𝜕𝜋
= 𝑃𝑀𝑃𝐿 − 𝑊 = 0
𝜕𝐿
𝑊
𝑀𝑃𝐿 = (1)
𝑃

where MPL denotes marginal product of labor. Given production function is:

𝑌 = 10𝐾 0.5 𝐿0.5

When K=400, the production function is:

𝑌 = 200𝐿0.5

Marginal production of labor at K = 100:

100
𝑀𝑃𝐿 =
𝐿0.5

Putting MPL function in equation (1) yields

100 𝑊
=
𝐿0.5 𝑃

Solving for L yields the labor demand function:

100𝑃 2
𝐿𝐷 = ( )
𝑊

100 2
𝐿𝐷 = ( )
𝑊/𝑃
(b)
The labor demand and supply functions are:
𝑊
𝐿𝑆 = 10
𝑃

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 100 2
𝐿𝐷 = ( )
𝑊/𝑃
Market clearing condition is:
𝐿𝐷 = 𝐿𝑆

100 2 𝑊
( ) = 10
𝑊/𝑃 𝑃

Solving for W/P gives real wages:

𝑊
= 10
𝑃
Nominal wages at P=1:

𝑊 = 10

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

Real GDP: 𝑌 = 200𝐿∗ 0.5 = 2000

(c)
The labor demand and supply functions are:
𝑊
𝐿𝑆 = 10
𝑃

100 2
𝐿𝐷 = ( )
𝑊/𝑃
Market clearing condition is:
𝐿𝐷 = 𝐿𝑆

100 2 𝑊
( ) = 10
𝑊/𝑃 𝑃

Solving for W/P gives real wages:

𝑊
= 10
𝑃
Nominal wages at P=2:

𝑊 = 20

At these wages, the labor demand and supply are equal at:

𝐿∗ = 100

Real GDP: 𝑌 = 200𝐿∗ 0.5 = 2000

(d)
With P = 2, we have the same equilibrium quantity of labor and real GDP, as with P = 1. Thus,
we have:

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Aggregate supply curves of real GDP:

2000 Y

(e)
Productivity increases Shifts to right
Technological change/improvement Shifts to right
New natural resources discovered Shifts to right
Damage of natural resources Shifts to left
Climate change Shifts to left
FDI: Capital increases Shifts to right
Increase in human capital Shifts to right
Immigration: Labor force growth: Shifts to right
Increase in marginal income tax rate Shifts to left
Input prices: increase in oil price in international market or exchange rate Shifts to left

Q:
(a) Suppose the production function in Pakistan economy is as follows:

𝑌 = 10𝐾 0.5 𝐿0.5

where Y is the real GDP, K is the amount of capital, and L is the amount of labor. Assume
that the country possesses 400 units of capital. Solve the profit maximization problem of
the representative firm and find the labor demand function for given level of capital stock.

(b) The labor supply function is:

𝑊
𝐿𝑆 = 10(1 − 𝑡)
𝑃
where t is marginal income tax rate.

Assume t = 0.1 (10%). Find the equilibrium in the labor market: real wages (W/P) and
quantity of labor in the market. Also, compute real GDP.

(c) Suppose, the government increases the tax rate to t = 0.2 (20%). Find the equilibrium in the
labor market: real wages (W/P) and quantity of labor in the market. Also, compute real
GDP.
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(d) Show the effect of the increase in the tax rate on aggregate supply curve of real GDP.

Key:
(a)
Define profit as total revenue minus total costs:

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

𝜋 = 𝑃𝑌 − 𝑅𝐾 − 𝑊𝐿

𝜋 = 𝑃𝐹(𝐾, 𝐿) − 𝑅𝐾 − 𝑊𝐿

For given K:

̅ , 𝐿) − 𝑅𝐾
𝜋 = 𝑃𝐹(𝐾 ̅ − 𝑊𝐿

Representative firm’s problem:

̅ , 𝐿) − 𝑅𝐾
max 𝜋 = 𝑃𝐹(𝐾 ̅ − 𝑊𝐿
𝐿

First order necessary condition for profit maximization:

𝜕𝜋
= 𝑃𝑀𝑃𝐿 − 𝑊 = 0
𝜕𝐿
𝑊
𝑀𝑃𝐿 = (1)
𝑃

where MPL denotes marginal product of labor. Given production function is:

𝑌 = 10𝐾 0.5 𝐿0.5

When K=400, the production function is:

𝑌 = 200𝐿0.5
Marginal production of labor at K = 400:

100
𝑀𝑃𝐿 =
𝐿0.5

Putting MPL function in equation (1) yields

100 𝑊
=
𝐿0.5 𝑃

Solving for L yields the labor demand function:

100𝑃 2
𝐿𝐷 = ( )
𝑊

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 100 2
𝐿𝐷 = ( )
𝑊/𝑃
(b)
The labor supply function is:

𝑊
𝐿𝑆 = 10(1 − 𝑡)
𝑃
where t is marginal income tax rate.

At t = 0.1 (10%), the labor supply function is:

𝑊
𝐿𝑆 = 9
𝑃

Market clearing condition is:

𝐿𝐷 = 𝐿𝑆

100 2 𝑊
( ) =9
𝑊/𝑃 𝑃

Solving for W/P gives real wages:

𝑊
= 10.36
𝑃
Nominal wages at P=1:

𝑊 = 10.36

At these wages, the labor demand and supply are equal at:

𝐿∗ = 93.217

Real GDP: 𝑌 = 200𝐿∗ 0.5 = 1931

(c)
The labor supply function is:

𝑊
𝐿𝑆 = 10(1 − 𝑡)
𝑃
where t is marginal income tax rate.

At t = 0.2 (20%), the labor supply function is:

𝑊
𝐿𝑆 = 8
𝑃

Market clearing condition is:

𝐿𝐷 = 𝐿𝑆

100 2 𝑊
( ) =8
𝑊/𝑃 𝑃

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Solving for W/P gives real wages:

𝑊
= 10.77
𝑃
Nominal wages at P=1:

𝑊 = 10.77

At these wages, the labor demand and supply are equal at:

𝐿∗ = 86.177

Real GDP: 𝑌 = 200𝐿∗ 0.5 = 1856

(d)
Solving each of the above parts with P = 2 yields the same equilibrium quantity of labor and
real GDP, as with P = 1. Thus, we have:

Aggregate supply curves of real GDP:

t = 0.2 0.1
P

1856 1931 Y

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