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Mariko J. Klasing
ECON 2102 I: Intermediate
Macroeconomics
Lecture 5: Supply of goods and
services (Ch. 3.1 & 3.2)
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Mariko J. Klasing
Outline of general model
A closed economy, market-clearing model
Supply side
factor markets (supply, demand, price)
determination of output/income
Demand side
determinants of C, I, and G
Equilibrium
goods market
loanable funds market
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Mariko J. Klasing
In this lecture, you will learn
what determines the economys total
output/income ( = supply side of the economy)
how the prices of the factors of production are
determined
how total income is distributed
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Mariko J. Klasing
Factors of production
K = capital:
tools, machines, and structures used in
production
L = labor:
the physical and mental efforts of
workers
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Mariko J. Klasing
The production function
denoted Y = F(K, L)
shows how much output (Y) the economy can
produce from
K units of capital and L units of labor
reflects the economys level of technology
exhibits constant returns to scale
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Mariko J. Klasing
Returns to scale: A review
Initially Y
1
= F(K
1
, L
1
)
Scale all inputs by the same factor z:
K
2
= zK
1
and L
2
= zL
1
(e.g., if z = 1.25, then all inputs are increased by 25%)
What happens to output, Y
2
= F (K
2
, L
2
)?
If constant returns to scale, Y
2
= zY
1
If increasing returns to scale, Y
2
> zY
1
If decreasing returns to scale, Y
2
< zY
1
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Mariko J. Klasing
Example 1
( , ) F K L KL =
( , ) ( )( ) F zK zL zK zL =
z KL =
2
z KL =
2
z KL =
( , ) zF K L =
constant returns to
scale for any z > 0
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Mariko J. Klasing
Example 2
( , ) F K L K L = +
( , ) F zK zL zK zL = +
z K z L = +
( , ) z F K L =
decreasing
returns to scale
for any z > 1
( )
z K L = +
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Mariko J. Klasing
Example 3
( , ) F K L K L = +
2 2
( , ) ( ) ( ) F zK zL zK zL = +
2 2
( , ) z F K L =
2
increasing returns
to scale for any
z > 1
( )
z K L = +
2 2 2
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Mariko J. Klasing
Now you try
Determine whether constant, decreasing, or increasing
returns to scale for each of these production functions:
(a)
(b)
L K Y(K,L) /
2
=
0.5 0.3
L K Y(K,L) =
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Mariko J. Klasing
Assumptions of the model
1. Technology is fixed.
2. The economys supplies of capital and labor
are fixed at
and K K L L = =
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Mariko J. Klasing
Cobb-Douglas production
function
a particular production function we will be using a lot in
this course
features constant returns to scale
1 0 , ) , (
1
< < =

o
o o
L K L K F
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Mariko J. Klasing
Determining GDP
Output is determined by the fixed factor supplies
and the fixed state of technology:
, = ( ) Y F K L
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Mariko J. Klasing
The distribution of national
income
determined by factor prices,
the prices per unit that firms pay for the
factors of production
wage = price of L
rental rate = price of K
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Mariko J. Klasing
Notation
W = nominal wage
R = nominal rental rate
P = price of output
W/P = real wage
(measured in units of output)
R/P = real rental rate
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Mariko J. Klasing
How factor prices are determined
Factor prices are determined by supply and
demand in factor markets.
Recall: Supply of each factor is fixed.
What about demand?
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Mariko J. Klasing
Demand for labor and capital
Assume markets are competitive:
each firm takes W, R, and P as given.
Basic idea:
A firm hires another unit of labor
and capital if the cost does not exceed the
benefit.
cost = real wage / real rental rate of capital
benefit = marginal product of labor / marginal
product of capital
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Mariko J. Klasing
Formally: Profit maximization of
firms
Firms want to maximize profits, taking W, R and P as
given:
Marginal product of labor (MPL) = Real wage
Intuition?

) , (

0
) , (
: 1) FOC
) , ( max
,
P
W
L
L K F
W
L
L K F
P
RK WL L K F P
L K
=
c
c

=
c
c
= H
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Mariko J. Klasing
Marginal product of capital (MPK) = Real rental rate
Intuition?

) , (

0
) , (
: 2) FOC
P
R
K
L K F
R
K
L K F
P
=
c
c

=
c
c
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Mariko J. Klasing
Marginal product of labor (MPL)
definition:
The extra output the firm can produce
using an additional unit of labor
(holding other inputs fixed):
MPL = F(K, L+1) F(K, L)
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Mariko J. Klasing
Exercise 1
a. Determine MPL at each
value of L.
b. Graph the production
function.
c. Graph the MPL curve with
MPL on the vertical axis
and
L on the horizontal axis.
L Y MPL
0 0 n.a.
1 10 ?
2 19 ?
3 27 8
4 34 ?
5 40 ?
6 45 ?
7 49 ?
8 52 ?
9 54 ?
10 55 ?
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Mariko J. Klasing
Y
output
MPL and the production function
L
labor
F K L ( , )
1
MPL
1
MPL
1
MPL
As more labor is
added, MPL |
Slope of the production
function equals MPL
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Mariko J. Klasing
Marginal product of capital (MPK)
definition:
The extra output the firm can produce
using an additional unit of labor
(holding other inputs fixed):
MPL = F(K+1, L) F(K, L)
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Mariko J. Klasing
Y
output
MPK and the production function
K
capital
1
MPK
1
MPK
1
MPK
As more capital
is added, MPK
|
Slope of the production
function equals MPK
) , ( L K F
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Mariko J. Klasing
Diminishing marginal returns
We usually assume that as a factor input is
increased,
its marginal product falls (other things equal).
Intuition:
Suppose |L while holding K fixed
fewer machines per worker
lower worker productivity
Or: suppose |K while holding L fixed
fewer people who can operate the machines
lower productivity or capital
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Mariko J. Klasing
Example: The Black Death
In 1348, the Black Death killed 60 % of the population in England
huge fall in labor L
Real wages in England, 1205-1645
(index, 1865=100)
0
10
20
30
40
50
60
70
80
90
1205 1255 1305 1355 1405 1455 1505 1555 1605
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Mariko J. Klasing
Exercise (part 2)
Suppose W/P = 6.
d. If L = 3, should firm hire more
or less labor? Why?
e. If L = 7, should firm hire more
or less labor? Why?
L Y MPL
0 0 n.a.
1 10 10
2 19 9
3 27 8
4 34 7
5 40 6
6 45 5
7 49 4
8 52 3
9 54 2
10 55 1
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Mariko J. Klasing
MPL and the demand for labor
Each firm hires labor
up to the point where
MPL = W/P.
Units of
output
Units of labor, L
MPL,
Labor
demand
Real
wage
Quantity of labor
demanded
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Mariko J. Klasing
MPK and the demand for labor
Each firm hires labor
up to the point where
MPK = R/P.
Units of
output
Units of capital, K
MPK,
Capital
demand
Real
rental
rate
Quantity of capital
demanded
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Mariko J. Klasing
Brief review
Profit maximizing firms hire labor and employ capital
such that W/P=MPL and R/P=MPK
With a standard production function that is concave
in K and L, the marginal product of a factor is falling
as this factor increases.
Intuition:
Suppose |L while holding K fixed
fewer machines per worker
lower worker productivity
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Mariko J. Klasing
Brief review
Or: suppose |K while holding L fixed
fewer people who can operate the machines
lower productivity or capital
What happens to W/P (=MPL) as |K and R/P
(=MPK) as |L
1) Each worker has more machines to use: labor
is more productive, increase in MPL and real wage
2) More people available to operate each
machine: capital is more productive, increase in
MPK and the real rental rate of capital
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Mariko J. Klasing
Y
output
MPL and an increase in K
L
labor
1
MPL
1
MPL
) , (
2
L K F
) , (
1
L K F
1
MPL
1
MPL
(K/L) MPL
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Mariko J. Klasing
Y
output
MPK and an increase in L
K
capital
1
MPK
1
MPK
) , (
2
L K F
) , (
1
L K F
1
MPK
1
MPK
(L/K) MPK
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Mariko J. Klasing
With Cobb-Douglas
0 ) 1 )( (
0 ) 1 (
) 1 (
1 0 , ) , (
1
1 2
1 1
1
< =
< =
= =
= =
< < = =

o o
o o
o o
o o
o o
o o
o o
o o
o o
o
L K F
L K F
L
Y
L K MPL
K
Y
L K MPK
L K L K F Y
LL
KK
Cobb-Douglas features diminishing marginal returns
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Mariko J. Klasing
How income is distributed:
total labor income =
If a production function has constant returns to
scale, then
total capital income =
W
L
P
MPL L =
R
K
P
MPK K =
Y MPL L MPK K = +
labor
income
capital
income
national
income
This means, that firms profits are zero!
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Mariko J. Klasing
The ratio of labor income to total
income in the U.S.
0
0.2
0.4
0.6
0.8
1
1960 1970 1980 1990 2000
Labors
share
of total
income
Labors share of income
is approximately constant over time.
(Hence, capitals share is, too.)
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Mariko J. Klasing
Income distribution with Cobb-
Douglas Production Function
The Cobb-Douglas production function has
constant factor shares:
capital income = MPK x K = (o Y/K) x K = o Y
labor income = ((1 o )Y/L) x L = (1 o )Y
Hence firms profits are zero:
0 ) 1 (
) 1 (
/
= =
=
= H
Y Y Y
K
K
Y
L
L
Y
Y
K MPK L MPL Y P
o o
o o
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Mariko J. Klasing
Outline of model
A closed economy, market-clearing model
Supply side
factor markets (supply, demand, price)
determination of output/income
Demand side
determinants of C, I, and G
Equilibrium
goods market
loanable funds market
DONE
DONE
Next
Summary
Total output is determined by
the economys quantities of capital and labor
the level of technology
Competitive firms hire each factor until its
marginal product equals its price.
If the production function has constant returns to
scale, then labor income plus capital income
equals total income (output).
CHAPTER 3 National Income
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