Lecture 1 1-1

ECN407 Adv. Macroeconomics

Lecture 2

Firm’s Profit Maximization

Dr. Arshad Ali Bhatti

Spring 2018

Firm’s Profit Maximization

• Behavior of the representative consumer

• Behavior of the representative firm

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-2

The Representative Firm

• The production function.

• Profit maximization and labor demand.

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The Firm’s Production Function

Properties:
• Constant returns to scale  Allows us to consider a representative firm
• Output increasing in labor input or capital input
• Marginal product of labor decreases with labor input
• Marginal product of capital decreases with capital input
• Marginal product of labor increases with capital input

• Marginal product of a factor of production: additional output that

can be produced with one additional unit of factor input, holding
constant the quantities of the other factor inputs
• What is ɀ ?

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-3

Production Function, Fixing Capital

and Varying Labor

The marginal product of

labor decreases as the
labor input increases.

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Production Function, Fixing Labor

and Varying Capital

The marginal product of

capital decreases as the
capital input increases.

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-4

Marginal Product of Labor

Schedule

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Adding Capital Increases the

Marginal Product of Labor

More capital increases the

marginal product for each
level of labor input!

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-5

Total Factor Productivity Increases

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Effect of an Increase in TFP on the Marginal

Product of Labor

Higher productivity
increases the marginal
product for each level of
labor input!

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-6

Factors causing a change in TFP

• Technological Innovation
• Innovation in production processes and management
techniques.

• Good weather
• Production in agricultural and construction sectors.
• Government regulations
• Mandatory installation of pollution abatement equipment
{decreases Z ???}

• Change in the relative price of energy

• Increase in the relative price of energy… decreases Z

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Specific Production Function

• Cobb-Douglas Production function Y = zK α N1−α

• Since α + (1 – α) = 1, the function exhibits constant returns to scale
• This implies α will be the share that capital receives of national income,
and 1- α will be the share that labor receives, and that these shares
are constant.
• This is consistent with income data from NIPA (National Income and
Product Accounts)
• In fact, α = 0.36, and 1- α=0.64

Pakistan: α = 0.35, and 1- α=0.65

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-7

Solow Residual

• We sometimes refer to the Solow residual as Total Factor

Productivity (TFP)

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Solow Residual (United States)

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

ECN407: Adv. Macroeconomics

Lecture 1
Dr Arshad Ali Bhatti, IIIE Fall 2018/3

Dr Arshad Ali Bhatti, IIIE Fall 2018/3

10%

12%
-6%

-4%

-2%

0%

2%

4%

6%

8%

100

150

200

250

300

350

400

450
1965

50
0
1966
1965
1967

Output Growth
1966
1968 1967
1969 1968
1970 1969
1971 1970
1972 1971

TFP Growth (Pakistan)

TFP Growth (Pakistan)

1972
1973
1973
1974
1974
1975 1975
1976 1976
1977 1977
1978 1978
1979 1979
1980
1980
1981
1981 1982

TFP-Pakistan
1982 1983
1983 1984
1984 1985
1985 1986
1987
1986
1988
1987 1989
1988 1990
1989 1991
1990 1992
1991 1993
1994
1992
1995
1993 1996
1994 1997
1995 1998
1996 1999
TFP Growth

1997 2000
2001
1998
2002
1999
2003
2000 2004
2001 2005
2002 2006
2003 2007
2008
Dr Arshad Ali Bhatti, Fall 2017

2004
2005
2006
Lec 2-16

Lec 2-15

2007
2008

1-8
 Lecture 1 1-9

Profit Maximization

The firm’s problem is to choose N to

maximize profits:
π = zF(K,N) - wN

When the firm maximizes profits, the

marginal product of labor equals the real
wage:

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Revenue, Variable Costs, and Profit

Maximization

Revenue: zF(K,N)
Variable cost: wN
Profits maximized where
MPN = w

What if MPN > w?

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-10

Revenue, Variable Costs, and Profit

Maximization

Revenue: zF(K,N)
Variable cost: wN
Profits maximized where
MPN = w

What if MPN < w?

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The MPN Curve Is the Labor Demand Curve of

the Profit- Maximizing Firm

This is true because the

firm hires labor up to the
point where MPN = w

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-11

Any questions???

Now…little mathematics

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Aside

• Constant Returns to Scale (CRS)

• Definition
• A production function , has CRS
if for any number λ > 0, we have that
λ ,λ λ ,

• That is, if the production function exhibits CRS

then changing all inputs by a factor λ changes
the output by the same factor λ.

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-12

PF: Assumptions

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Cont.

• Exercise: Show that a Cobb-Douglas function

satisfies the assumptions stated
above.
• We usually assume a Cobb-Douglas production
function that also satisfies CRS.
• To solve for the profit-maximizing labor demand
N∗, we also assume that the PF satisfies the
Inada conditions:

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-13

Firm’s Problem

• To find some to maximize the profit

• function:

• Solution provides the FOC as:

• That is, the marginal product of labor equals

the wage rate. For more details, we need to
have a specific functional form of the
production function.
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Firm’s Problem

• Exercise:
• Let 4 / /
, K = 16, and w = 2.
• Solve for the optimal labor demand.
• Solution:
• We compute the marginal product of Labor:

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-14

Firm’s Problem

• Using profit max condition:

• Therefore N*=16

• Profit max ???

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Firm’s Problem

• Exercise:
• Let , z = z0, K = K0, and w = ,
where α ∈ (0, 1), and z0, K0, and are positive
real numbers.

• The optimal labor demand is given by

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ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017

 Lecture 1 1-15

Firm’s Problem

• Exercise:
• Let , z = z0, K = K0, and w = ,
where α ∈ (0, 1), and z0, K0, and are positive
real numbers.
• And max profit is

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Thanks

Dr Arshad Ali Bhatti, IIIE Fall 2018/3 Lec 2-30

ECN407: Adv. Macroeconomics Dr Arshad Ali Bhatti, Fall 2017