In this chapter, we study the behavior of firms, specifically the production

of output and optimal use of inputs.Weuse this theory of firm

behavior to understand the sources and causes of growth in developed
and developing countries.
Wemodel the output of an average or “representative” firm as the
outcome of a Cobb–Douglas production function with technology, capital,
and labor as inputs. Technology is assumed to be freely available,
but capital and labor are costly inputs.Wederive two important properties
of this production function: constant returns to scale and declining
marginal products. Next, we solve for a firm’s profit-maximizing choices
of labor and capital where the firm takes as outside of its control the
market prices for labor (wage rates) and capital (rental rates).Weshow
that when a firm maximizes its profits, it sets the marginal product of
labor equal to the wage rate for labor and sets the marginal product of
capital equal to the rental rate on capital.
When all firms in the economy produce output according to a Cobb–
Douglas production, we can derive average rates of growth of output
and capital in a developed economy with a stable population. Specifically,
we show that when the rate of return on capital is constant, output
of an economy cannot increase solely by the accumulation of capital.
Rather, the level of technology must increase for sustained growth to
occur, and further the rate of growth of technology determines the rate
of growth of both output and capital.Wealso use the framework of
Cobb–Douglas production to discuss the growth rate of output and
capital in less developed economies, and the role of capital income taxes
in determining the level of capital, output, and wages.
In the final section of the chapter, we discuss measurement of the
three inputs of the production function, capital, labor, and technology. where the last equality comes from
the identity that 2α ∗ 21−α = 2.
These equations tell us that the output of two small firms usingCobb–
Douglas production is the same as the output of one firmthat is twice
as large.
With the assumption of Cobb–Douglas production, and the
assumption of perfect competition, we can act as if there is only
one firm – a representative firm – in the US economy.
The assumption of perfect competition is important because we
will assume later in this chapter that each firm takes the price of its
inputs – the market rental rate on capital and the market wage rate
on labor – as given and outside of its control. This assumption is
not controversial in the case of capital, since (conditional on capital
structure and earnings prospects) firms cannot dictate to investors
the price of their stock or debt. The assumption seems less valid in
the case of labor, since there are more than a few locations in which
employment is dominated by one or two major firms, and these firms
may be able to dictate wages. However, as long as labor is mobile, at
least over long periods of time, then these firmswill have to eventually
act as if wages are set outside of their control