Macroeconomics: Lection 4

Riccardo Franceschin

ECON 202
6th October, 2021
Production Determinants

Many inputs needed for production, but when considering the whole country:
Which are the most important inputs needed for production?
• Capital (K)
• Labour (N)

The same amount of capital and labor force can lead to very different results,
depending on how good we are in organizing them in the most efficient way

We call the missing component Total Factor Productivity (A)

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The Production Function

The mathematical object that represent the amount produced Y in a certain period,
given the amount of K and N is called the production function

Y = AF(K, N)

F can be in principle any function, but empirically, we see that one good way of
represent the production function is

Y = AKα N(1−α)

α is around 0.3 for the US

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Characteristics of this function

Notice that A, K and N are all positive numbers!

• It is increasing in A: for given amount of capital and labour, higher
productivity means higher production
• It is increasing in both K and N: keeping A and one of the two inputs fixed,
the production raises with the remaining input
• It has a constant return to scale: if you double both inputs, the production
doubles (and similarly X3, X4, ...). Mathematically:

AF(mK, mN) = mAF(K, N)

• Decreasing marginal product of labour

• Decreasing marginal product of capital

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Marginal Product

In economics we call marginal product the partial derivative of the production

function with respect to one of its input.

If you don’t remember what a partial derivative is...

• We want to know the increase of production derived by increasing only one
input by 1 unit
• We do this for all possible points: this is the partial derivative!

In other words, the marginal product of an input is the additional production

obtained by increasing only one input by 1 additional unit

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Decreasing Marginal Product

Y = AF(K, N) = AKα N1−α

This production function has the following partial derivatives

 1−α
∂Y N
= Aα
∂K K
 α
∂Y K
= A(1 − α)
∂N N
∂Y ∂Y
As capital K increases ∂K diminishes, similarly if you increase N ∂N declines.

Rationale: the first pieces of input is immensely important, then the value of
decreases as the input is less scarce

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Supply Shocks

• We call supply (or productivity) shocks, changes in the production function

that result in changes in Y
• Positive supply shock: better organization, technological innovations,
reduction in bureaucracy
• Negative supply shock: supply-chain disruptions, additional regulations, ...
• Supply shocks change the shape of the production function

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How K changes?

• Firms take decision about the number of people to employ and the amount of
capital to invest
• Capital is a stock that is accumulated over time through investment (flow)
• Capital is slowly reduced by depreciation

Kt+1 = (1 − δ)Kt + It

• If we look at short period of time (one year), we can assume capital as fixed

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How L changes?

• Firms can adjust Labour more freely with hirings and firings (extensive
margin)
• The can also adjust hours worked (intensive margin)
• These adjustment creates fluctuations in the employed workforce

Nt = Nt−1 + Ht − Ft

• If you are looking at the aggregate level, we can interpret N as the number of
employed workers

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Labour Demand

Firms demand labour for production. How do they choose?

Assumptions:
• Firms want to maximize their profits (revenues minus costs)
• Each firm is too small to determine wages: they take it as given
• All workers are the same, all hours worked are the same

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Profit Maximizers

• Firms earn by selling output

R=P×Y
• Firms pay for the capital used in the production

Ck = r × K

• Firms pay for the workforce employed

Cn = w × N

• Firms want only to maximize profits

Π = R − Ck − Cn = PY − rK − wN

• Possible critiques: firms sometimes care about other aspects (CSR)

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Price-Takers

• In a country like Turkey there are millions of firms, most of them with few
employees
• The wage they choose does not change much in the aggregate, we can assume
they conform to the norms
• Possible critiques: firms have some monopsonistic power, wages are centrally
bargained, ...

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Homogeneous Workers

• We assume there is just one type of labour for tractability

• In reality, there are different type of workers that complement each other
• More complicated models take Human Capital into consideration
• Including heterogeneity in Workers’ skills is one of the topic at the frontier of
the research at the moment

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Marginal benefit = marginal cost

• A firm will hire workers as long as the gains from one additional worked
hour is higher than the additional cost of that hour
• The cost of 1 hour of work is the wage:

∂Cn
=w
∂N
• The firm hires workers, decreasing the MPN until marginal revenues
P × MPN = w
• Remember that MPN is decreasing in N, so by increasing N, the firm is
reducing the marginal revenue

∂Y
P =w
∂N

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Marginal profits

Notice that we are not looking at the level of revenues or the total amount paid by
the firm to workers, but only on the costs and benefits of the last worker

MR=MC does NOT mean zero profit, it means zero marginal profit!

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Numerical Example

Suppose Y = 2K0.5 N0.5 and that the capital is fixed at 100. Compute the production and
the labor demand of the firm if the wage is 5.

2 1000.5 10
MPN = × 0.5 = 0.5
2 N N
MPN = MC = 5

N0.5 = 10/5 = 2

N = 4 and Y = 40

Suppose the economy is composed by 10 identical firms as the previous one. Compute
aggregate production and employment.
Nagg = 40 and Yagg = 400

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Labour Demand Curve

The Labour Demand Curve is the curve that represents the amount of labour
employed by firm, for every possible wage level. It is downward sloping
w

w
w̄

LD
N

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Aggregate Labour Demand

• From the individual labour demand of a single firm, we can recover the
aggregate labour supply by summing all the individual labour demand
• The aggregate (or individual) labour demand will not move for a change in
the wage! This determines a shift along the curve
• The curve moves for variations in the MPN

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Shifts in Labour Demand

• Change in productivity (TFP)

• Change in capital (K)
• Change in the production function (α or other structural changes)
• Change in prices (alert! Here exogenous prices)

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Exogenous vs Endogenous Variables

It is an important distinction in every economic model

• Exogenous variables: variables that are determined outside the model (from
the literature, randomly, directly from observations, from intuition,...)
• Endogenous variables: variables that are determined within the model, they
are a deterministic function of other variables
• Until now, Y and N are endogenous variables. A, P,W, K, α are all exogenous
variables

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Numerical Example: aggregate labor
demand
Assuming the economy is the one previously described, compute the aggregate labor
demand (Employment as function of Wage)

MPN = MC = w

N0.5 = 10/w

N = 100/w2

1000
Nagg =
w2
Suppose that an innovation increases A from 2 to 4. How does the aggregate labour
demand change?
The labour demand curve shifts upwards, analytically:

4000
Nagg =
w2
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