Econ 202: Macroeconomics

Productivity, Output and Employment – 1

Alpay Filiztekin
The Production Function Marginal Products

The Production Function

What determines the quantity of goods and services that an

economy can produce?

A key factor is the quantity of inputs—such as capital goods,

labor, raw materials, land, and energy—that producers in the
economy use.
Economists refer to inputs to the production process as factors
of production.

All else being equal, the greater the quantities of factors of

production used, the more goods and services are produced.

Alpay Filiztekin Econ 202: Macroeconomics 2 / 20

The Production Function Marginal Products

The Production Function

Of the various factors of production, the two most important are

capital (factories and machines, for example) and labor
(workers).

We are leaving other inputs out, as we are interested in

value-added generation.

Alpay Filiztekin Econ 202: Macroeconomics 3 / 20

The Production Function Marginal Products

The Production Function

The quantities of capital and labor (and other inputs) used in

production don’t completely determine the amount of output
produced.

Equally important is how effectively these factors are used.

For the same stocks of capital and labor, an economy with

superior technologies and management practices, for example,
will produce a greater amount of output than an economy
without those abilities.

Alpay Filiztekin Econ 202: Macroeconomics 4 / 20

The Production Function Marginal Products

The Production Function

The effectiveness with which capital and labor are used may be
summarized by a relationship called the production function.
A convenient way to write the production function is

Y = AF (K , L)

where
Y = real output produced in a given period of time;
K = quantity of capital used in the period;
L = the number of workers employed in the period;
F = a function relating output Y to capital K and labor L;
A = a number measuring overall productivity (sometimes
called total factor productivity, TFP).

Alpay Filiztekin Econ 202: Macroeconomics 5 / 20

The Production Function Marginal Products

The Production Function

Empirical studies show that the relationship between output

and inputs (in general) can be described reasonably well by the
following production function:

Y = AK 1−α Lα

where 0 < α < 1 and which is called a Cobb-Douglas

production function.

Under certain conditions, the parameter 1 − α in the

Cobb-Douglas production function corresponds to the share of
income received by owners of capital, whereas labor receives a
share of income equal to α.

Alpay Filiztekin Econ 202: Macroeconomics 6 / 20

The Production Function Marginal Products

Growth Accounting
Based on this formulation, we can decompose output growth
into change in factors of production and change in TFP:
The production function can be expressed in logarithmic form
as:

ln(Y ) = ln(A) + (1 − α)ln(K ) + αln(L)

Then the growth rate is:

∆ln(Y ) = (1 − α)∆ln(K ) + α∆ln(L) + ∆ln(A)

or in words:
growth in output = contribution of capital + contribution of labor
+ change in TFP

Alpay Filiztekin Econ 202: Macroeconomics 7 / 20

The Production Function Marginal Products

Growth Accounting in Turkey

8% 7.5%
Assuming a=2/3
7%

6% 5.6%

4.8%
5% 5.0% 1.2%

0.9% 3.9%
4%
0.5% 3.2%

3% 1.6% 0.2% 2.5%

0.6% 2.3% 1.5%

2%

1% 2.3%
2.0% 1.9%
1.6%
1.2%
0%
1950-59 1960-79 1980-89 1990-2001 2002-2017
Source: Penn World Tables 9.0 Contr. K Contr. L TFP Growth Growth

Alpay Filiztekin Econ 202: Macroeconomics 8 / 20

The Production Function Marginal Products

The Shape of Production Function

The production function can be shown graphically.

The easiest way to graph it is to hold one of the two factors of

production, either capital or labor, constant and then graph the
relationship between output and the other factor.

Alpay Filiztekin Econ 202: Macroeconomics 9 / 20

The Production Function Marginal Products

The Shape of Production Function

Y

D
8
DY=0.5 C
7.5
DY=1.5
6 B

2 3 4 K

Alpay Filiztekin Econ 202: Macroeconomics 10 / 20

The Production Function Marginal Products

The Shape of Production Function

Most production functions exhibits two properties:

• The production function slopes upward from left to
right. The slope of the production function reveals that, as
the capital stock increases, more output can be produced.
• The slope of the production function becomes flatter
from left to right. This property implies that although
more capital always leads to more output, it does so at a
decreasing rate.

Alpay Filiztekin Econ 202: Macroeconomics 11 / 20

The Production Function Marginal Products

The Marginal Product of Capital

The marginal product of capital, or MPK, is the increase in
output produced that results from a one-unit increase in the
capital stock.
• The marginal product of capital is positive. Whenever
the capital stock is increased, more output can be
produced. Because the marginal product of capital is
positive, the production function slopes upward from left to
right.
• The marginal product of capital declines as the capital
stock is increased. Because the marginal product of
capital is the slope of the production function, the slope of
the production function decreases as the capital stock is
increased.

Alpay Filiztekin Econ 202: Macroeconomics 12 / 20

The Production Function Marginal Products

The Marginal Product of Capital

Y
Slope = MPK

8
D
7.5

6 B

2 4 K

Alpay Filiztekin Econ 202: Macroeconomics 13 / 20

The Production Function Marginal Products

The Marginal Product of Capital

The tendency for the marginal product of capital to decline as

the amount of capital in use increases is called the
diminishing marginal productivity of capital.

The economic reason for diminishing marginal productivity of

capital is as follows:
When the capital stock is low, there are many workers for each
machine, and the benefits of increasing capital further are
great; but when the capital stock is high, workers already have
plenty of capital to work with, and little benefit is to be gained
from expanding capital further.

Alpay Filiztekin Econ 202: Macroeconomics 14 / 20

The Production Function Marginal Products

The Marginal Product of Labor

Similar to MPK, the marginal product of labor, or MPL, is the

increase in output produced that results from a one-unit
increase in the labor.

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The Production Function Marginal Products

The Marginal Product of Labor

Y
Slope = MPL

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The Production Function Marginal Products

Supply Shocks

The production function of an economy doesn’t usually remain

fixed over time.
Economists use the term supply shock to refer to a change in
an economy’s production function.

A positive, or beneficial, supply shock raises the amount of

output that can be produced for given quantities of capital and
labor. A negative, or adverse, supply shock lowers the amount
of output that can be produced for each capital-labor
combination.

Alpay Filiztekin Econ 202: Macroeconomics 17 / 20

The Production Function Marginal Products

Supply Shocks

Typical examples of supply shocks are:

• changes in weather,
• new regulations,
• political uncertainty,
• new technologies,
• changes in the supplies of factors of production other than
labor and capital.

Suppose there is an “oil shock” (that is, oil prices do increase),

or if you like, political uncertainty rises:

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The Production Function Marginal Products

Supply Shocks
Y

D
Adverse
supply shock

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The Production Function Marginal Products

A Technical Note on Production Function

Returns to Scale in production function.

Let the production function be:

Y = AF (K , L)

• Constant Returns to Scale

mY = AF (mK , mL)
• Increasing Returns to Scale
mY > AF (mK , mL)
• Decreasing Returns to Scale
mY < AF (mK , mL)

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