Chapter 3

Argue whether the statements are true or false.

1. The production function is the mathematical law that gives the relation of the prices of the
inputs, with the required quantity of inputs.

The statement is false. The production function determines how much output is produced
from given amounts of capital and labor.

Y = f (K, L)
2. In a production function we assume that the supply of labor (as an input) is fixed.

The statement is false. In a production function we assume that the supply of capital (as an
input) is fixed.

3. A production function has constant returns to scale if a doubling of the amount of all inputs
leads to a doubling of the output.

The statement is true. A production function has constant returns to scale if an increase of
an equal percentage in all factors of production, causes an increase in output of the same
percentage. In this case the amount of inputs doubles.

4. A competitive firm will continue to hire workers up to the point at which the marginal
product of labor (MPL) equals zero.

The distribution of national income is determined by factor prices. Factor prices are the amounts
paid to each unit of the factors of production. In an economy where the two factors of
production are capital and labor, the two factor prices are the wage workers earn and the rent
the owners of capital collect.

The price paid to any factor of production depends on the supply and demand for that factor’s
services. Because we have assumed that supply is fixed, the supply curve is vertical. The demand
curve is downward sloping. The intersection of supply and demand determines the equilibrium
factor price.

A competitive firm is small relative to the markets in which it trades, so it has little influence on
market prices. The firm cannot influence on the prices of the inputs or the prices of the
outputs. The firm sells its output at a price P, hires workers at a wage W, and rents capital at a
rate R.

The marginal product of labor (MPL) is the extra amount of output the firm gets from one extra
unit of labor, holding the amount of capital fixed. Most production functions have the property
of diminishing marginal product: holding the amount of capital fixed, the marginal product of
labor decreases as the amount of labor increases.

The statement is false.

The competitive firm’s demand for labor is determined by MPL = W/P.

W/P is the real wage—the payment to labor measured in units of output rather than in dollars.
To maximize profit, the firm hires up to the point at which the marginal product of labor equals
the real wage.
Exercises from the theory book
1. Use the neoclassical theory of distribution to predict the impact on the real wage and the real
rental price of capital of each of the following events: (Ex. 1 page 78)

a) A wave of immigration increases the labor force.

b) An earthquake destroys some of the capital stock.

c) A technological advance improves the production function. Y = 60 K0.5 L0.5

2. Suppose the production function in medieval Europe is Y = K0.5 L0.5, where K is the amount of land
and L is the amount of labor. The economy begins with 100 units of land and 100 units of labor. Use
a calculator and equations in the chapter to find a numerical answer to each of the following
questions (Ex. 2 page 78, we will answer the first three questions).

a. How much output does the economy produce?

Substitute the initial values of capital and labor in the production function to get the amount of
output.

b. What are the wage and the rental price of land?

Find MPL and MPK by computing the partial derivatives of the production function relative to labor
and capital.

c. What share of output does labor receive?

3. Suppose that an economy’s production function is Cobb–Douglas with parameter α = 0.3. What
fractions of income do capital and labor receive?

We know that the share of income that capital receives is given by the coefficient α = 0.3, so 30% of
national income consists of capital income.

In the Cobb Douglas function when α = 0.3, the share of work in revenue is 1- α = 0.7, so 70% of Y,
represent the share of output that labor receives.

4. The government raises taxes by $100 billion. If the marginal propensity to consume (MPC) is 0.6,
what happens to the following? Do they rise or fall? By what amounts? (Ex. 8 page 79)

a. Public saving
b. Private saving
c. National saving
d. Investment

5. Suppose that an increase in consumer confidence raises consumers’ expectations about their
future income and thus increases the amount they want to consume today. This might be
interpreted as an upward shift in the consumption function. How does this shift affect investment
and the interest rate?
Other exercises

1. Consider an economy described with the following equations.

Y= Y + F (K, L) =1200
Y= C + I + G
C=125 + 0.75 (Y - T)
I= I (r) = 200- 10r
G=G=150
T=T=100
a. Find the consumption for this economy.
b. Compute private saving, public saving, and national saving. Find the equilibrium
interest rate. Make the graphic presentation of S and I. Indicate whether the slope
of the investment function is positive or negative
c. Now suppose that G is increase by 50, and Y and T do not change. Compute again
private saving, public saving, and national saving for the new level of G. Do the
values change? Find the new equilibrium interest rate and make the graphic
presentation. Do we have a crowding out effect in this case? Explain.
d. Now suppose that G = 150 and T decreases by 20. Compute again the changes in
private saving, public saving, national saving, I, r. Do we have a crowding out effect
in this case? Explain.
e. If the country experiences a technological progress and I increase by 100 for each
level of interest rate, explain the shift of the investment curve, and what happens
with the savings and the real interest rate.
2. State whether the statement is true or false.

If investors become optimistic about the future / if the government cuts business taxes or it
subsidizes investment, then national savings, investment and interest rates will rise.
S = supply of loanable funds
I = demand for loanable funds.

3. Shortly after forming the new government, the new prime minister proposed a reduction
in government spending and an increase in taxes.

a. What would be the effect of this policy on the budget deficit?

b. Explain the long run effect of this policy in national savings, public savings, private savings.

c. Use the graphic presentation to show the long run effect of this policy on national savings, public
savings, private savings and real interest rate.

4. The interest rate of a bond depends on:

a) the term of the bond
b) the level of bond risk
c) type of taxes paid on the bond
d) all the above

5. Which of the following statements about national savings is incorrect?

a) national savings are given by the total value of the amount of money deposited in the banks.
b) national savings is the amount of private savings and public savings
c) national savings reflect the output that remains after households and government requirements
are met
d) national savings is equal to the level of equilibrium investments (value of investment for
equilibrium interest rate)

6. When total output is fixed and national savings are not a function of the interest rate, an increase
in government purchases increases:

a) national savings
b) public savings
c) equilibrium interest rate
d) private saving

7. If nominal interest rate is 8 % and the prices decrease by 5%, the real interest rate is:
The real interest rate is the nominal interest rate corrected for the effects of inflation, r = i –
expected inflation)

a) 8 % c) 13 %
b) 3 % d) –3 %

8. Suppose the consumption function is presented by the equation C = 100 + 0.8 (Y – T), disposable
income is 1000 and Y = 2000, then the marginal propensity to consume is:
a) 0.5 c) 0.8
b) 900 d) 0.9