Chapter 3

Aggregate
Production and
Productivity
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• To understand the production process in the

aggregate economy
• To examine the fundamental factors of
production
• To understand what determines the prices
and income of the factors of production,
and their shares of national income

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 Determinants of Aggregate
Production

• Factors of Production (inputs) include:

– Labor (L)
– Capital (K)
• Both factors are assumed to be exogenous
and fixed over time.

K K
LL

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 Production Function

• Aggregate production function

(production function) is a description of
how much output, Y, is produced for any
given amounts of factor inputs:

Y  F (K, L)

where F is the function that translates K

and L into Y

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 Cobb-Douglas Production Function

• Two observations on a production function:

– An efficient, developed economy generally
produces more with the same quantity of capital
and labor than an inefficient, primitive economy
– The shares of labor and capital income in the
U.S. economy have remained relatively constant
over time at about 70% labor and 30% capital

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 Cobb-Douglas Production Function
(cont’d)

• The Cobb-Douglas production function

incorporates the two ideas:

0.3 0.7
Y  F (K, L)  AK L

where A describes productivity (total

factor productivity)

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 Cobb-Douglas Production Function
(cont’d)

• From the perspective of workers, labor

productivity is the amount of output
produced per unit of labor
• Unlike labor productivity, total factor
productivity takes into account how
productive labor and capital are together

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 Cobb-Douglas Production Function
(cont’d)

Y
A  0.3 0.7
K L
• Example: Y=$10 trillion, K=$10 trillion,
L=100 million workers

10
A 0.3 0.7
 0.20
10 100

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 Application: Why Are Some Countries
Rich and Others Poor?

• Assume that every citizen works, so that

per capita income is the same as average
income (output) per worker, Y/L.
• Income per worker becomes:

0.3 0.7 0.3

Y AK L AK
y    0.3  Ak 0.3
L L L

where k is capital per worker

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 Application: Why Are Some Countries
Rich and Others Poor? (cont’d)

• The shortfall of per capita income in other

countries relative to the United States is
due more to lower productivity than it is to
lower amounts of capital per person

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 TABLE 3.1 PER CAPITA INCOME
RELATIVE TO THE UNITED STATES FOR
DIFFERENT COUNTRIES

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 Cobb-Douglas Production Function
Characteristics

• Two particularly attractive characteristics:

1. Constant returns to scale
2. Diminishing marginal product

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 Cobb-Douglas Production Function
Characteristics (cont’d)

• Constant returns to scale can be shown by

doubling both K and L into the previous
production function so that

0.3 0.7
Y  F (2K ,2L )  0.20(2K ) (2L )
 0.20  (20.320.7 )  K 0.3L0.7
 (20.320.7 )  F (K , L )
 2  F (K , L )

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 Cobb-Douglas Production Function
Characteristics (cont’d)

• Diminishing marginal product means

that as the amount of one factor input
increases, holding other inputs constant, the
increased amount of output from an extra
unit of the input (its marginal product)
declines

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 Cobb-Douglas Production Function
Characteristics (cont’d)

• To illustrate diminishing marginal product,

assume L=100:

Y = 0.20 ´ K 0.3(100)0.7
= 0.20 ´ K 0.3(25.1) = 5.0 ´ K 0.3

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 FIGURE 3.1 Production Function
Relating Output and Capital

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 Cobb-Douglas Production Function
Characteristics (cont’d)

• The marginal product of capital (MPK)

indicates how much output increases for
each additional unit of capital, holding other
inputs constant
– slope of the production function, ΔY/ΔK
– as the capital stock increases, the marginal
product of capital declines

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 FIGURE 3.2 Production Function
Relating Output and Labor

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 Cobb-Douglas Production Function
Characteristics (cont’d)

• The marginal product of labor (MPL)

indicates how much output increases for
each additional unit of labor, holding other
inputs constant
– as the amount of labor inputs increases,
the marginal product of labor declines

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 Changes in the Production Function:
Supply Shocks

• A supply shock is a change in the output

an economy can produce from the same
amount of capital and labor
– Positive (favorable) supply shocks
– Negative (adverse) supply shocks
• Represented by a change in A

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 Changes in the Production Function:
Supply Shocks (cont’d)

• Types of Supply Shocks:

– Technology shocks
– Natural environment shocks
– Energy shocks
• A negative (positive) supply shock causes
the aggregate production function to shift
downward (upward) and also causes the
marginal products of capital and labor to fall
(rise)

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 FIGURE 3.3 Response of the Production
Function to a Negative Supply Shock (a)

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 FIGURE 3.3 Response of the Production
Function to a Negative Supply Shock (b)

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 Determination of Factor Prices

• Analysis is conducted this analysis under a

classical framework, which assumes that the
economy:
– Has perfect competition
– Is at its long-term equilibrium level

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 Demand for Capital and Labor

• Nominal economic profits:

P  F (K, L)  RK  WL
where
P = average level of the prices of
goods and services
R = rental price of capital
W = wage rate

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 Demand for Capital and Labor
(cont’d)

• Real economic profits:

P= F(K,L) - (R / P)K - (W / P)L

where
R/P = real rental price of capital (rc)
W/P = real wage rate (w)

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 Demand for Capital and Labor
(cont’d)

• Profit maximization implies:

– firms demand a quantity of each factor of
production (capital and labor) up until the
marginal product of that factor falls to its real
factor price

MPK  (R / P)  rc

MPL  (W / P)  w

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 Supply of Capital and Labor

• Assume that the quantity of capital and

labor are given at fixed values,

LL

K K

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 Factor Market Equilibrium

• Market equilibrium:
– Labor market: DL  S L
– Capital market: DK  S K
• Excess supply: DL  SL or DK  S K
• Excess demand: DL  S L or DK  S K

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 FIGURE 3.4 Supply and Demand
Analysis of the Factor Markets (a)

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 FIGURE 3.4 Supply and Demand
Analysis of the Factor Markets (b)

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 Distribution of National Income

• Real Labor Income: wL  MPL  L

• Real Capital Income: rc K  MPK  K

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 Distribution of National Income
(cont’d)

• National Income (Y): Real Labor Income +

Real Capital Income
– divided between payments to labor and the
payments to capital, with the size of these
payments determined by the marginal products
of labor and capital
– the Cobb-Douglas production function implies
that the shares of labor income and capital
income in national income do not change even
as the total level of income rises and falls

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 Application: Explaining Real Wage
Growth

• What explains the changing trend rate of

growth in real wages?
• Because w = MPL = 0.7 (Y/L), real wages
and labor productivity (Y/L) should grow at
about the same rate over time

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 TABLE 3.2 GROWTH IN LABOR U.S.
PRODUCTIVITY AND REAL WAGES

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 Application: Oil Shocks, Real Wages,
and the Stock Market

• Supply and demand analysis helps explain

why both real wages and stock market
prices fell after the U.S. economy
experienced an oil price shocks in the last
35 years

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 FIGURE 3.5 Effect of a Negative Supply
Shock on Real Wage and the Real Rental
Price of Capital (a)

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 FIGURE 3.5 Effect of a Negative Supply
Shock on Real Wage and the Real Rental
Price of Capital (b)

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