Econ chapter 3
National income: where it all comes from and where it goes
GDP depends on
Quantity of output, FOP’s
Ability to turn inputs into output
Factors of production: inputs used to produce goods and services
Capital: set of tools that workers use (K)
Labor: time people spend working (L)
Both are fixed (bar over) and none wasted
Production function: shows how the quantities of FOP’s determine the quantity of goods
and services produced.
Y = F (K, L)
Output is a function of the amount of capital and labor
Available technology for turning capital and labor into output
Constant returns to scale: an increase of an equal percentage in all FOP’s causes an
increase in output of the same percentage.
zY = F ( zK , zL)
Neoclassical theory of distribution
factor prices: amounts paid to the FOP’s
for labor and capital they are wages and rent
Competitive firm: small relative to the markets in which it trades, so it has little
influence on the market prices.
Uses market prices because otherwise they would go out of business from other firms
Maximize profit: = revenue – costs
• Revenue = P x Y (p = selling price / y = amount produced)
• Labor costs = W x L (wage times amount of labor)
• Capital costs = R x K (rental price of capital times amount of capital)
♦ Profit = PY – WL – RK (revenue – labor costs – capital costs)
Profit = PF (K,L) – WL – RK
Marginal product of labor (MPL): extra amount of output the firm gets from one extra unit
of labor, holding capital fixed.
MPL= F (K, L+1) – F (K, L)
Diminishing marginal product: holding the amount of capital fixed, the MPL decreases
as the amount of labor increases.
Each worker makes less bread because there are more people and only a small
kitchen, making it crowded.
Afirm hires works until the extra revenue = wage • Profit = (P x MPL) – W
♦ MPL = W/P
W/P = real wage: the payment to labor measured in units of output rather
MPL = labor demand curve
Marginal product of capital (MPK): amount of extra output the firm gets from an extra
unit of capital, holding labor constant.
MPK = F(K + 1, L) – F(K,L)
• Difference between k and k +1
MPK = R / P
Real rental price of capital: rental price measured in units of goods rather than in
***the firm demands each factor of production until that factor’s marginal product
falls to equal its real factor price***
Economic profit: the income that remains after the firms have paid the FOP’s
Economic profit = Y – (MPL x L) – (MPK x K)
Accounting profit: the amount of revenue remaining for the owners of a firm after all
the FOP’s, except capit