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Topic 1 Consumer and Firm Behavior (Part 2)

Topic 1 Consumer and Firm Behavior (Part 2). The Representative Firm. Firms demand labor and supply consumption goods The choices of the firms are determined by i. the available technology and ii. profit maximization Our focus here is on the choices of a single, representative firm.

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Topic 1 Consumer and Firm Behavior (Part 2)

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  1. Topic 1Consumer and Firm Behavior (Part 2)

  2. The Representative Firm • Firms demand labor and supply consumption goods • The choices of the firms are determined by i. the available technology and ii. profit maximization • Our focus here is on the choices of a single, representative firm

  3. A Production Function • Describes the technological possibilities for converting factor inputs into outputs Y = zF(K,Nd) • Y is output of consumption goods • z is total factor productivity • F is a function • K is the quantity of capital input • Nd is the quantity of labor input (total hours worked)

  4. Since this is a static, or short run analysis, firm cannot vary its quantity of plant and equipment, K is a fixed input • Firm can vary the labor input (Nd) • z captures the degree of sophistication of the production process • Higher z means that more output can be produced

  5. Marginal Product • The marginal product of a factor of production is the additional output that can be produced with one additional unit of that factor input, holding constant the quantities of the other factor inputs • We will look at MPN and MPK

  6. MPN Output (Y) Slope = MPN A F(K*, Nd) Labor (N) N*

  7. The marginal product of labor is the slope of the production function at a given point • Note that the marginal product of labor declines with the quantity of labor.

  8. MPK Output (Y) Slope = MPK A F(K , N*) Capital (K) K*

  9. This graph shows the production function when the quantity of labor is fixed, while the quantity of capital is allowed to vary • MPK is measured by the slope of this production function. • MPK also declines with the quantity of capital

  10. 5 Keys Properties of the Production Function • The production function exhibits constant returns to scale • Output increases when either the capital input or the labor input increases • The marginal product of labor decreases as the quantity of labor increases • The marginal product of capital decreases as the quantity of capital increases • The marginal product of labor increases as the quantity of capital input increases

  11. Changes in TFP and the Production Function • Changes in TFP are important as it also causes economic growth and influence business cycles • We must understand how a change in z alters the production technology

  12. TFP has two important effects on the production function; • When z increases, the production function shifts up • When z increases, the MPN increases

  13. Factors that could cause a change in TFP • Change in the organization of production or management techniques (for example: the introduction of assembly line by Henry Ford for the production of his Model T ford cars)

  14. Good weather especially true for the agricultural and construction sectors • Government regulations • strict environmental regulations which aim at improving the welfare of the population, but will decrease output

  15. Change in the relative price of energy • When the relative price of energy increases, firms use less energy in production, and this reduces the productivity of both capital and labor, z decreases.

  16. TFP and the Aggregate Production Function • The general form of the production function; Y = zF(K,Nd) • The specific form could be the Cob-Douglas production function, such as; Y = z Ka(Nd)1-a

  17. Where a ia a parameter, with 0 < a < 1 • The exponents of K and Nd sum to 1, which reflects constant returns to scale • From this function, a is the share that capital receives of national income (profits) • while (1-a) is the share that labor receives (wages income before taxes)

  18. An empirical estimation of the actual U.S. aggregate production function is Y = z K0.36(Nd)0.64 • The quantities of Y, K and Nd in the equation can all be measured • But how is z (TFP) measured?

  19. z cannot be measured directly • But it can be measured indirectly as a residual • Also known as the Solow residual z = Y K0.36(Nd)0.64 • This measure of TFP is named after Robert Solow

  20. The Firm’s Demand for Labor • The representative firm behaves competitively, (i.e. real wage is given) • The goal of the firm is to maximize its profit, where  = Y – wNd Total revenue total real variable cost

  21. Substituting for Y, using the production function Y = zF(K,Nd), the firm’s problem is to choose Nd to maximize profit  = zF(K,Nd) – wNd • K is fixed, and  is real profit

  22. Revenue, Variable Costs and Profit Maximization Revenue, Variable Costs wNd zF(K,Nd) A E B Labor Input D N*

  23. The firm maximizes profits by setting MPN = w …………. (4.11) • N* labor will be hired ( refer to pages 123-125) • Given a real wage w, the marginal product schedule tells us how much labor the firm needs to hire to achieve (4.11) • The MPN schedule is the demand curve for labor

  24. Labor demand curve Real Wage(w) MPN or labor demand curve Nd

  25. Labor Demand Curve

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