Agenda

1. Determinants of Aggregate Production

Aggregate Production 2. The Production Function

and and the Return to the Factors of Production
Productivity 3. Full-Employment Output

4. Supply Shocks

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Determinants of Aggregate Production Determinants of Aggregate Production

• Real GDP is determined by:
1. The amount of the factors of production, and
2. The production function which shows how firms
transform factors of production into output of
goods and services through the application of
technology (or productivity).
• For the aggregate economy, the factors of
production are:
1. Labor (L), the number of worker hours, and
2. Capital (K), the stock of productive assets.
• Technology (A) determines the productivity of
the factors of production.

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Determinants of Aggregate Production
• The economy’s production function is:
Y = A*F(K, L)
– This shows how much output (Y) can be produced
from given amounts of capital (K) and labor (L) and
from a given level of technology (A).
– The parameter A is a scalar and represents total
factor productivity or the effectiveness with which
the factors of production are used.
3-5
The Production Function: Output & Capital
• The production function, Y = A*F(K, L), can
be drawn as either:
1. Output and capital, or
2. Output and labor.
3-7
Determinants of Aggregate Production
• Total factor productivity is calculated as:
A = Y
F(K, L)
– Total factor productivity is like a recipe that
indicates how to use capital and labor together to
produce economic output.
3-6
The Production Function: Output & Capital
• The production function between output and
capital shows how:
– Economic output, Y, depends on
– the size of the capital stock, K,
– for a given labor force, L0, and
– for a given level of technology, A0.
3-8
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The Production Function: Output & Capital The Production Function: Output & Capital
• Marginal product of capital, MPK = Y/K

1. Equals the slope of this production function.

2. Is always positive.

3. Declines as the amount of capital increases.

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The Production Function: Output & Capital The Production Function: Output & Capital
MPK
• Two properties of this production function:

1. Exhibits increasing returns to capital.

• Slopes upward because more K produces more Y.

2. Exhibits diminishing marginal product of

capital.
• Slope becomes flatter because each additional
increment of K eventually produces smaller increments
of Y.
K
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3
Determination of Capital Returns, rc Determination of Capital Returns, rc
• Now, in equilibrium, the real cost of capital, rc, rc, MPK
will equal the marginal product of capital, i.e.,

rc = MPK
– So the MPK is also the demand for capital, KD.

• Suppose the supply of capital, KS, is fixed, i.e.,

KS = K
K

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The Production Function: Output & Capital The Production Function: Output & Capital
• If either L0 or A0 changes, what happens to: Y rc, MPK

1. The production function, Y0 Y = A0F(K, L0)

2. Economic output,
3. The marginal product of capital, and
4. The real (rental) cost of capital?
rc0 MPK

K K K K

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The Production Function: Output & Capital The Production Function: Output & Labor
• Factors that shift the demand for capital curve: • The production function, Y = A*F(K, L), can
be drawn as either:
1. Changes in the labor force, ΔL.
• Increases in L raise the MPK and shift the demand for 1. Output and capital, or
capital curve to the right.
2. Output and labor.
2. Supply (or technology) shocks, ΔA.
• Beneficial supply shocks raise the MPK and shift the
demand for capital curve to the right.

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The Production Function: Output & Labor The Production Function: Output & Labor
• The production function between output and
labor shows how:

– Economic output, Y, depends on

– the size of the labor force, L,

– for a given capital stock, K0, and

– for a given level of technology, A0.

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The Production Function: Output & Labor
• Marginal product of labor, MPL = Y/L
1. Equals the slope of this production function.
2. Is always positive.
3. Declines as the amount of labor increases.
3-21
The Production Function: Output & Labor
MPL
L
3-23
The Production Function: Output & Labor
• Two properties of this production function:
1. Exhibits increasing returns to labor.
• Slopes upward because more L produces more Y.
2. Exhibits diminishing marginal product of labor.
• Slope becomes flatter because each additional
increment of L eventually produces smaller increments
of Y.
3-22
Determination of Labor Returns, w
• Now, in equilibrium, the real wage, w, will
equal the marginal production of labor, i.e.,
w = MPL
– So the MPL is also the demand for labor, LD.
• Suppose the supply of labor, LS, is fixed, i.e.,
LS = L
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 Determination of Labor Returns, w The Production Function: Output & Labor
w, MPL • If either K0 or A0 changes, what happens to:
1. The production function,
2. Economic output,
3. The marginal product of labor, and
4. The real wage?

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The Production Function: Output & Labor The Production Function: Output & Labor

Y w, MPL • Factors that shift the labor demand, LD, curve:

Y0 Y = A0F(K0, L) 1. Changes in the capital stock, ΔK.
• Increases in K raise the MPL and shift the labor demand
curve to the right.

2. Supply (or technology) shocks, ΔA.

w0
• Beneficial supply shocks raise the MPL and shift the
MPL
labor demand curve to the right.

L L L L

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The Production Function: Output & Labor The Production Function: Output & Labor
• Factors that shift the labor supply, LS, curve: • Factors that shift the labor supply curve:

1. Changes in wealth. 3. Changes in the working–age population.

• Increases in wealth reduce labor supply and shift the • Increases in the working-age population increase labor
labor supply curve to the left. supply and shift the labor supply curve to the right.

2. Changes in expected future real wage. 4. Changes in the labor force participation rate.
• Increases in expected future real wage are like increases • Increases in the labor force participation rate also
in wealth that reduce labor supply and shift the labor increase labor supply and shift the labor supply curve to
supply curve to the left. the right.

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Full-Employment Output Full-Employment Output

Y
• Full-employment, or potential, output is the Y=A0F(K0, L)
level of output when the labor market is in
YP
(long-run) equilibrium.

YP = AF(K, L)

• The full-employment, or potential, output level

is also the economy’s long-run aggregate
supply, LRAS.
L L
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Full-Employment Output Supply Shocks
• Factors that change full-employment output: • Supply (or productivity) shocks occur if there
is a change in the amount of output that can be
1. Shifts in the demand for labor and/or supply of produced with a given amount of capital and
labor. labor.
• These affect the full-employment level of employment.
• Supply shocks can occur because of:
2. Shifts in the production function.
• From supply (or productivity) shocks or changes in the 1. Technology shocks
capital stock.
2. Natural environmental shocks
3. Energy price shocks
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Supply Shocks Supply Shocks: Y, K, the MPK and rc

• Supply shocks involve changes in A. Y rc, MPK
– These shocks rotate the production function.
Y0 Y = A0F(K, L0)

• Supply shocks can be either:

1. Positive (or favorable or beneficial), which rotates
the production function up.
rc0 MPK
2. Negative (or unfavorable or adverse), which
rotates the production function down.
K K K K

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 Supply Shocks: Y, L, the MPL, and w Supply Shocks

Y w, MPL • A positive supply shock causes:

Y0 Y = A0F(K0, L) 1. The production function to rotate higher,
2. The marginal product of capital to increase,
3. The real (rental) cost of capital to increase,
4. The marginal product of labor to increase, and
5. The real wage to increase.
w0 MPL

• A negative supply shock has opposite effects.

L L L L

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