Chapter 4

A Model of
Production

Prepared by Emily Marshall, Dickinson College

Copyright © 2018 W. W. Norton & Company
4.1 Introduction
 In this chapter, we learn:
 How to set up and solve a macroeconomic model
 The purpose of a production function and its use
for understanding differences in GDP per capita
across countries.
 The role of capital per person and technology in
explaining differences in economic growth.
 The relevance of “returns to scale” and
“diminishing marginal products”
 How to look at economic data through the lens of
a macroeconomic model
Introduction

 A model:
 A mathematical representation of a hypothetical
world that we use to study economic phenomena
 Consists of equations and unknowns with real-
world interpretations
 Macroeconomists:
 Document facts
 Build a model to understand the facts
 Examine the model to see how effective it is
4.2 A Model of Production
 Vast oversimplifications of the real world in a model
can still allow it to provide important insights.
 Consider the following model:
 Single, closed economy
 One consumption good
 Inputs in the production process:
 Labor (𝐿)
 Capital (𝐾)
 Production function:
 Shows how much output (Y) can be produced given any
number of inputs
Production Function

𝑌= 𝐹 𝐾, 𝐿 =𝐴 𝐾1/3 𝐿2/3

Productivity
Output Output Inputs
Parameter
Model

 Output growth corresponds to changes in 𝑌.

 There are three ways that 𝑌 can change:
1. Capital stock (K) changes
2. Labor force (L) changes
3. Ability to produce goods with given resources
(K, L) changes
 Technological advances occur (changes in A)
 TFP is assumed to be exogenous in the Solow model
Cobb-Douglas Production
Function
 The Cobb-Douglas production function is the
particular production function that takes the form
of:
 𝑌 = 𝐾 𝛼 𝐿1−𝛼
 α is assumed to be 1/3
 And F(K,L) is increasing in both K and L
 More inputs yield more output.
𝜕𝐹 𝜕𝐹
 > 0 and >0
𝜕𝐾 𝜕𝐿
 A production function exhibits constant returns to
scale if doubling each input exactly doubles
output.
Constant Returns to Scale (CRS)

 If increase 𝐾 and 𝐿 by x%
 𝑌 also increases by x%
 Mathematically,
 𝐹 𝛼𝐾, 𝛼𝐿 = 𝛼𝐹(𝐾, 𝐿)
 Homogeneous function (of degree 1)

 Standard replication argument

Output per Person (Intensive
Form)
 Divide output by the number of workers
𝑌 𝐾 𝐿 𝐾
=𝐹 , =𝐹 ,1
𝐿 𝐿 𝐿 𝐿
 per capita = per person = per worker
 Lowercase letters denote per capita
 We can rewrite output per person as
𝑦 = 𝑓(𝑘)
𝑌 𝐾
where 𝑦 = and k=
𝐿 𝐿
Typical Production Function

 Graph of 𝑦 = 𝑓 𝑘 = 𝑘1/3
 Note: if 𝑘 = 0 then 𝑦 = 𝑓 𝑘 = 0
10

6
y
4 k
2

0
0 200 400 600 800 1000
k
Returns to Scale Comparison

 Sum of exponents  Result

 Sum to 1  Constant returns to scale
 Sum to > 1  Increasing returns to scale
 Sum to < 1  Decreasing returns to scale
Allocating Resources


 π: profits
 r: rental rate of capital
 w: wage rate
 The rental rate and wage rate are taken as given
under perfect competition
 Hire capital until the MPK = r
 Hire labor until MPL = w
 For simplicity, the price of the output is
normalized to one
Marginal Products

 The marginal product of labor (MPL)

 The additional output that is produced when one unit
of labor is added, holding all other inputs constant
2 𝐾 1/3 2 𝑌
𝑀𝑃𝐿 = 𝐴 =
3 𝐿 3 𝐿
 The marginal product of capital (MPK)
 The additional output that is produced when one unit
of capital is added, holding all other inputs constant
Diminishing Marginal Product of
Capital in Production
Diminishing Returns
 Formally:
𝜕2 𝐹 𝜕2 𝐹
<0 <0
𝜕𝐾 2 𝜕𝐿2
 Suppose we have one unit of K and one unit of L.
 Assume this results in one unit of Y.
 Add a second unit of L.
 Previously, each unit of L had one unit of K to work with.
1
 Now, each unit of L has unit of K to work with.
2
 We are assuming that this will make each unit of L less
productive, and output will increase, but not double.
Solving the Model: General
Equilibrium—1
 Five Endogenous Variables  Five Equations
 Output (Y)  The production function
 The amount of capital (K)  The rule for hiring capital
 The amount of labor (L)  The rule for hiring labor
 The wage (w)  Supply equals the demand for labor
 The rental price of capital (r)  Supply equals the demand for
capital
Solving the Model: General
Equilibrium—2
The production function

The rule for hiring capital

The rule for hiring labor

Supply equals the demand for

labor
Supply equals the demand for
capital
Solution—1

 A solution to the model

 A new set of equations that express the five
unknowns in terms of the parameters and
exogenous variables
 General equilibrium
 Solution to the model when more than a single
market clears
Supply and Demand in the
Capital and Labor Markets
Solution—2

The production function

The rule for hiring capital

The rule for hiring labor

Supply equals the demand

for labor
Supply equals the demand
for capital
In This Model…

 The solution implies:

 firms employ all the supplied capital and labor in
the economy
 the production function is evaluated with the given
supply of inputs
𝑌 ∗ = 𝐹 𝐾, 𝐿 = 𝐴𝐾1/3 𝐿2/3
 𝑤 = 𝑀𝑃𝐿 evaluated at the equilibrium values of Y,
K, and L
 𝑟 = 𝑀𝑃𝐾 evaluated at the equilibrium values of Y,
K, and L
Interpreting the Solution
 The equilibrium wage is proportional to output
per worker
 Output per worker = (Y/L)

 The equilibrium rental rate is proportional to

output per capital
 Output per capital = (Y/K)

 In the United States, empirical evidence shows:

𝑤 ∗ 𝐿∗ 2 𝑟 ∗ 𝐾∗
∗ = and ∗ =

2 of production is paid to labor
3 𝑌 3 𝑌

1 of production is paid to capital 1
3
3
 The factor shares of the payments are equal to the
exponents on the inputs in the Cobb-Douglas function.
Labor’s Share of Income

Copyright © 2017 W. W. Norton & Company

Equilibrium

 All income is paid to capital or labor.

 Results in zero profit in the economy
 This verifies the assumption of perfect
competition.
 Also verifies that production equals spending
equals income.

Income=production
4.3 Analyzing the Production
Model
 Development accounting:
 The use of a model to explain differences in
incomes across countries

𝑦 ∗ = 𝐴𝑘1/3

 Setting the productivity parameter = 1

𝑦 ∗ = 𝑘1/3
The Empirical Fit of the
Production Function
 If the productivity parameter is 1, the model
overpredicts GDP per capita.
 Diminishing returns to capital implies that:
 Countries with low K will have a high MPK
 Countries with a lot of K will have a low MPK, and
cannot raise GDP per capita by much through
more capital accumulation
The Model’s Prediction for Per
Capita GDP (United States = 1)
Predicted Per Capita GDP in the
Production Model
The Model’s Prediction for Per
Capita GDP
Case Study: Why Doesn’t Capital
Flow from Rich to Poor Countries?
 If MPK is higher in poor countries with low K,
why doesn’t capital flow to those countries?
 Short Answer: Simple production model with no
difference in productivity across countries is
misguided
 We must also consider the productivity parameter
Productivity Differences:
Improving the Fit of the Model
 The productivity parameter measures how
efficiently countries are using their factor
inputs.
 total factor productivity (TFP)
 If TFP is ≠ to 1  better model
Total Factor Productivity

 Data on TFP is not collected.

 It can be calculated because we have data on
output and capital per person.
 TFP is referred to as the “residual.”
 A lower level of TFP
 implies that workers produce less output for any
given level of capital per person.
Measuring TFP So the Model
Fits Exactly—1
United States and Chinese
Production Functions
Measuring TFP So the Model
Fits Exactly—2
4.4 Understanding TFP
Differences
 Output differences between the richest and
poorest countries?
 Differences in capital per person explain about one-
third of the difference.
 TFP explains the remaining two-thirds.
 Thus, rich countries are rich because:
 They have more capital per person.
 More importantly, they use labor and capital more
efficiently.
 Why are some countries more efficient at using capital
and labor?
Understanding TFP Differences

 Human capital
 Technology
 Institutions
 Misallocation
Human Capital

 Human capital
 Stock of skills that individuals accumulate to make
them more productive
 Education and training
 Returns to education
 Value of the increase in wages from additional
schooling
 Accounting for human capital reduces the
residual from a factor of 11 to a factor of 6.
Technology

 Richer countries may use more modern and

efficient technologies than poor countries.
 Increases productivity parameter
Institutions

 Even if human capital and technologies are

better in rich countries, why do they have
these advantages?
 Institutions are in place to foster human
capital and technological growth.
 Property rights
 The rule of law
 Government systems
 Contract enforcement
Misallocation

 Misallocation
 Resources not being put to their best use
 Examples
 Inefficiency of state-run resources
 Political interference
4.5 Evaluating the Production
Model
 Per capita GDP is higher if capital per person
is higher and if factors are used more
efficiently.
 Constant returns to scale imply that output
per person can be written as a function of
capital per person.
 Capital per person is subject to strong
diminishing returns because the exponent is
much less than one.
Weaknesses of the Model

 In the absence of TFP, the production model

incorrectly predicts differences in income.
 The model does not provide an answer as to
why countries have different TFP levels.