EC 214 - MACROECONOMICS II

SPRING 2018 - 2019

CLASS 3

# Question 1
Determine which kind of returns to scale (increasing, constant, or decreasing) is exhibited
by each of the √
following
√ production functions:
3 3
a) F (K, L) = K 2 + L2
b) F (K, L) = min{K, L}
c) F (K, L) = K α Lβ where α + β > 1

* Solution of Question 1
First recall the following definitions

• F (zK, zL) = zF (K, L) ⇐⇒ F (K, L) is constant returns to scale (for any z > 0).

• F (zK, zL) > zF (K, L) ⇐⇒ F (K, L) is increasing returns to scale (for any z > 1).

• F (zK, zL) < zF (K, L) ⇐⇒ F (K, L) is decreasing returns to scale (for any z > 1).

a)
p
3
p
F (zK, zL) = (zK)2 + 3 (zL)2
√
3
√
3
= z 2 K 2 + z 2 L2
√
3
√3
√3
= z 2 ( K 2 + L2 ) < zF (K, L)
| {z }
F (K,L)

Therefore, F (K, L) exhibits decreasing returns to scale.

b) First, re-write the production function a little bit clearer:
(
K if K ≤ L
F (K, L) = min{K, L} =
L if K > L

Now let’s see what happens to output when we increase capital and labor by the same
amount z: (
zK if zK ≤ zL
F (zK, zL) = min{zK, zL} = = zF (K, L)
zL if zK > zL
So, F (K, L) exhibits constant returns to scale.
c)

F (zK, zL) = (zK)α (zL)β

= z α K α z β Lβ
= z α+β K α β
| {zL} > zF (K, L) since α + β > 1
F (K,L)

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As a result, F (K, L) displays increasing returns to scale.

# Question 2
Suppose the production of a representative firm in Bilgitopia is described with the following
Cobb-Douglas function:
Y = F (K, L) = θK α L1−α
where Y corresponds to real output (GDP), θ is the total factor productivity parameter
(TFP - shows how advanced/productive the aggregate productive activity is) and α is the
parameter showing the weight of physical capital (K) in production. L stands for the labor
supply of this economy. Physical capital and labor markets are competitive and ω and r to
denote real wage and rental rate of capital earned by workers and capital owners, respectively.
Using this information answer the following questions:
a) Assume that θ = 96, α = 1/3, K = 27000 and ω = 192. What is the employment
level at these parameter values? What does happen to employment if real wage increases to
ω = 384?
b) Now calculate the real wage rate (ω) when θ = 96, α = 1/3, K = 27000 and L = 1728.
Holding all else constant, what does happen to ω when physical capital stock increases to
K = 64000?
c) Which parameter determines the share of income earned by workers and capital owners
in this economy?
* Solution of Question 2
a) Since physical capital and labor markets are competitive, workers and capital owners
receive their marginal productivities as real wage and rental rate. That is, ω = M P L = ∂F ∂L
∂F
and r = M P K = ∂K (which follows from firms’ profit maximization).
Now, we are given information regarding ω, θ, α, and K, and we are supposed to find the
number of workers (L) employed at this scenario. We can do this by using ω = M P L = ∂F ∂L
:

∂F
ω = MP L = = (1 − α)θK α L−α
∂L
After that, plug in the known values of parameters to the expression above to solve L:

ω =(1 − α)θK α L−α

(1 − α)θK α
Lα =
ω
 1
(1 − α)θ α
L= K
ω
"
# 11
1 − 13 96 3
L= × 27000
192
 3  3
2 × 96 1
L= × 27000 = × 27000 = 1000
3 × 192 3

2
 Ceteris paribus, when the real wage rate is doubled, i.e. ω = 384, the quantity of labor
demanded is going to decline:

 1
(1 − α)θ α
L= K
ω
"
# 11
1 − 13 96 3
L= × 27000
384
 3  3
2 × 96 1
L= × 27000 = × 27000 = 125
3 × 384 6

Since we are only changing the real wage rate ω, we should be moving along the labor
demand curve - from point A to point B in the figure below:

Real
wage

Labor
demand

B
ω = 384

A
ω = 192

L = 125 L = 1000 Quantity of labor

b) At this part, θ, α, K and L are given. We are required to first calculate the equilibrium
real wage rate ω. We know that ω = M P L = ∂F∂L
. Therefore:

∂F
ω = MP L =
∂L
= (1 − α)θK α L−α

3
Now, plug in the parameter values into the expression above to find the value of ω:

ω = (1 − α)θK α L−α
 
1 1 1
= 1− × 96 × (27000) 3 × 1728− 3
3
2 1 1
= × 96 × (303 ) 3 × (123 )− 3
3
30
= 64 × = 160
12
Finally, when the physical capital stock increases to K = 64000 the labor demand func-
tion shifts to the right. As the labor supply is constant, this is expected to result in an
increase in the equilibrium real wage ω:

ω = (1 − α)θK α L−α
 
1 1 1
= 1− × 96 × (64000) 3 × 1728− 3
3
2 1 1
= × 96 × (403 ) 3 × (123 )− 3
3
40
= 64 × ≈ 213
12

Real
wage
Labor
supply

B
ω = 213

ω = 160 A Labor
demand 2

Labor
demand 1

L = 1728 Quantity of labor

c) We know that if the production function is constant returns to scale (and our Cobb-
Douglas production function is indeed constant returns to scale), then real GDP can be

4
written as the summation of the different types of income earned by factors of production.
∂F ∂F
Y = F (K, L) = ×L + ×K
∂L
|{z} ∂K
|{z}
MP L MP K

We also know that M P L = ω and M P K = r in an environment where labor and capital

are sold competitively (in these settings firms hire labor until the cost of the last worker
they employ is equal to the contribution of this last worker to production. In other words,
in order to maximize profits firms hire until the marginal cost of hiring an extra worker, the
market wage, is equal to the marginal benefit of this extra worker, the marginal product of
labor. The same argument applies to capital as well, so we also have M P K = r). Therefore,

ω = M P L = (1 − α)θK α L−α & r = M P K = αθK α−1 L1−α

and

Y =ω×L+r×K
ω×L r×K
1= +
Y }
| {z Y }
| {z
share of labor income share of capital income
in GDP in GDP

where
ω × L (1 − α)θK α L−α × L
=
Y Y
(1 − α)θK α L−α × L
=
θK α L1−α
(1 − α)θK α L1−α
=
θK α L1−α
=1 − α

So, the share of labor income in GDP is simply equal to 1 − α - which is also the weight
given to labor in production. From that result, the share of capital income in GDP follows
as α. Therefore, the parameter α is pivotal in the determination of the factor income shares
in this setting.