3 Building Blocks of The Macro Framework: 3.1 The Factor/input Market

ECON1220H&I * Intro Macro Chi-Wa Yuen
3 Building blocks of the macro framework
From the supply-demand perspective, there are 3 building blocks— viz., the 3 mar-
kets mentioned above.
3.1 The factor/input market
Assuming labor and (physical) capital as the only factors of production, this market
is itself made up of
– the labor market and
– the capital-input market.
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3.1.1 The labor market
(a) Labor demand N d
The …rm’s “scarcity”problem is to choose how much labor to hire nd — at a given

real wage rate (w) — so as to produce output (y s) to generate the highest possible
pro…t ( ) ; given the capital stock (k) and production technology AF (n; k) (where
A is known as the productivity parameter):
max ys w nd s:t: y s = AF ( nd ; k )
nd 0 ; y s 0 (+) (+)
() max AF nd; k w nd
nd 0 | {z }
ys
@y s
=) d
w=0
|@n
{z }
AFn(:)
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The production function exhibits positive but decreasing marginal products as well
as factor complementarity, i.e.,
productive inputs : Fn (:) > 0; Fk (:) > 0;
diminishing marginal productivities : Fnn (:) < 0; Fkk (:) < 0;
factor complementarity : Fnk (:) = Fkn (:) > 0;

where (:) = nd; k because, like total output y s; marginal output M P N (and
M P K ) is also a function of labor and capital.
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Pro…t-maximizing condition
AFn(:) = w
| {z }
MP N
Individual optimization
– marginal bene…t = the additional output produced (i.e., the marginal product
of labor, M P N )
– marginal cost = the extra wage paid to the worker (i.e., w)
– …rm’s pro…t-maximizing choice of labor is determined by the condition M P N =

wk
k Alternatively, one can express the pro…t-maximizing condition in nominal terms
P M P N = W;
where P is the general price level and W the nominal (money) wage. P M P N is also known as the
value of marginal product (V M P N ) :
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Comparative statics: As a direct implication of the law of diminishing returns

[Fnn (:) < 0], nd is decreasing in w — i.e., downward-sloping labor demand curve.
insert M P N and labor-demand curve diagram here
– Mathematically, we can solve the pro…t-maximizing equation to obtain the labor

demand function, nd( w ; A ; k ):
( ) (+) (+)
This labor demand function can be substituted into the production function and the pro…t function to
obtain respectively the output supply function
y s ( w ; A ; k ) = AF (nd(w; A; k); k);
( ) (+) (+)
and the indirect pro…t function,

( w ; A ; k ) = y s (w; A; k) wnd(w; A; k):
( ) (+) (+)
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Aggregation: Summing across all …rms, we get the aggregate labor demand curve
X
N d (w; ::) nd(w; ::)
f irms
insert horizontal aggregation of labor-demand diagram here
Factors a¤ecting N d
– N d depends positively on the capital input (due to factor complementarity) and

the technology, as well as the number of …rms.
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– Policy factors
salary taxes paid by the employees (rather than the employers) don’t matter
(unless workers gain bargaining power via a labor union)
corporate pro…ts taxes — which a¤ect investment decisons, hence future

capital stocks — don’t matter for current labor-hiring decisions, but may
reduce future demand for labor
– Dynamic factors
the …rm/economy’s past (current) investment (including R&D) decisions —

and any government policies on which they depend — matter for current
(future) labor demand
learning-by-doing or on-the-job training (OJT) e¤ects — how current em-

ployment decisions may a¤ect future labor productivity
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– Open-economy factors
entry/exit of multi-national corporations (MNCs) and foreign direct invest-

ment (FDI) — and any government policies on which such activities depend
business/investment opportunities abroad
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(b) Labor supply (N s)
The household’s “scarcity” problem to choose consumption (c) ; leisure (`) ; and
work hours (ns) to maximize utility (U ) subject to a time constraint and a budget
constraint, given the wage rate (w) and pro…t income from ownership of the …rm
( = (w; A; k)) :
(
ns + ` 1;
max U ( c ; ` ) s:t:
fc 0; 0 ` 1; 0 ns 1g (+) (+) c w ns + :
0 1
() max U @wns + ; 1 nsA

0 ns 1 | {z } | {z }
c `
Di¤erentiating the utility function with repect to worked hours, we get

@U (:) @U (:)
w+ ( 1) = 0
| @c
{z } | @`
{z }
Uc (:) U` (:)
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The utility function exhibits positive but decreasing marginal utilities as well as
complementarity between consumption and leisure, i.e.,
“goods” are good : Uc (:) > 0; U` (:) > 0;
diminishing marginal utilities : Ucc (:) < 0; U`` (:) < 0;
complements : Uc` (:) = U`c (:) > 0;

where (:) = (c; `) = (wns + ; 1 ns) because, like total utility U , marginal
utility M U; is also a function of consumption and leisure (and, hence, worked
hours).
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The utility-maximizing condition can be rewritten as:

U` (:)
=w
Uc (:)
– marginal cost = loss of leisure (measured in terms of goods by the marginal rate
dc U` (:)
of substitution between leisure and consumption, M RS d` = U (:)
)
dU =0 c
– marginal bene…t = increase in wage income (measured in terms of goods by the

real wage rate, w = W=P )
– utility-maximizing choice of labor supplied by individual household is determined

by the condition M RS = w
insert M RS as SE-component of labor-supply curve diagram here
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Comparative statics: The utility-maximizing equation can be used to derive the

labor supply function, ns( w ; ):yy Labor supply is usually increasing at low levels
(?) ( )
of w; but can be decreasing at su¢ ciently high w-levels. This backward-bending
property is the result of 2 opposite e¤ects, viz.,
– substitution e¤ect (SE): substitution of work for leisure as the opportunity cost
of leisure (= forgone real wage) is increased
– income/wealth e¤ect (IE/WE): work less in order to leave more time for leisure
— a “normal” good — as income/wealth increases
yy Substitutingthis labor supply function into the budget constraint and the utility function, we can also
derive respectively the consumption demand function,
cd(w ; ) = wns (w; ) + (w; );
(?) (+)
and the indirect utility function,

U (w ; ) = U cd(w; ); 1 ns (w; ) :
(?) (+)
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Aggregation: Summing across all households, we get the aggregate labor supply
curve
X
N s (w; ::) ns(w; ::)
households
insert horizontal aggregation of labor-supply diagram here
assuming, for simplicity, that the relevant segment of the N s curve is increasing in
w — i.e., upward-sloping labor supply curve
Factors a¤ecting N s
– Through the size of the workforce, both population size (hence, fertility/mortality
and emigration/immigration) and the labor force participation rate (LFPR) are
important determinants of N s
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– Policy factors
proportional salary taxes that would reduce the real wage received by the
worker from its pre-tax level w to its after-tax level w (1 w) w
other policy instruments including social-security (or payroll) taxes, unem-

ployment bene…ts, regulations on work hours and labor-union activities, ap-
prenticeship schemes and retraining programs, education policy, ...
– Dynamic factors
expected future wages we as well as the real interest rate r through intertem-
poral substitution in labor supply — given that the price of labor today in
terms of labor tomorrow is given by w (1 + r) =we
current and future stance of the other afore-mentioned government policies
– Open-economy factors
anything that a¤ects the worker’s migration and/or guest-working decisions

— e.g., immigration policies, international income tax principles/policies, ...
2/14/2022 14/36
(c) Market equilibrium — possibility of unemployment?
Under ‡exible wages, the equilibrium real wage (w) and labor employment (N ) are
determined jointly by equating labor supply to labor demand, i.e.,
N s (w; ::) = N d (w; ::)
insert labor-market equilibrium diagram here
Given this w and the equilibrium price level (P ) to be determined in the goods
market, the equilibrium nominal wage (W ) is simply the product of w and P:
Abstracting from search/matching frictions (frictional unemployment) and struc-

tural/sectoral shifts (structural unemployment), “full” employment — i.e., zero
(cyclical) unemployment over and above its natural (frictional + structural) level
— would prevail when the labor market clears.
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Under sticky wages due to, say, nominal-wage contracts (so W = W ),zz however,
the labor market need not clear, so that cyclical unemployment may arise. The
equilibrium real wage w (though ‡exible) cannot be determined without knowing
the equilibrium P: Given w; there are at least 3 alternative ways to determine
equilibrium N
i) demand(supply)-determined if there exists excess supply(demand) of labor —

under the short-side rule
ii) subject to bargaining between the employers and employees (if the labor market
is not perfectly competitive, e.g., in the presence of labor unions)
iii) determined according to other stipulations agreed upon in the labor contract,
e.g., leaving the …nal say about actual work hours (so N is demand-determined)
in each period to the employers — “let the boss decide”
zz Cf. Real-wage rigidity, say, “e¢ ciency wage” story.
2/14/2022 16/36
3.1.2 The market for capital input
(a) Demand for capital input kd
The …rm’s “scarcity” problem is to choose how much capital to rent kd — at

a given real rental rate (rk ) — so as to produce output (y s) to generate the
highest possible pro…t ( ) ; given the labor input (n) and production technology
AF (n; k) :
max ys rk kd s:t: y s = AF ( n ; kd )
kd 0 ; y s 0 (+) (+)
() max AF n; kd rk kd
kd 0 | {z }
ys
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Pro…t-maximizing condition
@y s
AFk (:) = rk
@kd | {z }
MP K
– marginal bene…t = the additional output produced (i.e., the marginal product
of capital, M P K )
– marginal cost = the extra rental paid to the capital owner (i.e., rk )
– …rm’s pro…t-maximizing choice of capital is determined by the condition M P K =

rk
Alternatively, one can express the pro…t-maximizing condition in nominal terms
P M P K = Rk ;
where P is the general price level and Rk the nominal (money) rental. P M P K is also known as
the value of marginal product (V M P K) :
2/14/2022 18/36
Comparative statics: As a direct implication of the law of diminishing returns

[Fkk (:) < 0], kd is decreasing in rk — i.e., downward-sloping capital demand curve.
insert M P K and capital-demand curve diagram here
– Mathematically, we can solve the pro…t-maximizing equation to obtain the cap-

ital demand function, kd( rk ; A ; n ):
( ) (+) (+)
This labor supply function can be substituted into the production function and the pro…t function to
obtain respectively the output supply function,
y s ( rk ; A ; n ) = AF (kd(rk ; A; n); n);
( ) (+) (+)
and the indirect pro…t function,

( rk ; A ; n ) = y s (rk ; A; n) rk kd(rk ; A; n):
( ) (+) (+)
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Aggregation: Summing across all …rms, we get the aggregate labor demand curve
X
K d (r k ; ::) kd(rk ; ::)
f irms
insert horizontal aggregation of capital-demand diagram here
K d depends positively on the productivity parameter (A) and the number of …rms,
as well as the labor input (due to factor complementarity). So any other (policy,
dynamic, and open-economy) factors that a¤ect N d may a¤ect K d as well?
Strictly speaking, the 2 input demand decisions should be combined by solving a single pro…t-
maximization problem:
maxd AF nd; kd w nd rk kd:
nd 0;k 0
The following two pro…t-maximizing conditions can then be used to solve for the quantity demanded of
labor nd and the quantity demanded of capital kd together, both as functions of the factor prices
(w; rk ) and the technology parameter (A) :
AFn nd; kd = w
AFk nd; kd = rk
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(b) Supply of capital input (ks)
The capital stock available today is the sum of (undepreciated) old capital carried
over from previous periods (k 1) and the newly produced capital arising from
investment in the current period (i) — i.e., k = (1 ) k 1 + i; where 0 < 1
is the depreciation rate.
P
Aggregate capital Ks s
f irms k is perfectly inelastically supplied by the …rms
based on their own previous investment (or by capital-goods producers) — assuming
…xed (e.g., 100%) capital utilization.
Other than the rate of capital (utilization, hence) depreciation, K s depends on

any (policy, dynamic, and open-economy) factors that would a¤ect the economy’s
aggregate investment in the past.
In other words, the two input demand functions should be expressed in terms of (w; rk ; A) ; viz.,
nd (w; rk ; A) and kd (rk ; w; A) : The same is true for the output supply function y s (w; rk ; A) and
indirect pro…t function (w; rk ; A) :
2/14/2022 21/36
(c) Market equilibrium
The equilibrium real rental (rk ) and capital-input employment (K ) are determined
jointly by equating capital supply to capital demand, i.e.,
K s = K d (rk ; ::)
insert labor-market equilibrium diagram here
Market for capital inputs is somewhat more ‡exible than that for labor. Assume,
for simplicity, that stickiness or rigidity of rentals is irrelevant here.
Cf. rental vs. purchase/sale markets
2/14/2022 22/36
3.1.3 Aggregate supply
Given labor (N ) and capital (K ) inputs (and the production e¢ ciency parameter
A), we can compute output supplied (Y s) from the production function:
Y s = AF (N; K ) :
Aggregate supply (AS ) traces how output (Y s) varies as the price level (P )
changes.
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Under perfect wage-‡exibility (so-called classical world), both the real and nominal
wages can adjust smoothly in response to changes in N s and/or N d; so that the
labor market clears all the time.
– Any changes in P would be matched by an equal proportionate change in W; so

as to keep w and N at their market-clearing levels (i.e., w0 and N0 respectively).
– It follows that Y s would stay at a constant — natural or potential (full-

employment) — level Y0s = AF (N0; K ) as P changes. In other words,
the AS curve is vertical (perfectly inelastic).
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Under nominal-wage contracts (so-called Keynesian world), in contrast, money

wages would be rigidly …xed at a level (W0) equal to the product of the market-
clearing real wage (w0) and the average price level expected to prevail over the
contract period P0e :
– At any instant of time within the contract period (call it “short run”), if the
actual price level turns out to be lower (higher) than expected, the resulting real
wage will be higher (lower) than its market-clearing level so that the employment
level— dictated by the …rm’s labor-demand decision under the contract— would
be lower (higher) than the full-employment level.
! !
W W0
P1 S P0e =) w1 = 0 T w0 = =) N1 = N1d S N0
P1 P0e
=) Y1s (= AF (N1; K )) S Y0s (= AF (N0; K )) :

In other words, the SRAS curve is upward-sloping.
2/14/2022 25/36
– When money wages are revised upon expiry of the existing contracts (call it
“long run”), however, full employment can be re-attained, so the LRAS curve
(same as the AS curve in the ‡ex-wage case) would become vertical. Hence,
the Keynesian long run (when wages/prices are perfectly ‡exible) is exactly
identical to the classical case.
insert LRAS & SRAS and their building blocks here
2/14/2022 26/36
Apart from the nominal-wage rigidity story, a similar AS relation, known as Lucas
supply function, can also be obtained under monetary misperceptions in a new
classical world.
– Following an unexpected increase in the general price level (caused by, say,
monetary injection), …rms/producers may mis-perceive it as an increase in the
(relative) prices of their own goods and thus hire more workers to produce more
output.
– On the other hand, workers may mis-perceive the general price increase as an
increase in their real wages and thus supply more labor services to the …rms to
help them increase production.
– In other words, confusion between general and relative price changes would give
rise to the Lucas supply function, where aggregate output would rise above (fall
below) its natural level as the general price level rises above (falls below) its
expected level, i.e.,
Y Y0 = (P P0e); so that Y T Y0 as P T P0e (LS)
This implies an upward-sloping SRAS .
2/14/2022 27/36
– This also implies a vertical LRAS — because in the long run, both producers
and workers would learn that they have mistaken a general-price change for a
relative-price change and would revise their in‡ation expectations and change
their production plans accordingly.
Aggregate supply in all of these possible cases — whether nominal-wage rigidity

or monetary misperceptions — can be summarized in the form of an approximate
linear relation (with slope given by some positive constant ) as follows:
Y Y0 = (P P0e); so that Y T Y0 as P T P0e
As we shall see later, the slope of the AS curve is an important determinant of the
e¤ectiveness of monetary policy as a stabilization tool.
The AS function can also take the form of the expectations-augmented Phillips curve (EAP C) :
Y Y0 = a(gp gpe0 ); (EAPC)
with P = P 1 (1 + gp ); P e = P 1 (1 + gpe0 ); and a = P 1 . In other words, the EAP C is like a
mirror image of AS; and is sometimes called the pseudo-AS function.
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3 Building Blocks of The Macro Framework: 3.1 The Factor/input Market

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3 Building Blocks of The Macro Framework: 3.1 The Factor/input Market

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ECON1220H&I * Intro Macro Chi-Wa Yuen

3 Building blocks of the macro framework

3.1 The factor/input market

– the labor market and

– the capital-input market.

3.1.1 The labor market

(a) Labor demand N d

The …rm’s “scarcity”problem is to choose how much labor to hire nd — at a given

productive inputs : Fn (:) > 0; Fk (:) > 0;

diminishing marginal productivities : Fnn (:) < 0; Fkk (:) < 0;

factor complementarity : Fnk (:) = Fkn (:) > 0;

– marginal cost = the extra wage paid to the worker (i.e., w)

– …rm’s pro…t-maximizing choice of labor is determined by the condition M P N =

Comparative statics: As a direct implication of the law of diminishing returns

insert M P N and labor-demand curve diagram here

– Mathematically, we can solve the pro…t-maximizing equation to obtain the labor

and the indirect pro…t function,

insert horizontal aggregation of labor-demand diagram here

– N d depends positively on the capital input (due to factor complementarity) and

corporate pro…ts taxes — which a¤ect investment decisons, hence future

the …rm/economy’s past (current) investment (including R&D) decisions —

learning-by-doing or on-the-job training (OJT) e¤ects — how current em-

entry/exit of multi-national corporations (MNCs) and foreign direct invest-

business/investment opportunities abroad

(b) Labor supply (N s)

() max U @wns + ; 1 nsA

Di¤erentiating the utility function with repect to worked hours, we get

“goods” are good : Uc (:) > 0; U` (:) > 0;

diminishing marginal utilities : Ucc (:) < 0; U`` (:) < 0;

complements : Uc` (:) = U`c (:) > 0;

The utility-maximizing condition can be rewritten as:

– marginal bene…t = increase in wage income (measured in terms of goods by the

– utility-maximizing choice of labor supplied by individual household is determined

insert M RS as SE-component of labor-supply curve diagram here

Comparative statics: The utility-maximizing equation can be used to derive the

and the indirect utility function,

insert horizontal aggregation of labor-supply diagram here

other policy instruments including social-security (or payroll) taxes, unem-

current and future stance of the other afore-mentioned government policies

anything that a¤ects the worker’s migration and/or guest-working decisions

(c) Market equilibrium — possibility of unemployment?

N s (w; ::) = N d (w; ::)

insert labor-market equilibrium diagram here

Abstracting from search/matching frictions (frictional unemployment) and struc-

i) demand(supply)-determined if there exists excess supply(demand) of labor —

3.1.2 The market for capital input

(a) Demand for capital input kd

The …rm’s “scarcity” problem is to choose how much capital to rent kd — at

– …rm’s pro…t-maximizing choice of capital is determined by the condition M P K =

Comparative statics: As a direct implication of the law of diminishing returns

insert M P K and capital-demand curve diagram here

– Mathematically, we can solve the pro…t-maximizing equation to obtain the cap-

and the indirect pro…t function,

insert horizontal aggregation of capital-demand diagram here

(b) Supply of capital input (ks)

Other than the rate of capital (utilization, hence) depreciation, K s depends on

(c) Market equilibrium

insert labor-market equilibrium diagram here

Cf. rental vs. purchase/sale markets

3.1.3 Aggregate supply

– Any changes in P would be matched by an equal proportionate change in W; so

– It follows that Y s would stay at a constant — natural or potential (full-