Chapter 3 Overhead #1.F2016

Chapter 3 #1: Productivity, Output and Employment: Abel, Bernanke, Croushore, Kneebone
Economics 303: OVERHEADS: D. McClintock
Chapter 3 (#1)
Productivity Output and Employment
Table of Contents
3.1 How Much Does the Economy Produce? The Production Function.
3.2 The Demand for Labour
3.3 The Supply of Labour
3.4 Labour Market Equilibrium
3.5 Unemployment: A Closer Look
Intellectual property of Douglas McClintock and authors cited above Page 1

3.1 How Much Does the Economy Produce? The Production Function.
Inputs that are used in the production process are known as the factors of
production. All else being equal, the greater the quantities of factors of
production used, the more goods and services are produced.
Production Function
The production function is a mathematical expression relating the
amount of output (Y) produced to quantities of capital and labour
utilized.
We can write the production function as follows:
Y = AF(K, N)

Y = AF(K, N)
Where Y represents output Y in the current period

A = a number measuring overall productivity. (Also known as total
factor productivity
K = the capital stock, or quantity of capital used in the current
period
N = number of workers employed in the current period.
F = a function relating output Y to capital K and labour N
Application:
Many Canadian economists agree that the Canadian economy as a whole
can be represented fairly accurately by a Cobb Douglas Production
Function. In a Cobb Douglas Production function, the exponents add up
to one. This means that if a country doubles its inputs, production Y will
double.
Empirical Studies show the Canadian economy can be represented by:
Y = AK0.3 N0.7
Let’s look at the data

The Production Function for Canada 2008 to 2012

(See bottom of Table 3.1 on page 50)
Y = AK0.3 N0.7 (Equation 3.2)
Year Real GDP Capital K Labour Total factor Growth in

(billions of 2007 (billions of (millions of productivity total factor
dollars) 2007 dollars) workers)
A Productivity
(% change in A)
2008 1585 1757 17.1 23.10 -1.5*
2009 1542 1818 16.8 22.50* -2.6
2010 1621 1847 17.0 23.32* 3.7
2011 1704 1937 17.3 23.91* 2.5
2012 1752 2033 17.5 24.04* 0.5
*Calculated from previous year – not shown.
Since total labour productivity (A) is not observed, we can figure it out
by substituting the known variables into the production function and
solving for A.
Let’s do it for 2012.

1752 = A*20330.3 17.50.7
Solving for A Then A = 24.04
Calculating productivity in this way ensures that the production function
relationship (Equation 3.2) is satisfied exactly for each year.

The Shape of the Production Function

The production function can be shown graphically. The easiest way is to
hold one of the two factors of production, either capital or labour
constant and then graph the relationship between output and the other
factor.
In our case, we’re going to hold labour constant (N) at its 2012 level of
17.5 million workers and then adjust the dollar amount of capital.
Recall the production function for Canada can be represented by:
Y = AK0.3 N0.7
For 2012
Y = 24.04(K 0.3) (17.5 0.70) = 178.26K 0.3
So the function Y = 178.26K 0.3

Insert Figure 3.1

The Canadian production function shares two properties consistent with

most production functions.
1) The production function slopes upward and to the right.

(This tells us that as more capital is employed, output increases)
2) The slope of the production function becomes flatter.

(After some point, as an economy employs more capital, output
increases but increases at a decreasing rate)

The Marginal Product of Capital

The marginal product of capital (or MPK) is the increase in output
produced resulting from a one-unit increase in the capital stock. As a
result, the MPK is ΔY/ΔK
Two Properties
1) The marginal product of capital is positive. Whenever more capital
stock is added, output increases. This is why the production function
slopes from upward from left to right.
2) The marginal product of capital declines as the capital stock
increased.
From Figure 3.2, the slope of the production function at point D (where
the capital stock is $300 billion) is smaller than the slope at point B,
where the capital stock is $100 billion.
The tendency for the MPK to decline is called the diminishing marginal
productivity of capital.
When the capital stock is low, there are many workers for each machine so by increasing the
capital stock, production (and hence GDP) will increase and the benefits of increasing capital are
great.
However, when the capital stock is high, there are little benefits of increasing the stock of capital
as workers have many machines to work with – so there is little benefit of adding to the capital
stock.

The Marginal Product of Labour
We could do the same for labour by holding capital constant and then
adjusting the number of workers.
Like the MPK, the marginal product of labour (MPN) is the additional
output produced by each additional unit of labour. Like the MPK, the
economy will experience diminishing marginal product of labour.

By fixing capital at its 2012 level ($2,033 billion) and using the
productivity factor of 24.04, we can look at how labour affects output.
(Y)
Y = AK0.3N0.7
Y = (24.04) (2,0330.3)(N0.7) =
Y = 236.25N0.7

By substituting millions of workers for N, we get
Workers (N) Y = 236.25N0.7 ΔY/ΔN

(Millions)
1 236
10 1,184 105.33
15 1,573 77.8
17.5 1,752 71.6
From the graph (Figure 3.2) and the table above, the economy
experiences diminishing marginal returns to labour.(In other words,
MPN grows smaller)

Supply Shocks (Page 55)

The production function does not usually remained fixed over time.
Economists use the term “supply shock” or sometimes called “a
productivity shock” - refers to a change in the production function.
A positive or beneficial supply shock raises the amount of output that
can be produced by the same amount of labour and capital. A negative
supply shock lowers the amount of output.
Examples of supply shocks are the weather, such as a drought or really
cold weather and/ or inventions or innovations in management
techniques. (just in time inventory)
Supply shocks impact the “A” in the production function equation.
Figure 3.3

The Demand For Labour

The demand for labour comes from the employer’s side of the market.
An employer will hire more workers if the marginal revenue of hiring
the last worker is equal (or greater) than the cost of hiring that additional
worker.
An increase in investment and the capital stock of the economy is an
important variable for increasing economic growth. However, because
increasing the capital stock takes time, we’re going to assume that the
capital stock is fixed and that the only variable factor is labour. We will
change this assumption later on.
Therefore, we make the following assumptions:

1) Workers are all alike. (Homogeneous)
2) Firms view the wage of workers as being determined in a
competitive labour market and not set by individual firms.
3) The firm is a profit maximizer.

The Marginal Product of Labour and Labour Demand

The Clip Joint (Dog Grooming)
# of Number of Marginal Marginal Total
Workers Dog’s Product of Revenue Revenue
Groomed Labour Product(MRPN)
(MPN) MRPN = MPN *P
P = $10
0 0
11 $110
1 11 $110
9 $90
2 20 $200
7 $70
3 27 $270
5 $50
4 32 $320
3 $30
5 35 $350
1 $10
6 36 $360
The firm charges $10 (P = $10) for grooming.
The firm pays a wage rate of $80 per day. As a result, the profit
maximizing condition is the firm will hire workers up to where the
MRP=MC.
From the table above, the profit maximizing number of workers is 2.

Real Wage
The real wage measures the unit of output. Algebraically, the real wage
(w) is the nominal wage (W) divided by the price level. (P)
w = W/P
In our example, the nominal wage is $80 per day and the price is $10 per
dog.
So the real wage is 8 groomings per day. To find the profit maximizing
output level of employment, The Clip Joint compares this real cost of an
additional worker with the real benefit of an additional worker, MPN.
The MPN of the first worker is 11 groomings per day, which exceeds the
real wage of 8 groomings per day.
The MPN of the second worker is 9 groomings per day, which exceeds
the real wage of 8 groomings per day
The MPN of the 3rd worker is 7 groomings per day, which is less than
the real wage of 8 groomings per day. Therefore, the quantity of labour
demanded by the Clip Joint is two workers – the same result when we
compared the cost and benefits in nominal terms.

A Change in the Wage

Now suppose for some reason the nominal wage rate drops to $60 per
day for groomers. How many workers would the firm hire?
From the table we constructed earlier, the marginal revenue product of
hiring the 3rd person is $70 but the wage is $60. It would make sense for
the firm to hire the 3rd worker.
By hiring the 4th worker, the marginal revenue product is $50 but the
daily wage rate is $60 – so the firm cannot be profit maximizing if the
firm hires the 4th worker. As a result, the profit maximizing number of
workers is 3.
Real Wage
Again, the above change in wage rate is a change in the nominal wage
rate. We can also look at it from the real wage perspective.
The marginal product of hiring the 3rd worker is 7 grooming per day but
the real wage rate is $6 ($60/$10) or 6 groomings per day. The MPN >
w
For the 4th worker, this person can groom 5 dogs per day but the real
wage is $6 (or 6 groomings per day)
MPN < w – so the firm cannot be profit maximizing.
Therefore, the quantity of labour demanded is 3 workers. As the real

wage decreases, hiring increases!

The Marginal Product of Labour and the Labour Demand Curve

(Page 60)
Figure 3.4
The amount of labour demanded is determined by locating the point on

the MPN curve at which the MPN equals the real wage rate (w) the
amount of labour corresponding to that point is the amount of labour
demanded.
When the real wage is w*, at point A and the quantity of labour
demanded is N*. The labour demand curve ND, shows the amount of
labour demanded at each level of the real wage.
The labour demand curve is identical to the MPN curve.

Labour Demand
The labour demand curve is the same as the MPN curve except that the
vertical axis measures the real wage for the labour demand curve and the
marginal product of labour for the MPN curve.
Factors that Shift the Labour Demand Curve

The labour demand curve shifts in response to factors that change the
amount of labour that firms want to employ at any given level of the real
wage.

Suppose the playing of Taylor Swift songs soothes the dogs and they are
now much easier to groom. The firm can double the number of dog
groomings per day.
(A reduction of payroll taxes, such as lower EI premiums would have
the same effect as it increases the after tax MPN – page 62 or an increase
in capital, such as providing more machines)
The Clip Joint (Dog Grooming) while playing Taylor Swift. Beneficial
Supply Shock
# of Number of Marginal Marginal Total
Workers Dog’s Product of Revenue Revenue
Groomed Labour Product(MRPN)
(MPN) MRPN = MPN *P
P = $10
0 0
22 $220
1 22 $220
18 $180
2 40 $400
14 $140
3 54 $540
10 $100
4 64 $640
6 $60
5 70 $700
2 $20
6 72 $720
The firm charges $10 (P = $10) for grooming. Nominal wage = $80 day.
Now remember that the real wage is 8 groomings per day. ($80/$10)

By hiring the 4th workers, this worker’s MPN of 10 groomings per day is
more than the real wage of 8 groomings per day. As a result, it is
profitable for the firm to hire the 4th worker.
By hiring the 5th worker, the MPN is 6 groomings per day, which is less
than the real wage of 8 groomings per day. (Or $8 if that is easier but
remembering that this is the real wage)
Therefore, the firm would hire 4 workers. (Remember before it was 2
workers)

Aggregate Demand for Labour

The aggregate labour demand curve is the sum of the labour demand
curves for all firms in an economy. Therefore, the factors that shift the
labour demand for a firm also shift the aggregate labour demand curve.
Factors that Shift the Aggregate Labour Demand Curve
All Else Equal, An Causes the Labour Explanation
Increase In Demand Curve to
Shift
Productivity Right Beneficial supply
shock increases MPN
and shifts MPN curve
up and to the right.
Capital Stock Right Higher capital stock

increases MPN and
shifts MPN up and to
the right.
Note: It is important to note that when we say an increase in productivity causes the labour
demand to shift to the right, it is the only factor that is changing. (i.e. no change in the capital
stock) This seldom happens in real life but we need a starting point.

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Chapter 3 #1: Productivity, Output and Employment: Abel, Bernanke, Croushore, Kneebone

Economics 303: OVERHEADS: D. McClintock

3.2 The Demand for Labour

3.3 The Supply of Labour

3.4 Labour Market Equilibrium

3.5 Unemployment: A Closer Look

Intellectual property of Douglas McClintock and authors cited above Page 1

We can write the production function as follows:

Intellectual property of Douglas McClintock and authors cited above Page 2

Where Y represents output Y in the current period

Empirical Studies show the Canadian economy can be represented by:

Intellectual property of Douglas McClintock and authors cited above Page 3

The Production Function for Canada 2008 to 2012

Y = AK0.3 N0.7 (Equation 3.2)

Year Real GDP Capital K Labour Total factor Growth in

Let’s do it for 2012.

Intellectual property of Douglas McClintock and authors cited above Page 4

The Shape of the Production Function

Intellectual property of Douglas McClintock and authors cited above Page 5

Insert Figure 3.1

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The Canadian production function shares two properties consistent with

1) The production function slopes upward and to the right.

2) The slope of the production function becomes flatter.

Intellectual property of Douglas McClintock and authors cited above Page 7

The Marginal Product of Capital

Intellectual property of Douglas McClintock and authors cited above Page 8

The Marginal Product of Labour

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Intellectual property of Douglas McClintock and authors cited above Page 10

By substituting millions of workers for N, we get

Workers (N) Y = 236.25N0.7 ΔY/ΔN

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Supply Shocks (Page 55)

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The Demand For Labour

Therefore, we make the following assumptions:

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The Marginal Product of Labour and Labour Demand

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A Change in the Wage

MPN < w – so the firm cannot be profit maximizing.

Therefore, the quantity of labour demanded is 3 workers. As the real

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The Marginal Product of Labour and the Labour Demand Curve

The amount of labour demanded is determined by locating the point on

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Factors that Shift the Labour Demand Curve

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Aggregate Demand for Labour

Capital Stock Right Higher capital stock

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