3.

Production and income

in the long-run

3.1 What people earn

3.2 What people spend
(consumption and investment)
 What people earn

What people earn depends mainly on two

things:
(a) the quantity of the factors of
production they own
(b) the price paid to each of the factors of
production.
 What people earn

Example: Poverty
implies low income.

implies low rentals to the production

factors already owned by the poor, e.g.,

typically unskilled labour, land that is
unproductive, distant, or inaccessible.
 What people earn

Relieving really poverty entails:

changing the rentals of the factors owned

by the poor by making them more

wanted or productive.
augmenting the factors owned by the poor

(beyond simple labour), e.g., agrarian

reform, education, facilitating saving.
3.1 What people earn
 What people earn
Factors of production: given amounts of capital
and labour
K=K
L=L
Production function: the flow of output
depends on the amount of capital and of
labour.
Y = F (K , L )
 What people earn

Households are paid by firms, which are

profit-maximisers.
Crucial question: how much will firms pay
for each of the factors of production?
To answer this, we analyse the
characteristics of production.
Characteristics of production

Returns to scale: suppose given

amounts of the factors produce a
certain quantity
Y = F (K , L).
The function F exhibits constant
returns to scale if
hY = F (hK , hL), h > 0.
 Characteristics of production

Example. (Cobb-Douglas (C-D)

function)
Y = L1/2K1/2 ,
(25)1/2(100)1/2 = 50
(425)1/2(4100)1/2= 200 = 450.
Hence C-D function is constant returns
to scale.
 Characteristics of production
The marginal product of a factor is the change in
output resulting from a one-unit increase in a
factor, holding all other factors constant.
For example:
F(K0, L0) = Y0
F(K0, L0 +1) = Y1
So, the marginal product of labour at (K0,L0) is
(Y1 Y0), i.e. MPL(K0,L0) = (Y1 Y0).
 Characteristics of production

If the function F is continuous and differentiable,

the marginal products of capital and labour are
Y
MPL = = FL (K , L )
L
Y
MPK = = FK (K , L )
K
 Characteristics of production

In the case of the Cobb-Douglas function,

a 1-a
Y =K L
MPL = (1 - a )K a L-a = (1 - a )(K L )a
MPK = a (K a -1 )(L1-a ) = a (L K )1-a
Note that MPL falls as L increases and MPK falls as
K increases, holding the other factor constant.
 Characteristics of production

Diminishing marginal productivity says that

as a rule, the marginal product of any
factor declines, the more of that same
factor is employed.
(Always remembering that all other factors
are held constant in such experiments.)
Diminishing marginal productivity

Total Marginal
Factors used Product Product
(0 man, 1 lathe) 0 --
(1 man, 1 lathe) 4 4
(2 men, 1 lathe) 7 3
(3 men, 1 lathe) 9 2
(4 men, 1 lathe) 10 1
(5 men, 1 lathe) 10 0

 Total and marginal product
Total
product Total
product
10 (=10)

9
8 Marginal Area under
7 product curve (= 10)
6

4 4
3 3

2 2

1 1

1 2 3 4 5 1 2 3 4 5
Labour Labour
 Profit-maximisation
Profit = Revenue Labour cost Capital cost
= Y WL RK
= F(K,L) WL RK.
To maximise profits:
Hire a factor up to the point where the
added cost of an additional unit is just
equal to its contribution to revenue.
 Profit-maximisation
To see why this is so, suppose you already
employ (K, L). Then profits are:
0 = F(K,L) WL RK
If you employ one more labourer:
1 = F(K,L + 1) W(L + 1) RK.
The change in profits is:
1 0 = [F(K,L + 1) F(K,L)] W
= MPL (K,L) W
 Profit-maximisation

Because 1 0 = MPL W :
more labour will be hired if MPL > W because
then profits would increase;
employment will be reduced if MPL < W because
then profits would decrease;
employment will not change if MPL = W, which
means profits are maximised at that point.
So, if firms are profit-maximisers, they would
pay factors their marginal product.
Assumption of full employment

Full-employment: the output produced is

obtained by employing all the existing
factors of production:
Y = F (K, L)
=Y.
Wage equals marginal product
MPL

W0

MPL

L0 Labour
 Profit-maximisation

Because 1 0 = MPL W :
more labour will be hired if MPL > W because
then profits would increase;
employment will be reduced if MPL < W because
then profits would decrease;
employment will not change if MPL = W, which
means profits are maximised at that point.
So, if firms are profit-maximisers, they would
pay factors their marginal product.
 Labour supply and wages
MPL

A more abundant
labour supply

leads to a
lower wage
W0

W1

MPL

L0 L1 Labour
 Increase in the
other factor and wages
MPL

An increase in
capital raises
MPL

W1

W0

and
raises
wages
MPL

L0 Labour
 Implications of marginal
productivity theory of distribution
If nothing else changes, higher employment of a
factor comes only at the expense of a lower
reward.
The more abundant a factor is, the lower is its
reward.
The more abundant other factors become, the
higher is the reward of the factor which has not
increased.
Technological progress benefits all factors by
increasing employment without lowering factor
rewards.
3.2 What people spend
 The components of spending

In a complete description, this is:

E=C+G+I+XM
But without foreign trade, this just reduces
to:
E=C+G+I.
Essentially just the division into consumption
(C + G) and investment (I).
Question is, how is this division determined?
Spending on goods and services

Consumption rises with disposable income:

C = C (Y T ), where T is taxes.
+
Investment falls with a higher interest rate:
I = I (r )

Government consumption and taxes are
given:
G = G and T = T
 All together now
E = C + G + I definition of spending
C =C (Y T ) consumption function
I = I (r ) investment function
G=G government consumption
T = T taxes
F (K, L) = Y full employment output
E =Y spending must equal output
 Solving the model
F (K, L) = Y
Y=E
Y = C (Y T) + G + I (r )
Y = C (Y T ) + G + I (r )
Y = C + G + I(r)
But add and subtract T to obtain:
(Y T C ) + (T G) = I
which says private saving and public saving
together finance investment
 Solving the model
(Y T C ) + (T G) = I(r )
SP + SG = I (r )
S = I (r)
At full employment, both private and
public saving are predetermined. The
interest rate adjusts to equate available
saving and investment.
The interest rate equates S and I
r

r0
I (r )

S S, I
 Increasing G or lowering T raises r
r
Total saving falls when
government
raising the consumption rises or
interest rate taxes fall
and reducing
investment

r1

r0
I (r )

S S, I
 Summary
At full employment, the level of output is pre-
determined by the available capital and
labour.
So the only question remaining is how output
will be divided into consumption and
investment (by both private sector and
government).
Private saving is pre-determined, as are
government spending and taxes.
 Summary
So it is investment that adjusts to the
available saving through the interest rate.
Higher saving means a lower interest rate
and higher investment.
While the division between consumption and
investment is merely a re-arrangement of
current output and income, it has impli-
cations for growth and future output.
End of section
 The result is the same even if
saving also depends on r
People may save more (or consume less)
if r is higher
C = C (Y T, r), so we write
Y T C (Y T, r ) = SP
SP = Y T C (Y T, r )
So private saving is no longer constant but
increases with r .
SP = SP (Y T, r )
S = SP (Y T , r ) + ( T G )
 Upward-sloping S +SG
r
S

r0

I (r )

S, I
 Consumption function
C
C (Y T)

DC
Slope = DC/D(Y T)
marginal propensity to consume
D(Y T)

YT
Investment and the interest rate
1. Any investment project entails spending to
purchase physical assets (machines, buildings,
livestock, etc.)
2. The investment project yields a return or profit
rate into the future (e.g., 10%, 20%).
3. Investors borrow funds from households which
also demand a return for the use of their money.
This is the interest rate, r.
Investment and the interest rate

4. If the rate of return is greater than the

interest rate, a project will be undertaken.
5. The lower the interest rate is, the more
projects will become viable, and the more
investment spending takes place.
6. So investment spending rises as the
interest rate falls.
Investment and the interest rate

25%

20%

r = 15%
10%

r = 8%
mall shoe factory piggery

pesos of investment
 Investment function
r

I (r )