CH3MEMO - Economics 3307 Main Points of Chapter 3 1 A...

Economics 3307
Main Points of Chapter 3
1. A production process converts inputs into outputs . This chapter introduces the aggregate production
function Y = F(K,L), which says that total output in the economy, or Real GDP (Y) is a function of
the total amount of capital (K) and labor (L) used by firms in the production process.
2. K and L have positive but decreasing marginal products. That is, Y increases with increases in K or
L (positive marginal product), but as K or L gets larger and larger the marginal increase in Y caused
by using still more K or L gets smaller and smaller.
3. Firms maximize profits, which means they will hire additional capital and/or labor as long as the
marginal revenue of doing so exceeds the marginal cost. Firms are maximizing profits when the
marginal revenue of each input equals the marginal cost. These conditions are (i) P·MPL = W for
labor, and (ii) P·MPK = R for capital, where P is the price of output, MPL is the marginal product of
labor, W is the wage rate, MPK is the marginal product of capital, and R is the rental price of capital.
4. We can rearrange these conditions to imply MPL = (W/P) and MPK = (R/P). These conditions give
us the demand curve for labor and the demand curve for capital.
5. We assume in Chapter 3 that the supplies of capital and labor are exogenous. This means that the
labor supply curve and capital supply curve are vertical lines.
6. In equilibrium, (W/P) has adjusted so that the aggregate demand for labor equals the supply of labor,
and (R/P) has adjusted so that the aggregate demand for capital equals the supply of capital.
7.