381 Ch 3

381 Ch 3 - CHAPTER 3 National Income Where It Comes From and Where It Goes Questions for Review 1 The factors of production and the production

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Questions for Review 1. The factors of production and the production technology determine the amount of out- put an economy can produce. The factors of production are the inputs used to produce goods and services: the most important factors are capital and labor. The production technology determines how much output can be produced from any given amounts of these inputs. An increase in one of the factors of production or an improvement in tech- nology leads to an increase in the economy’s output. 2. When a firm decides how much of a factor of production to hire or demand, it considers how this decision affects profits. For example, hiring an extra unit of labor increases output and therefore increases revenue; the firm compares this additional revenue to the additional cost from the higher wage bill. The additional revenue the firm receives depends on the marginal product of labor ( MPL ) and the price of the good produced ( P ). An additional unit of labor produces MPL units of additional output, which sells for P dollars per unit. Therefore, the additional revenue to the firm is P × MPL . The cost of hiring the additional unit of labor is the wage W . Thus, this hiring decision has the following effect on profits: Δ Profit = Δ Revenue – Δ Cost = ( P × MPL ) – W . If the additional revenue, P × MPL , exceeds the cost ( W ) of hiring the additional unit of labor, then profit increases. The firm will hire labor until it is no longer profitable to do so—that is, until the MPL falls to the point where the change in profit is zero. In the equation above, the firm hires labor until Δ profit = 0, which is when ( P × MPL ) = W . This condition can be rewritten as: MPL = W/P . Therefore, a competitive profit-maximizing firm hires labor until the marginal product of labor equals the real wage. The same logic applies to the firm’s decision regarding how much capital to hire: the firm will hire capital until the marginal product of capital equals the real rental price. 3. A production function has constant returns to scale if an equal percentage increase in all factors of production causes an increase in output of the same percentage. For exam- ple, if a firm increases its use of capital and labor by 50 percent, and output increases by 50 percent, then the production function has constant returns to scale. If the production function has constant returns to scale, then total income (or equivalently, total output) in an economy of competitive profit-maximizing firms is divided between the return to labor, MPL × L , and the return to capital, MPK × K . That is, under constant returns to scale, economic profit is zero. 4. A Cobb-Douglas production function function has the form F(K,L) = AK α L 1– α . The text showed that the parameter α gives capital’s share of income. (Since income equals out- put for the overall economy, it is also capital’s share of output.) So if capital earns one- fourth of total income, then a = 0.25. Hence, = 0.25 0.75 .
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This note was uploaded on 04/07/2011 for the course ECON 381 taught by Professor Staff during the Winter '08 term at BYU.

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381 Ch 3 - CHAPTER 3 National Income Where It Comes From and Where It Goes Questions for Review 1 The factors of production and the production

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