3.1 How Much Does the Economy Produce?

The Production Function
 Factors of production
 Capital
 Labor
 Others (raw materials, land, energy)
 Productivity of factors depends on technology and management
 The production function
 Y = AF(K,N)
 Parameter A is “total factor productivity”
 Application: The production function of the U.S. economy and U.S. productivity growth
 Cobb-Douglas production function works well for U.S. economy:
Y = A K0.3 N0.7
 Data for U.S. economy—Table 3.1
 Productivity growth calculated using production function
 Productivity moves sharply from year to year
 Productivity grew slowly in the 1980s and the first half of the 1990s
Table 3.1 US Production Function, 1980–2001

Figure 3.1 The production function relating output and capital

 The shape of the production function
 Two main properties of production functions
 Slopes upward: more of any input produces more output
 Slope becomes flatter as input rises: diminishing marginal product as input increases
 Graph production function (Y vs. one input; hold other input and A fixed)
 Marginal product of capital, MPK = ΔY/ΔK (Key Diagram 1; Fig. 3.2)
 Equal to slope of production function graph (Y vs. K)
 MPK always positive
 Diminishing marginal productivity of capital
 Marginal product of labor, MPN = ΔY/ΔN (Fig. 3.3)
 Equal to slope of production function graph (Y vs. N)
 MPN always positive
 Diminishing marginal productivity of labor

Key Diagram 1 The production function

Figure 3.2 The marginal product of capital

Figure 3.3 The production function relating output and labor