EF3441: Intermediate Macroeconomics
Prepared by Dr. Tam
Lecture 3
The Main Goal of this Lecture
▶ Understand the firm’s profit maximization problem
▶ To do that, we need to
▶ list the properties of the firm’s production function,
▶ show how the firm optimizes profit given production function.
The Firm
▶ A firm converts inputs (factors of production) into output
(consumption goods)
▶ Goal of the firm: maximize profits
▶ Assumptions:
▶ Firms are very smart
▶ They all have similar technology: a representative firm
▶ They use only two (input) factors of productions: capital and
labor
▶ Live one period (relaxed later in the course)
▶ No financing issue (relaxed later in the course)
The Production Function
▶ Let:
▶ Capital: K
▶ Labor employed: N d
▶ Total factor productivity (TFP): z
▶ Output: Y
▶ The Ability of a firm to transform factors of production into
output is summarized by the production function F
Y = zF (K , N d )
▶ Properties of production function (homogeneous of degree
one):
λY = zF (λK , λN d ) = λzF (K , N d )
Properties of the Production Function
▶ Monotonicity:
▶ Marginal product of capital
∂Y
= MPK > 0
∂K
▶ Marginal product of labor
∂Y
= MPN > 0
∂N
▶ Concavity:
▶ Declining MPK
∂MPK
<0
∂K
▶ Declining MPN
∂MPN
<0
∂N
▶ Change in capital and MPN
∂MPN
>0
∂K
Production Function, Fixing the Quantity of Labor and Varying the Quantity of
Capital
Production Function, Fixing the Quantity of Capital and Varying the Quantity of
Labor
Marginal Product of Labor Curve for the Representative Firm
Adding Capital Increases the Marginal Product of Labor
Output increases, given everything else is fixed. That causes the
MPN curve to shift up.
Total Factor Productivity Increases
Output increases, given everything else is fixed. That causes the
output curve to rotate (because Y = 0 when N d = 0) upward.
The Problem of the Firm
Some additional assumptions:
▶ The objective of a firm is to maximize profits.
▶ A firm owns the capital (for now) from an endowment. i.e.,
capital is given.
▶ Firms take the wage as given by the market.
▶ No taxes in the baseline environment.
▶ The firm chooses the demand for labor: N d .
Profit Function
▶ Let:
▶ Revenue: zF (K , N d )
▶ Labor cost: wN d
▶ Profit: π = zF (K , N d ) − wN d
▶ The firm maximizes profit by choosing N d :
max zF (K , N d ) − wN d
Nd
Profit Maximization
max zF (K , N d ) − wN d
Nd
FOC:
∂zF (K , N d )
−w =0
∂N d
∂zF (K , N d )
⇒ = MPN = w
∂N d
Profit Maximization, Con’t
max zK 0.3 N 0.7 − wN
N
FOC:
∂zF (K , N)
−w =0
∂N
and
∂zF (K , N)
= 0.7zK 0.3 N −0.3
∂N
So we get 0.7zK 0.3 N −0.3 − w = 0. Solve for N,
10/3
0.7z
N= K
w
Optimal Labor Choice
(labor cost)
(revenue)
Choose N d so that MPN = w .
Solution: Intuition
▶ Suppose MPN > w , then raise N d : revenue raise faster than
the costs.
▶ Suppose MPN < w , then lower N d : revenue decrease faster
than the costs
▶ In both cases, we reach a contradiction so that the only
alternative is:
MPN = w
Labor Demand and Wage
Question: how is w determined?
Labor Demand and Wage, Con’t
Wage
Labor supply
Labor demand
Employment
