The Representative Firm
The Representative Firm
Panos Margaris
Department of Economics
Recap
The Representative Firm
Last lecture:
• Consumers derive utility from consumption and leisure
• Optimal choice: maximize utility subject to budget constraint
I FOC: MRSl,c = w or MRSl,c = (1 ⌧) w
Production Function
The Representative Firm
Y = zF (K , N d )
• Constant returns to scale on both inputs
• Diminishing returns to each input (K , N d )
I The marginal product of labor decreases as the labor input increases (keeping capital constant)
I the marginal product of capital decreases as the capital input increases (keeping labor constant)
• The marginal product of labor increases as the quantity of capital increases and vice versa
The Marginal Product of Labor
The Representative Firm
The Marginal Product of labor is the slope of the production function at a given point.
Note that the marginal product of labor declines with the quantity of labor employed.
The Marginal Product of Capital
The Representative Firm
The slope of the production function is the marginal product of capital, and the marginal
product of capital declines with the quantity of capital.
Example - Constant Returns to Scale in Both Inputs
The Representative Firm
(1 a)
Assume the production function Y = zF (K , N d ) = zK a N d with z = 1, a = 0.3.
(1 a)
MPK = zaK a 1 Nd
a
MPN = z(1 a)K a N d
a z K N Y MP N MP K
0.30 1.00 1.00 1.00 1.00 0.70 0.30
0.30 1.00 2.00 2.00 2.00 0.70 0.30
0.30 1.00 3.00 3.00 3.00 0.70 0.30
0.30 1.00 4.00 4.00 4.00 0.70 0.30
0.30 1.00 5.00 5.00 5.00 0.70 0.30
0.30 1.00 6.00 6.00 6.00 0.70 0.30
0.30 1.00 7.00 7.00 7.00 0.70 0.30
0.30 1.00 8.00 8.00 8.00 0.70 0.30
0.30 1.00 9.00 9.00 9.00 0.70 0.30
0.30 1.00 10.00 10.00 10.00 0.70 0.30
Example - Diminishing Returns to Scale in Labor
The Representative Firm
(1 a)
Assume the production function Y = zF (K , N d ) = zK a N d with z = 1, a = 0.3.
(1 a)
MPK = zaK a 1 Nd
a
MPN = z(1 a)K a N d
a z K N Y MP N MP K
0.30 1.00 1.00 1.00 1.00 0.70 0.30
0.30 1.00 1.00 2.00 1.62 0.57 0.49
0.30 1.00 1.00 3.00 2.16 0.50 0.65
0.30 1.00 1.00 4.00 2.64 0.46 0.79
0.30 1.00 1.00 5.00 3.09 0.43 0.93
0.30 1.00 1.00 6.00 3.51 0.41 1.05
0.30 1.00 1.00 7.00 3.90 0.39 1.17
0.30 1.00 1.00 8.00 4.29 0.38 1.29
0.30 1.00 1.00 9.00 4.66 0.36 1.40
0.30 1.00 1.00 10.00 5.01 0.35 1.50
Example - Diminishing Returns to Scale in Labor
The Representative Firm
Output always increases, but at a decreasing rate
Output
10
Y
0
0 2 4 6 8 10
Labor
Example - Diminishing Returns to Scale in Labor
The Representative Firm
The marginal product of labor declines as the quantity of labor used in the production
process increases
Marginal Product of Labor
0.7
0.6
MPN
0.5
0.4
2 4 6 8 10
Labor
The Marginal Product of Labor
The Representative Firm
What if we double capital?
a z K N Y MP N MP K
0.30 1.00 2.00 1.00 1.23 0.86 0.18
0.30 1.00 2.00 2.00 2.00 0.70 0.30
0.30 1.00 2.00 3.00 2.66 0.62 0.40
0.30 1.00 2.00 4.00 3.25 0.57 0.49
0.30 1.00 2.00 5.00 3.80 0.53 0.57
0.30 1.00 2.00 6.00 4.32 0.50 0.65
0.30 1.00 2.00 7.00 4.81 0.48 0.72
0.30 1.00 2.00 8.00 5.28 0.46 0.79
0.30 1.00 2.00 9.00 5.73 0.45 0.86
0.30 1.00 2.00 10.00 6.17 0.43 0.93
Example - Diminishing Returns to Scale in Labor
The Representative Firm
Doubling capital and then keeping it constant, tilts the output curve upwards
Output
K=1
6
K=2
4
Y
0
0 2 4 6 8 10
Labor
Example - Diminishing Returns to Scale in Labor
The Representative Firm
Doubling capital and then keeping it constant, shifts the marginal product of labor
upwards
Marginal Product of Labor
K=1
0.8 K=2
MPN
0.6
0.4
2 4 6 8 10
Labor
The Marginal Product of Labor
The Representative Firm
What if we double z (keeping K = 1)?
a z K N Y MP N MP K
0.30 2.00 1.00 1.00 2.00 1.40 0.60
0.30 2.00 1.00 2.00 3.25 1.14 0.97
0.30 2.00 1.00 3.00 4.32 1.01 1.29
0.30 2.00 1.00 4.00 5.28 0.92 1.58
0.30 2.00 1.00 5.00 6.17 0.86 1.85
0.30 2.00 1.00 6.00 7.01 0.82 2.10
0.30 2.00 1.00 7.00 7.81 0.78 2.34
0.30 2.00 1.00 8.00 8.57 0.75 2.57
0.30 2.00 1.00 9.00 9.31 0.72 2.79
0.30 2.00 1.00 10.00 10.02 0.70 3.01
Example - Diminishing Returns to Scale in Labor
The Representative Firm
Doubling capital and then keeping it constant, tilts the output curve upwards
Output
10 K=1
K=2
K=1, z=2
Y
0
0 2 4 6 8 10
Labor
Example - Diminishing Returns to Scale in Labor
The Representative Firm
Doubling z, shifts the marginal product of labor upwards more comparing to doubling
capital
Marginal Product of Labor
1.5
K=1
K=2
K=1, z=2
1
MPN
0.5
2 4 6 8 10
Labor
The Marginal Product of Labor
The Representative Firm
An increase in total factor productivity or capital has two e↵ects: More output is
produced given each quantity of the labour input, and the marginal product of labour
increases for each quantity of the labour input.
Profit Maximization
The Representative Firm
When the firm maximizes profits, the marginal product of labor equals the real wage
• MPN = w
The only variable the firm can change in the one-period model is the quantity of labor
The firm doesn’t care about investment and capital because this is a one-period model
• This period capital K is given and cannot be changed
• There is no future to invest in (we will talk about investment in the two-period model)
Profit Maximization
The Representative Firm
Y = zF (K , N d ) is the firm’s revenue, while wN d is the firm’s variable cost. Profits are
the di↵erence between the former and the latter. The firm maximizes profits at the point
where marginal revenue equals marginal cost. or MPN = w . Maximized profits are the
distance AB, or the distance ED.
Profit Maximization
The Representative Firm
a z K N w Y MP N Cost Profits
0.30 1.00 1.00 1.00 0.40 1.00 0.70 0.40 0.60
0.30 1.00 1.00 2.00 0.40 1.62 0.57 0.80 0.82
0.30 1.00 1.00 3.00 0.40 2.16 0.50 1.20 0.96
0.30 1.00 1.00 4.00 0.40 2.64 0.46 1.60 1.04
0.30 1.00 1.00 5.00 0.40 3.09 0.43 2.00 1.09
0.30 1.00 1.00 6.00 0.40 3.51 0.41 2.40 1.11
0.30 1.00 1.00 7.00 0.40 3.90 0.39 2.80 1.10
0.30 1.00 1.00 8.00 0.40 4.29 0.38 3.20 1.09
0.30 1.00 1.00 9.00 0.40 4.66 0.36 3.60 1.06
0.30 1.00 1.00 10.00 0.40 5.01 0.35 4.00 1.01
Profit Maximization
The Representative Firm
Output
Profits
1
Profits
0.8
0.6
2 4 6 8 10
Labor
Profit Maximization
The Representative Firm
The reason that the firm maximizes profits at the point where MPN = w is that if
MPN > w , the firm can increase profits by hiring more labor. If MPN < w , hiring more
labor reduces profits.
Take for example the following profit function:
⇣ ⌘1 a
⇡ = Y w N d = zK a N d w Nd
The partial derivative with respect to labor (which is the only choice variable) is:
@⇡ ⇣ ⌘ a
= z (1 a) zK a N d w = MPN w
@N d
For this derivative to be zero:
MPN = w
Labor Demand Curve
The Representative Firm
The Marginal Product of Labor is also the firm’s demand curve for labor
This is true because the firm will hire labor up to the point where the marginal product of
labor equals the real wage
Labor Demand
0.7
0.6
Wage
0.5
0.4
2 4 6 8 10
Labor
Production Function
The Representative Firm
Consider the production function:
⇣ ⌘ 1
⇣ ⌘1
2
Y = zF K , N d = zK 2 N d (1)
With z = 2, K = 4.
Write down the maximization problem and find N d (w ). Find optimal N d if w = 12 ,
w = 1, w = 2, and w = 2.
Solution:
1 1
⇡ = zK 2 N 2 wN
1 1 1 1
1 1
@⇡
@N = 0 , 2 zK N
2 2 w = 0 , 12 2 ⇤ 4 2 N 2 =w , (2)
1 2 2
, N 2 = w2 , N = w2 = w2
w = 12 ! N = 42 = 16
w = 1 ! N = 22 = 4 (3)
w = 2 ! N = 12 = 1
Production Function
The Representative Firm
Paul owns a firm that produces output (Y ) with capital (K ) and labor (N) as inputs.
The production function is Y = zK a N 1 a with z = 100, K = 1 and a = 0.5. Each worker
supplies one unit of labor. Each unit of labor is paid the wage rate w . The price at this
output is sold is normalized to P = 1. Suppose that w = 6.25.
A) When Paul hires 16 workers, each workers produces on average 25 goods ( YN = 25). If
he hires 9 more workers, YN falls to 20. Has Paul hired lazy workers? Explain how Paul
can make each worker more productive.
Solution:
• Y = 100N 0.5 . This happens because each additional worker is less productive than the
previous one. For example, the fixed level of capital is shared among more workers, so each
worker has less capital to work with.
Production Function
The Representative Firm
B). Paul Observes the wage rate and then decides to hire 100 workers. Is Paul a good
businessman? How many workers should Paul hire to maximize profits?
Solution:
• Firms maximize profits when MPN = w . In this case MPN = 50N 0.5 . With 100 workers,
MPN = 50 ⇤ 100 0.5 = 5. This is less than the wage rate, so Paul hired too many workers.
• To maximize profits:
0.5 6.25
MPN = w , 50N = 6.25 , N 0.5 = 50 ,
2 50 2 (4)
, N = 6.25
50 = 6.25 = 82 = 64
Production Function
The Representative Firm
C). The government decides to prevent any firm from polluting. Paul discovers that
polluting can be avoided at the cost of 0.25 units of output per unit of output produced.
How many workers will Paul hire if w = 6.25?
Solution:
• The new profit function is:
⇡=Y wN 0.25Y , ⇡ = 0.75Y wN (5)
• To maximize profits:
@⇡ 6.25
= 0 , 0.75 ⇤ 50N 0.5 w = 0 , 37.5N
@N
0.5
= 6.25 , N 0.5
= 37.5 ,
(6)
, N 0.5 = 37.5
6.25 , N
0.5
= 6 , N = 36
Production Function
The Representative Firm
D). To alleviate the cost of reducing pollution, the government decides to pay Paul’s firm
1.25 per worker hired. How many workers will Paul hire if w = 6.25?
Solution:
• The new profit function is:
⇡ = 0.75Y wN + 1.25N (7)
• To maximize profits:
@⇡ 5
= 0 , 0.75 ⇤ 50N 0.5 w + 1.25 = 0 , 37.5N
@N
0.5
= 6.25 1.25 , N 0.5
= 37.5
, N 0.5 = 37.5
5 ,N
0.5
= 7.5 , N = 56.25
(8)
Production Function
The Representative Firm
E). How will policies introduced in C and D a↵ect the labor demand curve? How will the
equilibrium wage be a↵ected if all firms in the economy are identical to Paul’s firm?
n
W NS
E
6 25
.
-- --
- -
-
---
W = 6 25
.
:
i
I
(
ii
- 2
W = 50N
- "
2
W = 37 JN
.
3 656 254.
N
-
-
W = 37 .
5N- + 1 .
25