1 00:00:00,040 --> 00:00:02,460 The following content is provided under a Creative 2 00:00:02,460 --> 00:00:03,870 Commons license. 3 00:00:03,870 --> 00:00:06,910 Your support will help MIT OpenCourseWare continue to 4 00:00:06,910 --> 00:00:10,560 offer high quality educational resources for free. 5 00:00:10,560 --> 00:00:13,460 To make a donation or view additional materials from 6 00:00:13,460 --> 00:00:18,090 hundreds of MIT courses, visit MIT OpenCourseWare at 7 00:00:18,090 --> 00:00:19,340 ocw.mit.edu. 8 00:00:23,415 --> 00:00:24,690 JON GRUBER: At the beginning of the lecture, we're going to 9 00:00:24,690 --> 00:00:26,600 actually talk about productivity, one of the most 10 00:00:26,600 --> 00:00:29,600 important topics in economics. 11 00:00:29,600 --> 00:00:31,920 And really one of the most famous applications-- 12 00:00:31,920 --> 00:00:34,095 or, more generally, misapplications-- 13 00:00:34,095 --> 00:00:37,260 of the principles of diminishing marginal product 14 00:00:37,260 --> 00:00:39,540 in the history of economics. 15 00:00:39,540 --> 00:00:42,400 Many of you may have heard of a guy named Thomas Malthus. 16 00:00:42,400 --> 00:00:48,620 He was a famous philosopher who, in 1798, posited the 17 00:00:48,620 --> 00:00:51,460 theory that we're all in big trouble. 18 00:00:51,460 --> 00:00:53,950 And he did so following the basic tenets that I've taught 19 00:00:53,950 --> 00:00:55,430 you so far. 20 00:00:55,430 --> 00:00:58,910 Malthus pointed out look, we've got-- 21 00:00:58,910 --> 00:01:01,290 he said, think about production of food. 22 00:01:01,290 --> 00:01:03,420 He said, with the production of food you've got, as with 23 00:01:03,420 --> 00:01:05,129 any other production process-- he didn't put it in these 24 00:01:05,129 --> 00:01:07,640 terms, but basically he was appealing to what we 25 00:01:07,640 --> 00:01:08,330 learned last time. 26 00:01:08,330 --> 00:01:09,890 He said, like any other production process you've got 27 00:01:09,890 --> 00:01:12,680 two inputs, labor and capital. 28 00:01:12,680 --> 00:01:15,790 But with food, the capital is land. 29 00:01:15,790 --> 00:01:18,490 And unlike other kinds of capital, it's fixed even in 30 00:01:18,490 --> 00:01:19,870 the long-run. 31 00:01:19,870 --> 00:01:21,960 That is, we talked about the long-run being defined as the 32 00:01:21,960 --> 00:01:24,240 period of time over which all inputs are variable. 33 00:01:24,240 --> 00:01:25,660 Well, land is never variable. 34 00:01:25,660 --> 00:01:26,840 There's a certain amount of land on 35 00:01:26,840 --> 00:01:29,150 earth, that's not variable. 36 00:01:29,150 --> 00:01:31,800 And at the end of the day, production of food is 37 00:01:31,800 --> 00:01:34,940 essentially just short-run, there is no long-run. 38 00:01:34,940 --> 00:01:36,880 At the end of the day, production of food, capital's 39 00:01:36,880 --> 00:01:39,300 fixed, it's only labor. 40 00:01:39,300 --> 00:01:44,130 Moreover, in that situation labor has diminishing marginal 41 00:01:44,130 --> 00:01:47,810 product with a given amount of land. 42 00:01:47,810 --> 00:01:49,440 It doesn't matter how many workers you have, there's only 43 00:01:49,440 --> 00:01:50,290 so much you can grow on it. 44 00:01:50,290 --> 00:01:52,320 Obviously, as you increase workers you can grow more 45 00:01:52,320 --> 00:01:53,010 originally. 46 00:01:53,010 --> 00:01:56,110 But eventually, you'll run out of useful use for those 47 00:01:56,110 --> 00:02:00,170 workers, yet the demand for food will not stop growing. 48 00:02:00,170 --> 00:02:02,140 So basically, the demand for food is going to continue to 49 00:02:02,140 --> 00:02:05,140 grow unabated over time as population grows. 50 00:02:05,140 --> 00:02:07,850 Demand for food [? it fuels ?] proportional to population, so 51 00:02:07,850 --> 00:02:09,539 it's growing over time. 52 00:02:09,539 --> 00:02:13,960 Yet the production of food eventually has to slow down, 53 00:02:13,960 --> 00:02:16,170 because there's a diminishing marginal product of labor 54 00:02:16,170 --> 00:02:18,100 without an increasing capital. 55 00:02:18,100 --> 00:02:22,590 So basically what you've got is a forever growing demand, 56 00:02:22,590 --> 00:02:25,290 but a gradually slowing production, because the 57 00:02:25,290 --> 00:02:27,450 marginal product of labor's diminishing with this fixed 58 00:02:27,450 --> 00:02:29,230 capital or land. 59 00:02:29,230 --> 00:02:31,145 The result is mass starvation. 60 00:02:31,145 --> 00:02:34,850 So Malthus predicted that by about where we are now, if not 61 00:02:34,850 --> 00:02:37,270 before, the world would be suffering from mass 62 00:02:37,270 --> 00:02:38,370 starvation. 63 00:02:38,370 --> 00:02:39,590 Through the basic principles-- 64 00:02:39,590 --> 00:02:41,620 not because he's a crazy nutcase-- 65 00:02:41,620 --> 00:02:43,950 but the basic principles we've studied so far. 66 00:02:43,950 --> 00:02:46,140 Which you've got ever-increasing demand, but 67 00:02:46,140 --> 00:02:51,270 diminishing marginal product of producing food. 68 00:02:51,270 --> 00:02:55,520 And in the end you get mass starvation. 69 00:02:55,520 --> 00:02:58,810 Well, as we all know Malthus was wrong. 70 00:02:58,810 --> 00:03:03,620 World population has risen about 800% since he wrote his 71 00:03:03,620 --> 00:03:07,810 article at the end of the 18th century, and yet 72 00:03:07,810 --> 00:03:09,220 we're fatter than ever. 73 00:03:09,220 --> 00:03:10,790 Our problem is we eat too much, not enough. 74 00:03:10,790 --> 00:03:11,850 Now that's not true around the world, 75 00:03:11,850 --> 00:03:13,250 there's starvation elsewhere. 76 00:03:13,250 --> 00:03:16,670 But there's clearly no more starvation worldwide than 77 00:03:16,670 --> 00:03:19,590 there was at his time despite the fact that the world 78 00:03:19,590 --> 00:03:21,790 population has grown eight-fold. 79 00:03:21,790 --> 00:03:24,340 So what did Malthus get wrong? 80 00:03:24,340 --> 00:03:27,510 What Malthus got wrong is what I haven't taught you yet. 81 00:03:27,510 --> 00:03:31,410 Which is that aggregate production is not just about k 82 00:03:31,410 --> 00:03:36,530 and l, but also about productivity. 83 00:03:36,530 --> 00:03:38,090 It's also about productivity. 84 00:03:38,090 --> 00:03:41,585 That the production function really looks like-- the form 85 00:03:41,585 --> 00:03:46,850 of the production function, which we wrote last time as q 86 00:03:46,850 --> 00:03:50,280 equals f of k and l. 87 00:03:50,280 --> 00:03:56,250 Really more generally, can be written as q equals A, times f 88 00:03:56,250 --> 00:03:59,980 of k and l, where A is aggregate productivity. 89 00:04:02,620 --> 00:04:05,870 Really, let's say that this is big Q. If we think about the 90 00:04:05,870 --> 00:04:08,310 big Q for society, now let's think of aggregate quantity 91 00:04:08,310 --> 00:04:09,260 for society or else we wouldn't talk 92 00:04:09,260 --> 00:04:10,510 about a specific firm. 93 00:04:10,510 --> 00:04:12,820 But if we think about aggregate product, aggregate 94 00:04:12,820 --> 00:04:14,830 quantity produced in society, it's a function of the 95 00:04:14,830 --> 00:04:17,329 aggregate capital and labor of the society, but also a 96 00:04:17,329 --> 00:04:20,470 function of productivity. 97 00:04:20,470 --> 00:04:23,580 It's also a function of the fact that we use our inputs 98 00:04:23,580 --> 00:04:26,110 more effectively over time. 99 00:04:26,110 --> 00:04:31,260 So for example, one thing Malthus missed is that the 100 00:04:31,260 --> 00:04:33,830 acreage of land-- it's an empirical fact, the number of 101 00:04:33,830 --> 00:04:35,930 acres of land on Earth are fixed. 102 00:04:35,930 --> 00:04:37,910 Earth is not growing-- 103 00:04:37,910 --> 00:04:40,940 but the arability of that land is not fixed. 104 00:04:40,940 --> 00:04:43,660 We get better and better at figuring out how to grow more 105 00:04:43,660 --> 00:04:48,230 and more stuff on the same amount of land. 106 00:04:48,230 --> 00:04:51,570 That's the factor A, that's a productivity improvement. 107 00:04:51,570 --> 00:04:54,640 Likewise, agricultural technology has improved. 108 00:04:54,640 --> 00:04:57,060 We have disease-resistant seeds, we have better land 109 00:04:57,060 --> 00:04:58,040 management. 110 00:04:58,040 --> 00:05:02,760 The bottom line is we are making more and more of a 111 00:05:02,760 --> 00:05:06,770 given plot of land compared to what Malthus saw in his time. 112 00:05:06,770 --> 00:05:12,840 So while k if it's defined as land may be fixed, and l 113 00:05:12,840 --> 00:05:14,860 therefore there's diminishing marginal product of a given 114 00:05:14,860 --> 00:05:17,600 production function, the production function itself is 115 00:05:17,600 --> 00:05:23,120 improving over time because of productivity improvements. 116 00:05:23,120 --> 00:05:26,070 Productivity, the arability of land, disease-resistant seeds, 117 00:05:26,070 --> 00:05:29,540 and other things are making that given quantity of land 118 00:05:29,540 --> 00:05:31,460 more productive over time. 119 00:05:31,460 --> 00:05:36,295 So effectively, in the long-run if A goes up faster 120 00:05:36,295 --> 00:05:41,400 than the marginal product of labor diminishes, then overall 121 00:05:41,400 --> 00:05:44,235 quantity can increase even though k, the underlying level 122 00:05:44,235 --> 00:05:46,690 of land, is fixed. 123 00:05:46,690 --> 00:05:50,720 That's what Malthus missed, is that there's two factors going 124 00:05:50,720 --> 00:05:51,090 on over time. 125 00:05:51,090 --> 00:05:54,350 The marginal product of labor's falling, it's true, 126 00:05:54,350 --> 00:05:55,800 for a given plot of land. 127 00:05:55,800 --> 00:05:58,800 But we're making each plot of land so much more productive, 128 00:05:58,800 --> 00:06:00,350 it's overcoming that. 129 00:06:00,350 --> 00:06:03,230 And as a result, food production is actually rising 130 00:06:03,230 --> 00:06:04,950 per capita. 131 00:06:04,950 --> 00:06:10,430 So since 1950, world food consumption per capita has 132 00:06:10,430 --> 00:06:13,170 gone up 40%. 133 00:06:13,170 --> 00:06:17,370 Despite the fact that the Earth's not gotten any bigger, 134 00:06:17,370 --> 00:06:18,980 and despite the fact the population's grown a 135 00:06:18,980 --> 00:06:20,650 lot over that time. 136 00:06:20,650 --> 00:06:24,020 And basically this huge increase of agricultural 137 00:06:24,020 --> 00:06:27,690 productivity has overcome the diminishing 138 00:06:27,690 --> 00:06:28,880 marginal product of labor. 139 00:06:28,880 --> 00:06:32,410 There's actually a great little box in the Perloff Text 140 00:06:32,410 --> 00:06:34,980 about a single individual and his contributions to that. 141 00:06:37,550 --> 00:06:42,160 A scientist who led what's called the Green Revolution. 142 00:06:42,160 --> 00:06:47,470 He experimented in Mexico with different methods of improving 143 00:06:47,470 --> 00:06:49,900 agricultural productivity, and then essentially brought those 144 00:06:49,900 --> 00:06:52,870 to Southeast Asia-- 145 00:06:52,870 --> 00:06:55,260 India, Pakistan and other places. 146 00:06:55,260 --> 00:06:59,120 And they estimate, saved about a billion lives through the 147 00:06:59,120 --> 00:07:01,730 increase in agriculture productivity he made possible 148 00:07:01,730 --> 00:07:06,850 for this Green Revolution in Southeast Asia. 149 00:07:06,850 --> 00:07:10,080 Really, just changed the entire trajectory of that part 150 00:07:10,080 --> 00:07:12,580 of the world through the agricultural productivity 151 00:07:12,580 --> 00:07:13,830 improvements that he put in place. 152 00:07:13,830 --> 00:07:16,800 So it's very interesting putting a personal face on 153 00:07:16,800 --> 00:07:21,860 this impersonal letter A, how one scientist can really make 154 00:07:21,860 --> 00:07:24,020 a difference in that case. 155 00:07:24,020 --> 00:07:27,630 This also leads to the larger question which this course 156 00:07:27,630 --> 00:07:30,330 doesn't spent a lot of time on, but which is more of a 157 00:07:30,330 --> 00:07:32,660 macro question, which is what determines the overall 158 00:07:32,660 --> 00:07:36,270 standard of living in our country? 159 00:07:36,270 --> 00:07:40,010 The standard of living in our country, that is basically for 160 00:07:40,010 --> 00:07:44,850 a given level of labor we supply, what determines the 161 00:07:44,850 --> 00:07:48,860 level of our utility, of our social welfare, given how much 162 00:07:48,860 --> 00:07:50,880 labor we can supply? 163 00:07:50,880 --> 00:07:54,480 Well, ultimately, what's going to determine-- or another way 164 00:07:54,480 --> 00:07:56,030 to think of it is what determines the amount of stuff 165 00:07:56,030 --> 00:08:02,350 we can have for a given amount of labor effort we put in? 166 00:08:02,350 --> 00:08:04,790 Well, that's society's productivity. 167 00:08:04,790 --> 00:08:11,980 Society's productivity is how much more we can have for each 168 00:08:11,980 --> 00:08:14,940 given level of labor input. 169 00:08:14,940 --> 00:08:18,280 So what determines how much stuff we can have? 170 00:08:18,280 --> 00:08:24,150 Well, it's k and A. Given a fixed amount of labor input, 171 00:08:24,150 --> 00:08:27,260 given how much we work, what determines how much stuff we 172 00:08:27,260 --> 00:08:31,000 can have, with how much capital we have, and how 173 00:08:31,000 --> 00:08:34,010 productively we make use of it? 174 00:08:34,010 --> 00:08:38,590 Now, productivity in the US has followed a very 175 00:08:38,590 --> 00:08:39,280 interesting trend. 176 00:08:39,280 --> 00:08:42,200 So productivity, which is how much we produce for a given 177 00:08:42,200 --> 00:08:45,150 amount of inputs, has followed an interesting trend. 178 00:08:45,150 --> 00:08:50,800 From World War II until about 1973, productivity grew 179 00:08:50,800 --> 00:08:51,880 rapidly in the US. 180 00:08:51,880 --> 00:08:55,800 Productivity grew at about 2.3% per year-- 181 00:08:55,800 --> 00:08:57,720 2.4% per year-- 182 00:08:57,720 --> 00:09:00,580 from the end of World War II through 1973. 183 00:09:00,580 --> 00:09:04,400 That is, working no harder and having no more machines, we 184 00:09:04,400 --> 00:09:07,330 can consume 2.4% more stuff every single year. 185 00:09:10,070 --> 00:09:11,370 That's pretty impressive. 186 00:09:11,370 --> 00:09:13,182 That means we can just sit around, work no harder than we 187 00:09:13,182 --> 00:09:15,120 were, and have no more machines, and produce 2.4% 188 00:09:15,120 --> 00:09:15,860 more per year. 189 00:09:15,860 --> 00:09:17,500 Now, of course, over time we worked harder and had more 190 00:09:17,500 --> 00:09:20,850 machines, so overall output in US economy grew much faster 191 00:09:20,850 --> 00:09:22,820 than 2.4% a year. 192 00:09:22,820 --> 00:09:27,050 It grew more like 7-10% a year over that period. 193 00:09:27,050 --> 00:09:31,860 Yet, the point is that a lot of that we can get for free, 194 00:09:31,860 --> 00:09:33,440 essentially, without any harder 195 00:09:33,440 --> 00:09:35,340 work or any more capital. 196 00:09:35,340 --> 00:09:39,090 However, starting in 1973 until the early 1990s, 197 00:09:39,090 --> 00:09:43,530 productivity growth fell dramatically to 1% per year. 198 00:09:43,530 --> 00:09:46,940 That is literally we lost 1 1/2% per year of stuff we were 199 00:09:46,940 --> 00:09:47,990 getting before. 200 00:09:47,990 --> 00:09:50,040 We were getting 2 1/2% a year up to '73, all of a sudden 201 00:09:50,040 --> 00:09:51,460 it's down to 1%. 202 00:09:51,460 --> 00:09:54,280 That's 1 1/2% a year less stuff we can get unless we 203 00:09:54,280 --> 00:09:57,330 work harder to make up for it. 204 00:09:57,330 --> 00:09:59,340 Why did this happen? 205 00:09:59,340 --> 00:10:01,780 Well, we don't exactly know, but there's two good 206 00:10:01,780 --> 00:10:02,720 candidates. 207 00:10:02,720 --> 00:10:04,940 We know the two candidates, we just don't know the right 208 00:10:04,940 --> 00:10:06,270 proportions. 209 00:10:06,270 --> 00:10:11,410 One is that we have less capital in our society because 210 00:10:11,410 --> 00:10:13,530 savings fell. 211 00:10:13,530 --> 00:10:16,610 The amount of savings US households do fell 212 00:10:16,610 --> 00:10:17,640 dramatically. 213 00:10:17,640 --> 00:10:20,110 And the US has a very low savings rate. 214 00:10:20,110 --> 00:10:23,790 The US savings rate over this period averaged about 3%. 215 00:10:23,790 --> 00:10:25,640 That is, every dollar we earned we saved 216 00:10:25,640 --> 00:10:27,460 about 3% as a society. 217 00:10:27,460 --> 00:10:28,760 Compared to countries like Japan, where 218 00:10:28,760 --> 00:10:30,560 it's more like 20%. 219 00:10:30,560 --> 00:10:33,320 Every dollar they earn they save about 20%. 220 00:10:33,320 --> 00:10:34,430 Now why does that matter? 221 00:10:34,430 --> 00:10:36,420 Well, we'll talk about this later in the course, but 222 00:10:36,420 --> 00:10:39,500 essentially the amount we save determines the amount of 223 00:10:39,500 --> 00:10:41,640 capital we have in society. 224 00:10:41,640 --> 00:10:43,490 Because essentially, where do firms get the 225 00:10:43,490 --> 00:10:44,910 money to build machines? 226 00:10:44,910 --> 00:10:48,000 They get it by borrowing from households who save. And the 227 00:10:48,000 --> 00:10:50,180 less we save, the less money there is that firms could 228 00:10:50,180 --> 00:10:51,460 invest in building machines. 229 00:10:51,460 --> 00:10:54,420 And we'll talk about that at length later in the semester. 230 00:10:54,420 --> 00:10:57,900 But the bottom line is, the more we save as a country, the 231 00:10:57,900 --> 00:11:01,640 more money we have available, the more firms can take that 232 00:11:01,640 --> 00:11:02,960 money and build machines that improve 233 00:11:02,960 --> 00:11:04,150 our standard of living. 234 00:11:04,150 --> 00:11:06,890 And that saving fell a lot, and that's one reason. 235 00:11:10,530 --> 00:11:14,020 And the other reason is that productivity fell for reasons 236 00:11:14,020 --> 00:11:15,590 we don't quite understand. 237 00:11:15,590 --> 00:11:18,360 We know that productivity slowed down, but we don't 238 00:11:18,360 --> 00:11:23,410 quite understand why that is. 239 00:11:23,410 --> 00:11:28,200 But then in the 1990s, productivity shot up again. 240 00:11:28,200 --> 00:11:31,020 So productivity went back up towards our historic levels, 241 00:11:31,020 --> 00:11:35,670 from 1% back up to over 2% a year. 242 00:11:35,670 --> 00:11:36,740 Why is that? 243 00:11:36,740 --> 00:11:39,030 Well, it's unclear, but we think it's basically the IT 244 00:11:39,030 --> 00:11:40,660 revolution. 245 00:11:40,660 --> 00:11:44,610 Essentially, we think that the slow diffusion of computers, 246 00:11:44,610 --> 00:11:46,670 which people were predicting should increase productivity 247 00:11:46,670 --> 00:11:49,560 as way back as the 1980s, suddenly in the 1990s it 248 00:11:49,560 --> 00:11:50,700 really happened. 249 00:11:50,700 --> 00:11:54,920 And this IT revolution led to a big productivity increase. 250 00:11:54,920 --> 00:11:57,250 It's not clear if that's dying down now again, or if it's 251 00:11:57,250 --> 00:11:58,350 going to continue. 252 00:11:58,350 --> 00:11:59,440 It'll be interesting to see what happens 253 00:11:59,440 --> 00:12:00,360 over the next 15 years. 254 00:12:00,360 --> 00:12:04,250 So we have this period of high productivity growth, slowed 255 00:12:04,250 --> 00:12:08,870 down from '73 to the early '90s and then picked up again. 256 00:12:08,870 --> 00:12:10,990 We're not quite clear if that year's coming to an end or 257 00:12:10,990 --> 00:12:16,600 not, but that's sort of where we are now in that time path. 258 00:12:16,600 --> 00:12:18,100 What's very interesting-- 259 00:12:18,100 --> 00:12:19,675 so that's what happens to productivity, that's all I'll 260 00:12:19,675 --> 00:12:21,820 talk about it for this course, it's more of a macro topic. 261 00:12:21,820 --> 00:12:23,150 But I will mention an interesting 262 00:12:23,150 --> 00:12:25,210 micro spin on that. 263 00:12:25,210 --> 00:12:28,880 Which is, if society's more productive, that's like found 264 00:12:28,880 --> 00:12:30,060 money for society. 265 00:12:30,060 --> 00:12:32,540 That's like saying with all our resources we suddenly get 266 00:12:32,540 --> 00:12:34,020 extra money. 267 00:12:34,020 --> 00:12:36,730 Society then has to decide what to do with that. 268 00:12:36,730 --> 00:12:40,010 The US and Europe have followed very different paths 269 00:12:40,010 --> 00:12:41,260 in what to do with that money. 270 00:12:41,260 --> 00:12:43,070 In the US, we've taken that money and 271 00:12:43,070 --> 00:12:45,120 bought a lot more stuff. 272 00:12:45,120 --> 00:12:47,420 We have the highest standard of living in the world. 273 00:12:47,420 --> 00:12:50,900 We buy the most stuff per capita of anyone the world. 274 00:12:50,900 --> 00:12:53,330 In Europe, they took a lot of that money and took more 275 00:12:53,330 --> 00:12:55,790 leisure with it. 276 00:12:55,790 --> 00:12:58,200 They decided we're not going to quite have as much stuff, 277 00:12:58,200 --> 00:12:59,710 but we're going to have six weeks a year of vacation 278 00:12:59,710 --> 00:13:01,710 instead of two weeks a year of vacation. 279 00:13:01,710 --> 00:13:06,140 So if we go back to our discussion of what determines 280 00:13:06,140 --> 00:13:08,240 labor supply is the choice between leisure and 281 00:13:08,240 --> 00:13:11,730 consumption, and you think of the wage as the opportunity 282 00:13:11,730 --> 00:13:15,290 cost of leisure, well, what they've decided in Europe is 283 00:13:15,290 --> 00:13:17,360 to choose more along the leisure axis, and less along 284 00:13:17,360 --> 00:13:19,460 the consumption axis. 285 00:13:19,460 --> 00:13:22,490 In the US, we've chosen less among the leisure axis-- we 286 00:13:22,490 --> 00:13:24,000 work way harder than Europe-- 287 00:13:24,000 --> 00:13:26,000 but we have more stuff. 288 00:13:26,000 --> 00:13:28,860 And the question is, how do we feel about that choice? 289 00:13:28,860 --> 00:13:32,610 Has that been ultimately a welfare maximizing choice? 290 00:13:32,610 --> 00:13:34,345 Now an economist will say of course it's been, because it's 291 00:13:34,345 --> 00:13:35,650 a choice we made. 292 00:13:35,650 --> 00:13:37,750 Of course, it's been welfare maximizing. 293 00:13:37,750 --> 00:13:39,670 We talk about revealed preference, and people's 294 00:13:39,670 --> 00:13:41,800 choices reveal what they prefer. 295 00:13:41,800 --> 00:13:44,225 So our revealed preference, we just prefer stuff more and 296 00:13:44,225 --> 00:13:46,290 leisure less than Europe. 297 00:13:46,290 --> 00:13:49,690 But in fact, it's not clear that that is each individual's 298 00:13:49,690 --> 00:13:51,340 optimal choice. 299 00:13:51,340 --> 00:13:54,320 If a given individual says, look, I'd rather have less 300 00:13:54,320 --> 00:13:56,490 stuff and more time off, it may be hard to find the job 301 00:13:56,490 --> 00:13:58,260 that lets them do that. 302 00:13:58,260 --> 00:14:00,170 So while that may be the choice we've made as a society 303 00:14:00,170 --> 00:14:02,180 with our social institutions, that may not serve the 304 00:14:02,180 --> 00:14:04,340 interests of every individual in society. 305 00:14:04,340 --> 00:14:05,380 And that's the kind of trade-off we 306 00:14:05,380 --> 00:14:06,870 need to think about. 307 00:14:06,870 --> 00:14:08,725 So anyway, that's sort of what I wanted to say on 308 00:14:08,725 --> 00:14:09,220 productivity. 309 00:14:09,220 --> 00:14:09,880 Yeah, question? 310 00:14:09,880 --> 00:14:12,826 AUDIENCE: Does higher productivity translate into 311 00:14:12,826 --> 00:14:17,490 more income, or more income for individuals who will buy 312 00:14:17,490 --> 00:14:18,718 stuff [INAUDIBLE] taking more leisure? 313 00:14:18,718 --> 00:14:21,510 JON GRUBER: Because basically the point is think of our 314 00:14:21,510 --> 00:14:23,750 economy as a pie. 315 00:14:23,750 --> 00:14:29,280 That basically the idea is let's think of you have a 316 00:14:29,280 --> 00:14:36,170 start up, and your start up is such that you can make this 317 00:14:36,170 --> 00:14:40,640 product, and you could make $1 million a 318 00:14:40,640 --> 00:14:44,180 year with 10 workers. 319 00:14:44,180 --> 00:14:45,230 You could make $1 million worth of 320 00:14:45,230 --> 00:14:46,065 stuff with 10 workers. 321 00:14:46,065 --> 00:14:49,460 So each of your workers takes home $100,000. 322 00:14:49,460 --> 00:14:52,070 Now imagine that you discover new technology which lets you, 323 00:14:52,070 --> 00:14:53,470 with the same amount of workers, make 324 00:14:53,470 --> 00:14:55,100 $2 million a year. 325 00:14:55,100 --> 00:14:58,180 Well, some of that you'll keep, but some of it you'll 326 00:14:58,180 --> 00:14:59,880 pay your workers more. 327 00:14:59,880 --> 00:15:02,330 So suddenly they have more money, because you've suddenly 328 00:15:02,330 --> 00:15:07,020 managed to make twice as valuable stuff with the same 329 00:15:07,020 --> 00:15:08,050 amount of resources. 330 00:15:08,050 --> 00:15:09,150 So that's the situation which improves 331 00:15:09,150 --> 00:15:11,850 our standard of living. 332 00:15:11,850 --> 00:15:12,900 Other questions about that? 333 00:15:12,900 --> 00:15:14,930 Comments? 334 00:15:14,930 --> 00:15:17,370 OK, so the bottom line, coming back to sort of micro-theory 335 00:15:17,370 --> 00:15:18,960 we're talking about, is we have to think about production 336 00:15:18,960 --> 00:15:20,870 functions as having a productivity adjustment. 337 00:15:20,870 --> 00:15:23,385 Macro raises these big issues about sort of ultimately what 338 00:15:23,385 --> 00:15:25,280 determines our standard of living in this country, and 339 00:15:25,280 --> 00:15:27,270 how do we want to spend that money? 340 00:15:27,270 --> 00:15:31,050 So, with that as background, we're now going to stop 341 00:15:31,050 --> 00:15:32,920 talking about production and move on 342 00:15:32,920 --> 00:15:38,050 to cost. Cost is-- 343 00:15:38,050 --> 00:15:40,150 quite frankly this is perhaps my least favorite thing in the 344 00:15:40,150 --> 00:15:40,660 whole course. 345 00:15:40,660 --> 00:15:45,210 It's a little bit boring, but you need to understand how 346 00:15:45,210 --> 00:15:48,500 cost structure in a firm works to understand how firms make 347 00:15:48,500 --> 00:15:50,010 the decisions that ultimately get to be a lot more 348 00:15:50,010 --> 00:15:52,970 interesting again, so just sort of bear with me. 349 00:15:52,970 --> 00:15:55,030 Now, so we talked about costs, let's start with a couple of 350 00:15:55,030 --> 00:15:57,430 definitions. 351 00:15:57,430 --> 00:15:59,510 Basically, let's back up, where are we coming from? 352 00:15:59,510 --> 00:16:02,550 I talked about what the firm's decision is, the firm has to 353 00:16:02,550 --> 00:16:08,860 maximize profits, which is revenues minus cost. So we 354 00:16:08,860 --> 00:16:11,040 have to ask what are costs if we're going to make this 355 00:16:11,040 --> 00:16:12,230 profit maximizing decision. 356 00:16:12,230 --> 00:16:14,770 Well, costs are going to have a few components. 357 00:16:14,770 --> 00:16:19,450 The first component, costs are going to have really two major 358 00:16:19,450 --> 00:16:20,420 components-- 359 00:16:20,420 --> 00:16:26,355 fixed costs, and variable costs. 360 00:16:29,600 --> 00:16:32,370 Fixed costs and variable costs. 361 00:16:32,370 --> 00:16:35,476 Fixed costs are the costs of inputs that cannot be varied 362 00:16:35,476 --> 00:16:36,450 in the short-run. 363 00:16:36,450 --> 00:16:38,280 Remember, I said that the short-run is defined as a 364 00:16:38,280 --> 00:16:41,570 period over time which only some inputs can vary. 365 00:16:41,570 --> 00:16:43,580 Well, fixed costs are the costs of those inputs that 366 00:16:43,580 --> 00:16:46,390 can't vary in the short-run. 367 00:16:46,390 --> 00:16:48,090 Variable costs-- 368 00:16:48,090 --> 00:16:51,040 so that's like capital in the short-run-- 369 00:16:51,040 --> 00:16:53,630 variable costs are the cost of goods that can vary in the 370 00:16:53,630 --> 00:16:56,770 short run, that's like labor. 371 00:16:56,770 --> 00:17:04,440 So total costs is the sum of these two, so total costs 372 00:17:04,440 --> 00:17:09,900 equals fixed cost plus variable cost. 373 00:17:09,900 --> 00:17:13,869 Finally, another definition that's important is marginal 374 00:17:13,869 --> 00:17:20,849 cost, which is the change in cost with a change in output. 375 00:17:20,849 --> 00:17:22,520 So the marginal cost is just like-- 376 00:17:22,520 --> 00:17:26,240 remember, we want to think in terms of marginal decision 377 00:17:26,240 --> 00:17:26,950 making in this course. 378 00:17:26,950 --> 00:17:28,840 So the marginal cost is the change in cost with the change 379 00:17:28,840 --> 00:17:31,720 in-- actually, that should be a little q. 380 00:17:31,720 --> 00:17:34,050 The change in a firm's cost with the change in the firm's 381 00:17:34,050 --> 00:17:37,980 output is marginal cost. 382 00:17:37,980 --> 00:17:42,800 And then finally, average cost is just what it sounds like. 383 00:17:42,800 --> 00:17:53,270 Average cost is just c over q, it's just the average. 384 00:17:53,270 --> 00:17:55,480 So the difference between marginal and average cost, is 385 00:17:55,480 --> 00:17:57,690 basically average costs is the average over the whole set of 386 00:17:57,690 --> 00:17:58,250 goods produced. 387 00:17:58,250 --> 00:18:02,580 Marginal cost is the cost of that next unit of production. 388 00:18:02,580 --> 00:18:04,110 So those are our key definitions. 389 00:18:04,110 --> 00:18:08,300 Now with those in mind, let's ask how do we get costs? 390 00:18:08,300 --> 00:18:11,020 And the answer is we get them from the production function. 391 00:18:11,020 --> 00:18:15,730 Once we do a production function, we can derive costs. 392 00:18:15,730 --> 00:18:21,895 So if we have some production function, q equals f of l and 393 00:18:21,895 --> 00:18:40,290 k, then we can say the cost of producing q is equal to f of 394 00:18:40,290 --> 00:18:43,930 wl plus rk. 395 00:18:43,930 --> 00:18:49,160 Where w is the wage rate, or the rate you pay per unit of 396 00:18:49,160 --> 00:18:55,490 labor, and r is the rental rate, or the rate you pay per 397 00:18:55,490 --> 00:18:56,740 unit of capital. 398 00:18:58,650 --> 00:19:00,830 Now, let me just pause here for a second to talk about 399 00:19:00,830 --> 00:19:01,840 pricing capital. 400 00:19:01,840 --> 00:19:03,960 It's easy to think the cost of an hour of labor, it's the 401 00:19:03,960 --> 00:19:05,410 wage you pay for an hour. 402 00:19:05,410 --> 00:19:08,410 It's harder to think about the cost of a unit of capital. 403 00:19:08,410 --> 00:19:10,100 Because we buy the machines, right? 404 00:19:10,100 --> 00:19:12,240 So how do we think about the cost? 405 00:19:12,240 --> 00:19:14,690 I'm going to cover this later in the course, for now imagine 406 00:19:14,690 --> 00:19:17,390 all machines are rented. 407 00:19:17,390 --> 00:19:20,670 Imagine you rent every machine you use. 408 00:19:20,670 --> 00:19:24,530 And think of r as the rental price of that unit of capital. 409 00:19:24,530 --> 00:19:26,970 So with buildings it make sense, firms often rent the 410 00:19:26,970 --> 00:19:28,210 buildings they're in. 411 00:19:28,210 --> 00:19:30,520 Think of r as the rental price of that unit of building, or 412 00:19:30,520 --> 00:19:31,620 that unit of machine. 413 00:19:31,620 --> 00:19:34,260 We'll come back later to see why that's a sensible way to 414 00:19:34,260 --> 00:19:35,000 think about it. 415 00:19:35,000 --> 00:19:38,200 The key point is, the reason we have to do this is the wage 416 00:19:38,200 --> 00:19:41,360 is a flow measure, every hour I pay you a new wage. 417 00:19:41,360 --> 00:19:44,020 If I use the cost of buying the machine, that be a stock 418 00:19:44,020 --> 00:19:46,800 measure, so you couldn't really compare it to wages. 419 00:19:46,800 --> 00:19:48,010 So we want to use a flow measure. 420 00:19:48,010 --> 00:19:49,656 The flow measures is what we have to pay every period to 421 00:19:49,656 --> 00:19:50,560 rent the machine. 422 00:19:50,560 --> 00:19:50,990 Yeah? 423 00:19:50,990 --> 00:19:52,421 AUDIENCE: [INAUDIBLE] 424 00:19:52,421 --> 00:19:55,283 just take the cost of the machine and estimate the 425 00:19:55,283 --> 00:19:59,576 amount of time we want, and then divide it? 426 00:19:59,576 --> 00:20:00,465 JON GRUBER: Sure. 427 00:20:00,465 --> 00:20:01,920 No, and I'll cover that later. 428 00:20:01,920 --> 00:20:04,150 You could think of the rental-- 429 00:20:04,150 --> 00:20:07,420 if I bought the machine today and sold it tomorrow, that'd 430 00:20:07,420 --> 00:20:08,940 be like I rented it. 431 00:20:08,940 --> 00:20:11,160 And this would be the cost difference between what I paid 432 00:20:11,160 --> 00:20:13,750 for it and what I'd sell it for. 433 00:20:13,750 --> 00:20:15,420 But it's just easier to think of it as the rental, because 434 00:20:15,420 --> 00:20:17,310 the flow measure-- like the wage-- is a flow measure. 435 00:20:20,030 --> 00:20:25,540 Now, in the short-run, capital is fixed. 436 00:20:25,540 --> 00:20:34,950 So in the short-run, our fixed costs are rk bar. 437 00:20:34,950 --> 00:20:37,280 That's our fixed cost, the rental rate times the fixed 438 00:20:37,280 --> 00:20:41,210 amount of capital in the short-run. 439 00:20:41,210 --> 00:20:48,980 And our variable costs are w times l, which is 440 00:20:48,980 --> 00:20:50,280 a function of q. 441 00:20:50,280 --> 00:20:52,860 That is, the more you produce the more labor 442 00:20:52,860 --> 00:20:56,390 you use in the short-run. 443 00:20:56,390 --> 00:21:00,140 So total costs in the short-run, short-run total 444 00:21:00,140 --> 00:21:06,236 costs, are rk bar plus wL of q. 445 00:21:06,236 --> 00:21:08,230 k is not a function of q because k's fixed in the 446 00:21:08,230 --> 00:21:10,350 short-run, but the amount of labor used is a function of 447 00:21:10,350 --> 00:21:11,600 how much you produce. 448 00:21:15,600 --> 00:21:19,720 This implies that the marginal cost, the key concept we want 449 00:21:19,720 --> 00:21:23,880 to work with, marginal cost, which is the derivative of 450 00:21:23,880 --> 00:21:26,180 total costs with respect to quantity. 451 00:21:26,180 --> 00:21:34,500 So dc dq is going to be equal to w-- 452 00:21:34,500 --> 00:21:36,260 or, let's do it in deltas, because we're not doing 453 00:21:36,260 --> 00:21:36,730 calculus here. 454 00:21:36,730 --> 00:21:44,090 Delta c delta q is going to be w times delta l over delta q. 455 00:21:44,090 --> 00:21:46,490 That's going to be the marginal cost. 456 00:21:46,490 --> 00:21:49,290 The marginal cost-- so I'm just differentiating the total 457 00:21:49,290 --> 00:21:50,670 cost function-- 458 00:21:50,670 --> 00:21:54,420 is going to be the wage times delta l delta q. 459 00:21:54,420 --> 00:21:57,170 So the marginal cost of producing the next unit is 460 00:21:57,170 --> 00:21:59,840 going to be how much labor I have to produce to produce the 461 00:21:59,840 --> 00:22:06,450 next unit, times the wage I pay per unit of labor. 462 00:22:06,450 --> 00:22:09,460 Now, does anyone remember what we call this? 463 00:22:09,460 --> 00:22:12,990 I know this wasn't on the exam last night, so you may not-- 464 00:22:12,990 --> 00:22:14,620 cast your mind back to the lecture on Monday. 465 00:22:14,620 --> 00:22:18,530 Do you remember what we call delta l over delta q? 466 00:22:18,530 --> 00:22:18,690 Anyone? 467 00:22:18,690 --> 00:22:20,652 Bueller? 468 00:22:20,652 --> 00:22:21,460 No? 469 00:22:21,460 --> 00:22:22,870 It's the marginal product of labor. 470 00:22:22,870 --> 00:22:24,020 Remember from Monday? 471 00:22:24,020 --> 00:22:28,500 So this is the wage times the marginal product of labor. 472 00:22:28,500 --> 00:22:36,380 So what we say is that the marginal cost is equal to the 473 00:22:36,380 --> 00:22:42,380 wage times the marginal-- 474 00:22:42,380 --> 00:22:43,250 I'm sorry the wage over. 475 00:22:43,250 --> 00:22:44,450 I'm sorry, it's one over. 476 00:22:44,450 --> 00:22:46,180 That delta q does-- l was the marginal product. 477 00:22:46,180 --> 00:22:49,410 The wage over the marginal product of labor. 478 00:22:49,410 --> 00:22:51,240 So marginal cost is the wage over the 479 00:22:51,240 --> 00:22:53,490 marginal product of labor. 480 00:22:53,490 --> 00:22:56,990 Marginal product of labor was delta q delta l, so wage over 481 00:22:56,990 --> 00:23:00,310 the marginal product of labor is the marginal cost. 482 00:23:00,310 --> 00:23:02,090 So think about this intuitively. 483 00:23:02,090 --> 00:23:07,030 What we're saying is the cost of the next unit of production 484 00:23:07,030 --> 00:23:10,550 is declining with the marginal product of labor, it sort of 485 00:23:10,550 --> 00:23:11,020 makes sense. 486 00:23:11,020 --> 00:23:15,090 The more productive is a worker, the less expensive is 487 00:23:15,090 --> 00:23:17,090 producing the next unit. 488 00:23:17,090 --> 00:23:19,600 The less productive is the next worker, the more 489 00:23:19,600 --> 00:23:20,710 expensive is producing the next unit. 490 00:23:20,710 --> 00:23:23,330 So it's an inverse relationship between the 491 00:23:23,330 --> 00:23:27,710 marginal cost and the marginal product where the wage is the 492 00:23:27,710 --> 00:23:32,870 constant that scales that relationship. 493 00:23:32,870 --> 00:23:37,370 So basically, when workers are very, very high marginal 494 00:23:37,370 --> 00:23:39,250 product, then it's going to be cheap to 495 00:23:39,250 --> 00:23:40,805 produce the next unit. 496 00:23:40,805 --> 00:23:42,886 When workers have a low marginal product, it's going 497 00:23:42,886 --> 00:23:44,720 to be expensive to produce the next unit, and that's going to 498 00:23:44,720 --> 00:23:49,440 depend on what you actually have to pay the worker. 499 00:23:49,440 --> 00:23:52,330 Questions about that? 500 00:23:52,330 --> 00:23:55,490 So basically, the first key thing we want to derive here 501 00:23:55,490 --> 00:23:58,000 is that the marginal cost is directly related to the 502 00:23:58,000 --> 00:23:59,780 marginal product of labor, and the marginal product of labor 503 00:23:59,780 --> 00:24:02,410 we saw last time comes out of production function. 504 00:24:02,410 --> 00:24:07,330 So if you're given a wage, and given a production function, 505 00:24:07,330 --> 00:24:11,006 you should be able to derive the short-run marginal cost. 506 00:24:11,006 --> 00:24:14,230 You might someday be asked to do that. 507 00:24:14,230 --> 00:24:15,480 Now what about the long-run? 508 00:24:18,590 --> 00:24:21,620 The short-run's no fun, what about the long-run? 509 00:24:21,620 --> 00:24:26,070 In the long-run, firms can choose their mix 510 00:24:26,070 --> 00:24:26,940 of labor and capital. 511 00:24:26,940 --> 00:24:29,530 Remember, in the short-run the capital is fixed, so fixed 512 00:24:29,530 --> 00:24:31,320 costs rk bar. 513 00:24:31,320 --> 00:24:33,010 The only thing they could change was the amount of 514 00:24:33,010 --> 00:24:35,610 labor, so we could derive their marginal costs. 515 00:24:35,610 --> 00:24:36,490 What about in the long-run? 516 00:24:36,490 --> 00:24:38,630 Well, the long-run's a little more interesting because in 517 00:24:38,630 --> 00:24:43,350 the long-run firms get to choose their input mix to 518 00:24:43,350 --> 00:24:45,510 maximize their production efficiency. 519 00:24:45,510 --> 00:24:53,730 So input mix is chosen to maximize production efficiency 520 00:24:53,730 --> 00:24:57,970 which equates to minimizing costs. 521 00:24:57,970 --> 00:25:01,140 Maximizing production efficiency equates to 522 00:25:01,140 --> 00:25:04,130 minimizing costs. 523 00:25:04,130 --> 00:25:08,310 So we talked last time about isoquants, and the notion that 524 00:25:08,310 --> 00:25:13,010 isoquants were combinations of labor and capital that 525 00:25:13,010 --> 00:25:15,960 delivered the same output. 526 00:25:15,960 --> 00:25:18,635 Just like indifference curves are combinations of pizza and 527 00:25:18,635 --> 00:25:22,400 movies that deliver the same utility, isoquants are a 528 00:25:22,400 --> 00:25:23,840 combination of labor and capital that 529 00:25:23,840 --> 00:25:26,270 deliver the same output. 530 00:25:26,270 --> 00:25:31,150 The key point is that, technologically, any choice of 531 00:25:31,150 --> 00:25:33,930 labor and capital produces the same q, so there's nothing 532 00:25:33,930 --> 00:25:36,540 that tells you technologically which of those to use. 533 00:25:36,540 --> 00:25:41,000 We just know, technologically, there's a set of choices which 534 00:25:41,000 --> 00:25:42,080 deliver the same q. 535 00:25:42,080 --> 00:25:43,400 Well, how do we tell which to use? 536 00:25:43,400 --> 00:25:47,710 Well, we want to choose the one which is minimizing costs. 537 00:25:47,710 --> 00:25:50,890 So to do that, we're going to have to bring in the cost of 538 00:25:50,890 --> 00:25:51,900 those inputs. 539 00:25:51,900 --> 00:25:54,230 Just like we said there's a set of pizza and movies, all 540 00:25:54,230 --> 00:25:55,460 of which leave you indifferent. 541 00:25:55,460 --> 00:25:57,300 How do you decide which pizza and movies to choose? 542 00:25:57,300 --> 00:25:58,660 Well, you bring in the relative price 543 00:25:58,660 --> 00:26:00,800 of pizza and movies. 544 00:26:00,800 --> 00:26:03,050 Here, we're going to bring in the relative price of capital 545 00:26:03,050 --> 00:26:05,980 and labor to determine how we choose 546 00:26:05,980 --> 00:26:08,340 between capital and labor. 547 00:26:08,340 --> 00:26:11,840 So to do that, we're going to draw isocost lines which are 548 00:26:11,840 --> 00:26:14,530 going to be just like our old budget constraints. 549 00:26:14,530 --> 00:26:20,530 Isocost lines which represent the cost of different 550 00:26:20,530 --> 00:26:24,290 combinations of inputs, just like our old budget constraint 551 00:26:24,290 --> 00:26:27,390 represented the cost of different consumption goods. 552 00:26:27,390 --> 00:26:31,940 So if you look at figure 9-1, here we're going to have 553 00:26:31,940 --> 00:26:35,290 isocost curves which are going to represent-- 554 00:26:35,290 --> 00:26:40,460 and we're going to assume here that the wage is $5 an hour, 555 00:26:40,460 --> 00:26:44,760 and the rental rate is $10 per unit of capital. 556 00:26:48,580 --> 00:26:52,630 So, in other words, the $50 isocost line in figure 9-1 557 00:26:52,630 --> 00:26:56,120 shows all combinations of labor and 558 00:26:56,120 --> 00:26:59,970 capital that cost $50. 559 00:26:59,970 --> 00:27:03,970 So you could spend $50 in production if you had 10 units 560 00:27:03,970 --> 00:27:06,490 of labor, and no units of capital. 561 00:27:06,490 --> 00:27:08,620 Or five units of capital, and no units of labor, or any 562 00:27:08,620 --> 00:27:11,060 combination in between. 563 00:27:11,060 --> 00:27:12,610 These are all the combinations of labor and 564 00:27:12,610 --> 00:27:14,270 capital that cost $50. 565 00:27:14,270 --> 00:27:18,090 Likewise, the $100 isocost is all combinations of labor and 566 00:27:18,090 --> 00:27:21,920 capital that cost $100. 567 00:27:21,920 --> 00:27:32,020 So each of these isocosts give you the combination of inputs 568 00:27:32,020 --> 00:27:33,150 that cost a certain amount. 569 00:27:33,150 --> 00:27:35,740 Just like a budget constraint gave you the combination of 570 00:27:35,740 --> 00:27:39,640 pizza and movies on which you spent your income. 571 00:27:39,640 --> 00:27:42,520 Now, you may have said well, wait a second, the difference 572 00:27:42,520 --> 00:27:44,980 with consumers is we knew their income so we knew what 573 00:27:44,980 --> 00:27:46,230 their budget constraint is. 574 00:27:46,230 --> 00:27:50,470 Here we don't know whether to choose the $50 cost, the $100 575 00:27:50,470 --> 00:27:51,140 cost, $150. 576 00:27:51,140 --> 00:27:53,070 We don't know what the total amount is. 577 00:27:53,070 --> 00:27:54,510 That's what makes firms hard, that's why we 578 00:27:54,510 --> 00:27:55,700 have an extra step. 579 00:27:55,700 --> 00:27:56,930 So hold that thought, we'll come back 580 00:27:56,930 --> 00:27:59,180 to that next lecture. 581 00:27:59,180 --> 00:28:01,590 For now, let's just say there's a set of trade-offs 582 00:28:01,590 --> 00:28:05,720 that the firm can choose from, and a set of isoquants that 583 00:28:05,720 --> 00:28:06,430 they have. 584 00:28:06,430 --> 00:28:10,030 And what's the slope of this isocost line? 585 00:28:10,030 --> 00:28:13,120 It's the negative of the wage rental ratio. 586 00:28:13,120 --> 00:28:19,210 The slope of the isocost is minus w over r. 587 00:28:19,210 --> 00:28:21,590 The slope is minus w over r. 588 00:28:21,590 --> 00:28:26,170 It's basically the trade-off between labor and capital's 589 00:28:26,170 --> 00:28:28,180 going to be determined by the relative prices of those 590 00:28:28,180 --> 00:28:32,770 inputs, so slope is going to be minus w over r. 591 00:28:32,770 --> 00:28:35,790 So basically, how many units of capital do you have to give 592 00:28:35,790 --> 00:28:38,020 up to get the next unit of labor? 593 00:28:38,020 --> 00:28:42,600 Well, what this isocost tells you is you have to give up 1/2 594 00:28:42,600 --> 00:28:47,020 a unit of capital to get a unit of labor. 595 00:28:47,020 --> 00:28:49,440 So the slope is minus 1/2. 596 00:28:49,440 --> 00:28:51,390 Likewise, you could say you have to give up two units of 597 00:28:51,390 --> 00:28:53,370 labor to get one unit of capital. 598 00:28:53,370 --> 00:28:56,490 So that's why the slope is minus 1/2, that's what it's 599 00:28:56,490 --> 00:28:57,390 telling us. 600 00:28:57,390 --> 00:29:00,170 Once again, budget constraints are about opportunity costs. 601 00:29:00,170 --> 00:29:02,230 How much labor do you have to give up to get 602 00:29:02,230 --> 00:29:03,280 another unit of capital? 603 00:29:03,280 --> 00:29:05,010 Or how much capital do you have to give up to get another 604 00:29:05,010 --> 00:29:06,760 unit of labor? 605 00:29:06,760 --> 00:29:10,860 Now, armed with isoquants, which are like indifference 606 00:29:10,860 --> 00:29:13,150 curves, and these isocosts which are like budget 607 00:29:13,150 --> 00:29:16,610 constraints, we can then figure out what is the 608 00:29:16,610 --> 00:29:20,080 economically efficient combination of inputs for the 609 00:29:20,080 --> 00:29:22,430 firm to use. 610 00:29:22,430 --> 00:29:25,900 The economically efficient combination of inputs for a 611 00:29:25,900 --> 00:29:27,310 given level of output. 612 00:29:27,310 --> 00:29:40,450 So the economically efficient input combination for a given 613 00:29:40,450 --> 00:29:45,980 level of output is going to be determined by the tangency of 614 00:29:45,980 --> 00:29:50,420 the isoquant with the isocost, as you see in figure 9-2. 615 00:29:53,540 --> 00:29:56,600 Here we're going to use our same isoquant we had before, 616 00:29:56,600 --> 00:30:01,610 which is we're going to assume that q equals square 617 00:30:01,610 --> 00:30:03,610 root of k times l. 618 00:30:03,610 --> 00:30:06,820 So same production function we had before, which gave a 619 00:30:06,820 --> 00:30:08,285 series of isoquants last lecture. 620 00:30:11,420 --> 00:30:16,560 So basically, what we see is that the efficient-- 621 00:30:16,560 --> 00:30:30,270 if you want to produce a given amount of q, then basically 622 00:30:30,270 --> 00:30:33,170 what you're going to do is you're going to look for the 623 00:30:33,170 --> 00:30:39,060 tangency of that isoquant with the isocost. And you're going 624 00:30:39,060 --> 00:30:42,660 to say that the efficient way to produce that is going to be 625 00:30:42,660 --> 00:30:47,090 to use 2 1/2 units of capital and 5 units of labor. 626 00:30:47,090 --> 00:30:49,290 It's going to say look, given the relative prices that are 627 00:30:49,290 --> 00:30:52,260 given to us by this budget constraint, the production 628 00:30:52,260 --> 00:30:55,860 technology is given to us by this production function from 629 00:30:55,860 --> 00:30:58,070 which we derived isoquants last time. 630 00:30:58,070 --> 00:31:01,320 So the optimal combination of inputs to get this level of 631 00:31:01,320 --> 00:31:04,830 output is going to be 2 1/2 units of capital 632 00:31:04,830 --> 00:31:07,370 and 5 units of labor. 633 00:31:07,370 --> 00:31:09,070 And that will produce basically 634 00:31:09,070 --> 00:31:11,270 square root of 12 1/2. 635 00:31:11,270 --> 00:31:16,400 So basically the quantity will be equal to the square root of 636 00:31:16,400 --> 00:31:21,910 5 times 2 1/2, or the square root of 12 1/2 units of 637 00:31:21,910 --> 00:31:24,080 production. 638 00:31:24,080 --> 00:31:27,130 So basically, that is going to give us the 639 00:31:27,130 --> 00:31:28,530 efficient way to do that. 640 00:31:28,530 --> 00:31:31,470 Now, once again as always, we want to think about things 641 00:31:31,470 --> 00:31:34,420 intuitively, graphically, and mathematically. 642 00:31:34,420 --> 00:31:38,240 Let's think about for a second the mathematics. 643 00:31:38,240 --> 00:31:47,110 We know that the slope of the isoquant-- 644 00:31:47,110 --> 00:31:48,460 we talked last time-- 645 00:31:48,460 --> 00:31:51,325 the slope of the isoquant at any given point. 646 00:31:51,325 --> 00:31:54,070 The isoquant slope was the marginal rate of technical 647 00:31:54,070 --> 00:31:55,880 substitution. 648 00:31:55,880 --> 00:31:56,990 We defined that last time. 649 00:31:56,990 --> 00:31:59,010 The slope of the isoquant was the marginal rate of technical 650 00:31:59,010 --> 00:32:05,240 substitution which is the marginal product of labor over 651 00:32:05,240 --> 00:32:08,310 the marginal product of capital. 652 00:32:08,310 --> 00:32:10,090 And what we're saying is we want to set that marginal rate 653 00:32:10,090 --> 00:32:12,730 of technical substitution equal to the input costs 654 00:32:12,730 --> 00:32:14,764 ratio w over r. 655 00:32:17,370 --> 00:32:20,740 That's what we're saying, the efficient thing to do is to 656 00:32:20,740 --> 00:32:23,770 set the marginal rate of technical substitution equal 657 00:32:23,770 --> 00:32:26,020 to the price ratio. 658 00:32:26,020 --> 00:32:28,870 That's what happens when the slopes are equal. 659 00:32:28,870 --> 00:32:30,720 Now, once again, I find it easier to 660 00:32:30,720 --> 00:32:32,130 rewrite this equation-- 661 00:32:32,130 --> 00:32:34,160 once you've developed the intuition, I find it easier to 662 00:32:34,160 --> 00:32:35,190 think of it this way. 663 00:32:35,190 --> 00:32:37,670 Rewrite this as the marginal product of labor over the 664 00:32:37,670 --> 00:32:41,140 wage, equals the marginal product of capital over the 665 00:32:41,140 --> 00:32:43,450 rental rate. 666 00:32:43,450 --> 00:32:46,780 What this is telling us is the efficient place is where 667 00:32:46,780 --> 00:32:51,320 essentially for every dollar you spent on workers, you're 668 00:32:51,320 --> 00:32:55,400 getting the same return as a dollar spent on machines. 669 00:32:55,400 --> 00:32:57,430 The marginal product of labor over the wage is sort of the 670 00:32:57,430 --> 00:32:59,630 bang for buck of workers. 671 00:32:59,630 --> 00:33:01,500 What are you getting for your next dollar of wage? 672 00:33:04,220 --> 00:33:06,250 The marginal product of capital over r is the bang for 673 00:33:06,250 --> 00:33:06,940 the buck of machines. 674 00:33:06,940 --> 00:33:09,650 What are you getting for your next dollar of rent? 675 00:33:09,650 --> 00:33:11,760 And the efficient point is where these are equal. 676 00:33:11,760 --> 00:33:15,020 If they're not equal, then you have too much of one and not 677 00:33:15,020 --> 00:33:16,270 enough of the other. 678 00:33:18,300 --> 00:33:22,440 So basically, what we can do is we can 679 00:33:22,440 --> 00:33:25,420 solve in this example-- 680 00:33:25,420 --> 00:33:31,060 in this example, we could say the marginal product of labor 681 00:33:31,060 --> 00:33:35,395 is 1/2 k over the square root of k times l. 682 00:33:38,570 --> 00:33:41,120 The marginal product of capital from this production 683 00:33:41,120 --> 00:33:42,820 function is-- 684 00:33:42,820 --> 00:33:46,060 once again I'm using this production function q equals 685 00:33:46,060 --> 00:33:47,600 square root of k times l. 686 00:33:47,600 --> 00:33:51,580 Marginal project of capital is 1/2 l over square 687 00:33:51,580 --> 00:33:55,010 root of k times l. 688 00:33:55,010 --> 00:34:01,480 So the ratio of the marginal products is simply k over l. 689 00:34:01,480 --> 00:34:05,470 The marginal rate of technical substitution, given this 690 00:34:05,470 --> 00:34:06,940 production function, is k over l. 691 00:34:06,940 --> 00:34:09,570 That's the marginal rate of technical substitution. 692 00:34:09,570 --> 00:34:11,659 So this says that given this production function and these 693 00:34:11,659 --> 00:34:19,699 prices, at the optimum you should set k over l equal to w 694 00:34:19,699 --> 00:34:22,710 over r, which equals 1/2. 695 00:34:22,710 --> 00:34:25,810 So what this says is given this production function, 696 00:34:25,810 --> 00:34:29,480 these price ratios, the optimal thing to do is to use 697 00:34:29,480 --> 00:34:31,790 half as much capital as labor. 698 00:34:35,429 --> 00:34:38,070 Half as much capital as labor is the optimal thing to do, 699 00:34:38,070 --> 00:34:41,480 and that's what we see in figure 9-2, is the optimal 700 00:34:41,480 --> 00:34:44,460 thing to do is use half as much capital as labor. 701 00:34:44,460 --> 00:34:48,540 Now, in other words, let's say, to 702 00:34:48,540 --> 00:34:49,860 now develop the intuition. 703 00:34:49,860 --> 00:34:52,600 Imagine you told me no, I should use as much capital as 704 00:34:52,600 --> 00:34:54,530 I should use labor. 705 00:34:54,530 --> 00:34:56,429 As much capital as I should use labor. 706 00:34:56,429 --> 00:34:58,000 Imagine I told you that. 707 00:34:58,000 --> 00:35:00,130 Imagine I said no, in fact, the efficient thing to use is 708 00:35:00,130 --> 00:35:03,470 why not have one machine for every worker? 709 00:35:03,470 --> 00:35:06,740 How would you tell me intuitively why that's wrong? 710 00:35:06,740 --> 00:35:08,600 Why would I be wrong to say use one 711 00:35:08,600 --> 00:35:09,850 machine for every worker? 712 00:35:13,020 --> 00:35:15,290 Why would that be wrong, given the prices 713 00:35:15,290 --> 00:35:16,540 prevailing in the market? 714 00:35:19,260 --> 00:35:20,536 Someone can tell me this. 715 00:35:20,536 --> 00:35:21,012 Yeah? 716 00:35:21,012 --> 00:35:24,344 AUDIENCE: Well, renting machines is a lot more 717 00:35:24,344 --> 00:35:26,730 expensive than paying more workers. 718 00:35:26,730 --> 00:35:28,529 JON GRUBER: Twice as expensive to rent a 719 00:35:28,529 --> 00:35:29,144 machine as get a worker. 720 00:35:29,144 --> 00:35:32,100 AUDIENCE: So it would be more cost-effective to have the 721 00:35:32,100 --> 00:35:35,030 workers share machines rather than get a whole new machine. 722 00:35:35,030 --> 00:35:38,130 JON GRUBER: The key point is the machine costs twice as 723 00:35:38,130 --> 00:35:42,360 much, but the machine doesn't do twice as much. 724 00:35:42,360 --> 00:35:44,360 The machine and the worker do the same thing. 725 00:35:44,360 --> 00:35:46,450 The marginal rate of technical substitution is one. 726 00:35:46,450 --> 00:35:48,550 You're indifferent between one more machine and one more 727 00:35:48,550 --> 00:35:52,900 worker, but the machine cost twice as much as the worker. 728 00:35:52,900 --> 00:35:56,190 So you want more workers and fewer machines, right? 729 00:35:56,190 --> 00:35:58,590 Given the machines and workers, this is a perfectly 730 00:35:58,590 --> 00:36:02,000 substitutable production function. 731 00:36:02,000 --> 00:36:06,700 The marginal rate of technical substitution is k over l. 732 00:36:06,700 --> 00:36:09,360 You're perfectly indifferent between these two, given 733 00:36:09,360 --> 00:36:10,690 that-- not perfectly substitutable, but at this 734 00:36:10,690 --> 00:36:12,550 point you're indifferent between the two. 735 00:36:12,550 --> 00:36:14,870 So given that you're indifferent and the machines 736 00:36:14,870 --> 00:36:17,680 cost twice as much, why not buy half as many machines? 737 00:36:17,680 --> 00:36:18,588 Yeah? 738 00:36:18,588 --> 00:36:21,150 AUDIENCE: But then, if the machines cost twice as much, 739 00:36:21,150 --> 00:36:22,590 why buy any machines? 740 00:36:22,590 --> 00:36:24,520 JON GRUBER: Oh, that's very good point. 741 00:36:24,520 --> 00:36:26,540 Because it's not a perfectly substitutable function. 742 00:36:26,540 --> 00:36:27,270 My bad. 743 00:36:27,270 --> 00:36:30,250 If it was, if the production function-- 744 00:36:30,250 --> 00:36:30,790 great question. 745 00:36:30,790 --> 00:36:34,460 Let's say the production function was of the form q 746 00:36:34,460 --> 00:36:36,960 equals k plus l. 747 00:36:36,960 --> 00:36:38,370 That's perfectly substitutable production. 748 00:36:38,370 --> 00:36:41,390 Then you're right, in that situation you should only buy 749 00:36:41,390 --> 00:36:44,360 workers because they do exactly the same thing. 750 00:36:44,360 --> 00:36:46,020 But that's not the case here. 751 00:36:46,020 --> 00:36:48,880 This exhibits diminishing marginal product. 752 00:36:48,880 --> 00:36:52,180 So if you only bought workers, eventually each worker would 753 00:36:52,180 --> 00:36:55,070 do so much less that you'd be better off getting a machine. 754 00:36:55,070 --> 00:36:55,870 It's not perfectly 755 00:36:55,870 --> 00:36:57,986 substitutable, I misspoke before. 756 00:36:57,986 --> 00:37:02,970 At the margin they have an equal effect. 757 00:37:02,970 --> 00:37:06,290 But as you get more and more laborers, they'll be less and 758 00:37:06,290 --> 00:37:07,968 less productive, so eventually you're going to 759 00:37:07,968 --> 00:37:08,870 want to buy a machine. 760 00:37:08,870 --> 00:37:12,310 But you're only going to buy half as 761 00:37:12,310 --> 00:37:13,090 many machines as workers. 762 00:37:13,090 --> 00:37:14,690 You never want to buy one machine per worker. 763 00:37:14,690 --> 00:37:17,140 But you also don't want no machines per workers, because 764 00:37:17,140 --> 00:37:18,470 the workers won't have anything to do then. 765 00:37:18,470 --> 00:37:21,010 Here you'd want no machines per worker, right? 766 00:37:21,010 --> 00:37:24,320 The optimal thing to do, if you have a perfectly 767 00:37:24,320 --> 00:37:26,550 substitutable production function, you'd only just buy 768 00:37:26,550 --> 00:37:28,280 the cheaper input. 769 00:37:28,280 --> 00:37:30,080 But that's not the case when you have diminishing marginal 770 00:37:30,080 --> 00:37:32,630 products, then you're going to use a combination of inputs. 771 00:37:32,630 --> 00:37:37,100 But the combination used will be determined by the prices in 772 00:37:37,100 --> 00:37:39,670 the market. 773 00:37:39,670 --> 00:37:42,740 Other questions about that? 774 00:37:42,740 --> 00:37:46,630 So now we can ask, just as we asked in consumer theory, how 775 00:37:46,630 --> 00:37:49,000 does a price change in the price of goods affect your 776 00:37:49,000 --> 00:37:51,750 consumption decisions, we can ask how does a change in the 777 00:37:51,750 --> 00:37:54,380 price of inputs affect your production decisions? 778 00:37:54,380 --> 00:37:58,100 You could see that in the next page, figure 9-3. 779 00:37:58,100 --> 00:38:02,440 Imagine that wages went up. 780 00:38:02,440 --> 00:38:05,650 So imagine now wages, instead of being $5 an hour, 781 00:38:05,650 --> 00:38:07,050 are $7.50 an hour. 782 00:38:07,050 --> 00:38:08,610 They pass a new minimum wage, and wages go 783 00:38:08,610 --> 00:38:10,390 up to $7.50 an hour. 784 00:38:10,390 --> 00:38:11,730 What does that do? 785 00:38:11,730 --> 00:38:21,370 Well, that steepens the isocost. Your trade-off is now 786 00:38:21,370 --> 00:38:24,060 you're going to get fewer workers for every machine you 787 00:38:24,060 --> 00:38:27,270 give up, or more machines for every worker you give up. 788 00:38:27,270 --> 00:38:30,820 And so at the same isoquant, that's going to shift you to 789 00:38:30,820 --> 00:38:35,000 using less labor and more capital. 790 00:38:35,000 --> 00:38:36,920 By the same logic as before, you're going to use less labor 791 00:38:36,920 --> 00:38:42,760 and more capital, because you're going to see this shift 792 00:38:42,760 --> 00:38:44,200 in relative prices. 793 00:38:44,200 --> 00:38:46,770 This figure shows why the minimum wage leads to 794 00:38:46,770 --> 00:38:49,010 unemployment. 795 00:38:49,010 --> 00:38:49,890 We talked about it last time. 796 00:38:49,890 --> 00:38:52,430 We did in a graph, we just said supply and demand and 797 00:38:52,430 --> 00:38:52,810 showed you. 798 00:38:52,810 --> 00:38:55,060 But actually this is the underlying mechanics of how 799 00:38:55,060 --> 00:38:56,720 minimum wage leads to unemployment. 800 00:38:56,720 --> 00:38:58,930 Because the minimum wage, by change, is 801 00:38:58,930 --> 00:39:00,160 relative input prices. 802 00:39:00,160 --> 00:39:04,680 If the only way you could produce things was with labor, 803 00:39:04,680 --> 00:39:06,050 there wouldn't be much unemployment for a minimum 804 00:39:06,050 --> 00:39:08,390 wage because basically you wouldn't have anything else 805 00:39:08,390 --> 00:39:08,820 you could do. 806 00:39:08,820 --> 00:39:10,160 You'd still have to hire the workers. 807 00:39:10,160 --> 00:39:12,460 But, in fact, that's not the only way to produce things. 808 00:39:12,460 --> 00:39:14,270 You can substitute to capital. 809 00:39:14,270 --> 00:39:17,380 As a minimum wage goes up, firms will substitute towards 810 00:39:17,380 --> 00:39:20,210 capital, and that's why the minimum wage will lead to 811 00:39:20,210 --> 00:39:22,520 unemployment. 812 00:39:22,520 --> 00:39:24,310 So this is sort of the underlying mechanics of how 813 00:39:24,310 --> 00:39:26,280 that happens. 814 00:39:26,280 --> 00:39:29,600 All right, now armed with that-- 815 00:39:29,600 --> 00:39:31,800 so basically when we did consumer theory 816 00:39:31,800 --> 00:39:33,500 we were done here. 817 00:39:33,500 --> 00:39:38,240 We basically said, look, we now know you have a budget 818 00:39:38,240 --> 00:39:39,510 constraint, you have indifference curves, you're 819 00:39:39,510 --> 00:39:42,340 fine with their tangent, you're done. 820 00:39:42,340 --> 00:39:45,020 The reason firms are one step harder is you don't have a 821 00:39:45,020 --> 00:39:46,610 budget constraint. 822 00:39:46,610 --> 00:39:50,990 q is not given to you, q is ultimately decided by you. 823 00:39:50,990 --> 00:39:53,680 You the firm are going to decide on little q. 824 00:39:53,680 --> 00:39:55,500 With our example for consumers, your parents gave 825 00:39:55,500 --> 00:39:58,450 you $96, you had no choice. 826 00:39:58,450 --> 00:40:00,680 Well here the firm isn't given little q, it's going to 827 00:40:00,680 --> 00:40:01,870 decide little q. 828 00:40:01,870 --> 00:40:04,690 What that means is we're not done yet. 829 00:40:04,690 --> 00:40:07,360 There's one extra step we need to do with firms, which is 830 00:40:07,360 --> 00:40:11,030 figure out where little q comes from. 831 00:40:11,030 --> 00:40:13,990 So to do that, we're going to have to then say well, how 832 00:40:13,990 --> 00:40:18,190 does a firm think about the set of choices of little q? 833 00:40:18,190 --> 00:40:21,640 And how does it think about how it changes production as 834 00:40:21,640 --> 00:40:23,300 little q changes? 835 00:40:23,300 --> 00:40:24,700 So to see that, go to figure 9-4a. 836 00:40:29,290 --> 00:40:33,850 This shows the long-run expansion path for a firm. 837 00:40:33,850 --> 00:40:39,780 This shows how, as it produces different amounts of goods, it 838 00:40:39,780 --> 00:40:42,540 will choose different units of inputs. 839 00:40:42,540 --> 00:40:45,980 So for the first level of production, it chooses five 840 00:40:45,980 --> 00:40:47,540 machines and 10 workers. 841 00:40:47,540 --> 00:40:50,390 Then if it wants to double production, it chooses 10 842 00:40:50,390 --> 00:40:51,340 machines and 20 workers. 843 00:40:51,340 --> 00:40:56,570 So if it wants to increase production by another 50%, it 844 00:40:56,570 --> 00:40:59,770 chooses 15 machines and 30 workers, and so on. 845 00:40:59,770 --> 00:41:01,250 This is a linear expansion path. 846 00:41:01,250 --> 00:41:04,100 This says this firm is a production function, and 847 00:41:04,100 --> 00:41:08,040 prices are such that basically they always want these inputs 848 00:41:08,040 --> 00:41:09,260 in fixed proportions. 849 00:41:09,260 --> 00:41:11,450 So it would be a fixed proportional expansion path. 850 00:41:11,450 --> 00:41:14,430 No matter how much you choose to produce, you always want to 851 00:41:14,430 --> 00:41:17,460 use twice as much labor as capital. 852 00:41:17,460 --> 00:41:18,775 However, that doesn't have to be the case. 853 00:41:22,940 --> 00:41:26,360 So this long-run expansion path is going to be what 854 00:41:26,360 --> 00:41:29,680 becomes our underlying cost curve. 855 00:41:29,680 --> 00:41:32,703 This is where underlying cost curves are going to come from, 856 00:41:32,703 --> 00:41:34,500 and hopefully where supply is going to come from, is this 857 00:41:34,500 --> 00:41:35,780 long-run expansion path. 858 00:41:35,780 --> 00:41:37,780 This long-run expansion path is going to show us how much 859 00:41:37,780 --> 00:41:39,010 more we have to spend to produce 860 00:41:39,010 --> 00:41:41,270 different amounts of quantity. 861 00:41:41,270 --> 00:41:43,890 Now in this case, what you see here is that you have these 862 00:41:43,890 --> 00:41:44,700 fixed proportions. 863 00:41:44,700 --> 00:41:48,300 That as you increase quantity, that the input portion stays 864 00:41:48,300 --> 00:41:49,920 the same, but that doesn't have to be. 865 00:41:49,920 --> 00:41:53,675 For instance, figure 9b, you can imagine a world where, as 866 00:41:53,675 --> 00:41:57,230 you produce more units, capital becomes less 867 00:41:57,230 --> 00:41:58,275 productive. 868 00:41:58,275 --> 00:41:59,990 So you want more and more labor, but not 869 00:41:59,990 --> 00:42:01,220 that much more capital. 870 00:42:01,220 --> 00:42:04,230 So this might be the example of like McDonald's. 871 00:42:04,230 --> 00:42:08,610 If McDonald's wants to produce more burgers, ultimately 872 00:42:08,610 --> 00:42:11,420 there's only so many fryolators it can use. 873 00:42:11,420 --> 00:42:12,800 Ultimately, it needs more people to package up the 874 00:42:12,800 --> 00:42:14,100 burgers and sell them. 875 00:42:14,100 --> 00:42:15,920 So you might think that capital becomes less and less 876 00:42:15,920 --> 00:42:16,710 productive. 877 00:42:16,710 --> 00:42:22,670 And as a given McDonald's franchise expands its sales, 878 00:42:22,670 --> 00:42:25,830 it might want to increase the ratio of labor to capital. 879 00:42:25,830 --> 00:42:27,610 So this is a case where capital's becoming less 880 00:42:27,610 --> 00:42:28,350 productive. 881 00:42:28,350 --> 00:42:31,990 And as you see, as you expand production you're going to 882 00:42:31,990 --> 00:42:33,350 more labor and less capital. 883 00:42:33,350 --> 00:42:36,460 In other words, the marginal product of labor is still 884 00:42:36,460 --> 00:42:38,015 steep, and the marginal product of capital is 885 00:42:38,015 --> 00:42:38,650 flattening. 886 00:42:38,650 --> 00:42:42,060 So you want more and more labor, 887 00:42:42,060 --> 00:42:43,340 and not as much capital. 888 00:42:43,340 --> 00:42:44,630 That's one kind of expansion path. 889 00:42:44,630 --> 00:42:49,390 Figure 9c shows a different kind of expansion path. 890 00:42:49,390 --> 00:42:51,780 Here's one where labor becomes less productive. 891 00:42:51,780 --> 00:42:57,400 So this might be, for example, something which is a mass 892 00:42:57,400 --> 00:43:00,890 production process, like producing automobiles. 893 00:43:00,890 --> 00:43:06,350 Where basically as you produce more and more automobiles, you 894 00:43:06,350 --> 00:43:07,940 need more and more machines to produce them. 895 00:43:07,940 --> 00:43:09,680 The people just run the machines. 896 00:43:09,680 --> 00:43:12,120 So it's much more efficient to have to do it through more 897 00:43:12,120 --> 00:43:16,220 machines and less through more workers in automobile 898 00:43:16,220 --> 00:43:17,040 production. 899 00:43:17,040 --> 00:43:19,230 So in that case you could have a steeper expansion path, 900 00:43:19,230 --> 00:43:22,900 where basically the marginal product of labor is falling 901 00:43:22,900 --> 00:43:24,990 relative to the marginal product of capital, so you 902 00:43:24,990 --> 00:43:28,280 want to increase the ratio of capital to labor over time. 903 00:43:28,280 --> 00:43:32,440 The bottom line is as firms produce more, they may hold 904 00:43:32,440 --> 00:43:34,950 constant or may change the ratio of their inputs, but 905 00:43:34,950 --> 00:43:37,400 they'll clearly use more inputs. 906 00:43:37,400 --> 00:43:39,720 They're going to use more inputs, but the mix of the 907 00:43:39,720 --> 00:43:42,890 inputs they'll use will change with their production levels. 908 00:43:42,890 --> 00:43:44,800 So the question we have to ask is, well, what's going to 909 00:43:44,800 --> 00:43:45,650 determine their production level? 910 00:43:45,650 --> 00:43:48,100 Where does q come from? 911 00:43:48,100 --> 00:43:50,330 I'll have to leave that as a teaser for next time. 912 00:43:50,330 --> 00:43:53,080 Let me just say where q comes from, is q is going to come 913 00:43:53,080 --> 00:43:55,750 from market competition. 914 00:43:55,750 --> 00:43:56,550 We're going to get q-- 915 00:43:56,550 --> 00:43:58,250 I'm not done, I have one more thing to cover. 916 00:43:58,250 --> 00:44:01,960 But we're going to get q from market competition. 917 00:44:01,960 --> 00:44:03,320 Now there is one other thing I want to cover 918 00:44:03,320 --> 00:44:04,660 though related to costs. 919 00:44:04,660 --> 00:44:06,880 Which is an important concept that we have to have in the 920 00:44:06,880 --> 00:44:09,000 back of our mind, which when we come back, we think about 921 00:44:09,000 --> 00:44:10,100 competition. 922 00:44:10,100 --> 00:44:14,720 Which is fixed versus sunk cost. Fixed-- 923 00:44:14,720 --> 00:44:17,070 my wife always thought I was saying some costs, I'm not. 924 00:44:17,070 --> 00:44:19,330 I'm saying sunk costs. 925 00:44:19,330 --> 00:44:26,910 Fixed versus sunk costs. 926 00:44:26,910 --> 00:44:29,340 Fixed versus sunk costs. 927 00:44:29,340 --> 00:44:35,550 Sunk costs are costs which are fixed even in the long-run. 928 00:44:35,550 --> 00:44:38,840 Fixed costs are costs which are fixed in the short-run, 929 00:44:38,840 --> 00:44:42,440 and variable in the long-run, so capital. 930 00:44:42,440 --> 00:44:46,420 Sunk costs are costs which are fixed in the long-run. 931 00:44:46,420 --> 00:44:49,520 That is, they're foregone once you produce. 932 00:44:49,520 --> 00:44:52,880 The minute you produce one unit, those sunk costs are 933 00:44:52,880 --> 00:44:56,330 gone forever, and they cannot be 934 00:44:56,330 --> 00:44:57,580 changed even in the long-run. 935 00:45:00,540 --> 00:45:03,350 In other words, importantly, they cannot be changed by how 936 00:45:03,350 --> 00:45:04,750 much you produce. 937 00:45:04,750 --> 00:45:09,680 So in the long-run, you can change the cost of capital by 938 00:45:09,680 --> 00:45:12,420 building bigger or smaller plants, 939 00:45:12,420 --> 00:45:13,860 producing more or less. 940 00:45:13,860 --> 00:45:15,840 But some costs cannot be changed. 941 00:45:15,840 --> 00:45:17,400 So what's a classic example? 942 00:45:17,400 --> 00:45:19,920 Well, the classic example for example would be medical 943 00:45:19,920 --> 00:45:24,090 education, or any professional education. 944 00:45:24,090 --> 00:45:26,690 Once you've gone to med school and done all your grueling 945 00:45:26,690 --> 00:45:30,380 years of staying up all night, you've paid those costs. 946 00:45:30,380 --> 00:45:33,800 They're now paid for, and it doesn't matter if you see 947 00:45:33,800 --> 00:45:35,740 three patients the rest of your life or three million 948 00:45:35,740 --> 00:45:38,200 patients the rest of your life, you've already paid 949 00:45:38,200 --> 00:45:39,950 those costs. 950 00:45:39,950 --> 00:45:41,680 Think of that as the capital of a doctor's office. 951 00:45:41,680 --> 00:45:44,410 Now when you take your office as a doctor, if you want to 952 00:45:44,410 --> 00:45:46,910 see more patients in the short-run, they might be 953 00:45:46,910 --> 00:45:48,230 crammed into your office, and in the long-run you might 954 00:45:48,230 --> 00:45:49,350 build a bigger office. 955 00:45:49,350 --> 00:45:52,590 So in the short-run, how hard you work is variable. 956 00:45:52,590 --> 00:45:55,110 In the long-run, how big your office is is variable-- how 957 00:45:55,110 --> 00:45:57,050 many secretaries you hire, et cetera. 958 00:45:57,050 --> 00:45:59,720 But your medical school spending is gone. 959 00:45:59,720 --> 00:46:03,460 That's not variable in the long-run, that's sunk. 960 00:46:03,460 --> 00:46:08,050 And that's a very important distinction is between 961 00:46:08,050 --> 00:46:13,040 basically these fixed costs, what we call fixed costs. 962 00:46:13,040 --> 00:46:15,970 Which are costs where, like the costs of the office and 963 00:46:15,970 --> 00:46:18,120 the machinery the physician uses, which can be changed 964 00:46:18,120 --> 00:46:22,090 over a 10-year period, versus sunk costs which once paid are 965 00:46:22,090 --> 00:46:24,020 gone forever. 966 00:46:24,020 --> 00:46:27,170 And the key reason, just to give you a hint about why 967 00:46:27,170 --> 00:46:31,330 these will matter, is because when firms set up this-- 968 00:46:31,330 --> 00:46:36,850 we may see firms in the market losing money. 969 00:46:36,850 --> 00:46:38,520 You may see firms in the market losing money. 970 00:46:38,520 --> 00:46:39,990 In fact, in any point in time we see lots of firms in the 971 00:46:39,990 --> 00:46:41,500 market losing money. 972 00:46:41,500 --> 00:46:43,500 You might say, why don't they go out of business? 973 00:46:43,500 --> 00:46:45,250 The reason they don't go out of business is because they've 974 00:46:45,250 --> 00:46:47,980 already pay huge sunk costs. 975 00:46:47,980 --> 00:46:50,510 It's not efficient to go out of business. 976 00:46:50,510 --> 00:46:53,410 They've already invested a certain amount. 977 00:46:53,410 --> 00:46:55,680 It's not going to be efficient to go out of business, because 978 00:46:55,680 --> 00:46:57,680 then they'll give up the cost they've invested. 979 00:46:57,680 --> 00:47:00,170 So if you're a doctor, and you've spent all this money on 980 00:47:00,170 --> 00:47:03,705 med school, and you're not making money as a doctor in 981 00:47:03,705 --> 00:47:05,020 the first couple of years. 982 00:47:05,020 --> 00:47:07,370 If you quit and go do something else, you've just 983 00:47:07,370 --> 00:47:10,460 given up all the investment you made in med school. 984 00:47:10,460 --> 00:47:12,570 So if there's any prospect that eventually you'll make 985 00:47:12,570 --> 00:47:15,820 money, you might want to hang on and keep being a doctor. 986 00:47:15,820 --> 00:47:17,840 So that's the difference between a fixed cost and a 987 00:47:17,840 --> 00:47:18,360 sunk cost. 988 00:47:18,360 --> 00:47:20,590 So I'm going to come back to that, but it's important to 989 00:47:20,590 --> 00:47:23,205 remember that distinction when we talk about competition. 990 00:47:23,205 --> 00:47:25,930 So let me stop there, and we'll come back on 991 00:47:25,930 --> 00:47:26,850 Wednesday, I guess. 992 00:47:26,850 --> 00:47:27,600 Have a good three-day weekend. 993 00:47:27,600 --> 00:47:29,450 We'll come back on Wednesday and we'll talk about 994 00:47:29,450 --> 00:47:30,700 competition.