Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Production function: Turning inputs into outputs

Firms are constrained by the available technology for turning inputs (factors of production) into outputs (goods and services).

A convenient way of representing the technology available to firms is the production function. For a detailed look at the properties of the production function, check out Chapter 4. For now, take a look at the aggregate production function:

This expression is the production function for the economy as a whole. In words, it says that total output (Y) is a function (f) of the total quantity of capital (K) and labour (L) available to firms.

The better the available technology, the more efficient is the economy at turning inputs into outputs. Here’s another way of thinking about this: better technology means that more output can be produced from the same amounts of capital and labour.


Drawing the LRAS curve

The long-run aggregate supply (LRAS) curve shows graphically the total amount of output that an economy can produce, which is sustainable in the long run: it’s called the natural level of output ( ). The

level of output results when the factors of production are used at a normal intensity (for example, workers/machines don’t work 24 hours a day). Furthermore, some factors of production are going to be underemployed at the natural level of output.


Importantly, if output is at , unemployment in the labour market is also at its natural rate. (Chapter 6 provides a detailed explanation of the natural rate of unemployment.) At any given point in time, output (and therefore unemployment) can deviate from its natural rate, but the idea is that over time it tends to gravitate towards the natural rate.

The natural level of output is determined by the production function:

and emphasise that, at any given point in time, the amount of labour and capital is fixed. When output is at its natural rate , the factors of production are also being employed at their natural rate.

Figure 8-1 shows the LRAS curve, which is a vertical line showing that the natural level of output is independent of the price level. Essentially it illustrates how much stuff the economy can sustainably produce with its current level of technology and inputs.

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Figure 8-1: Long-run aggregate supply curve.


If you’ve studied microeconomics before, you may be surprised to see that the LRAS curve is a vertical line and not upward sloping like the traditional supply curve. The reason is that in the microeconomic supply-and-demand model, only the price of the particular good you’re looking at changes: all other prices remain constant. In the macroeconomic AD–AS model, however, when the price level falls, it means that all prices fall, including the price of firms’ inputs, which includes their employees’ (nominal) wages. Therefore, firms’ real profits are unaffected by a fall in the overall price level.