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

Getting Out What You (Marginally) Put In

You don’t have to be an economist to know that some people get a relatively large share of a nation’s output while others get very little at all. Why is this? Can economics shine any light on this important question?

In this section we describe a simple model that provides some clues. You will see that ‘factors of production’ like labour and capital are compensated according to their marginal product – that is, what they contribute personally to the firm’s output. However, to see this we need to build up the model slowly. First, we look at what firms do. Then, we show how a firm’s output varies with the amount of labour or capital it uses. Finally, we show how this determines the demand for labour and capital and ultimately the wages that workers receive and the rental income that the owners of capital receive. After you know these, you know how much of the ‘GDP cake’ each person receives! Don’t worry – we’re gonna take you through this slowly!

Modelling what firms do

We take a look at what firms do here because firms’ choices determine the demand for labour and capital – this is key in determining who gets what.

Firms use inputs such as workers, machines, factories and raw materials to

produce outputs. Here are some examples:


A company making chocolate:


Likely inputs: Employees, raw materials such as cocoa beans and milk, machines and a factory to house its workers and machines.


Outputs: Chocolate bars.


An airline:


Likely inputs: Staff (pilots, cabin crew, check-in staff), planes, fuel, the use of the airport.


Output: Flights.


A hotel:


Likely inputs: Staff (cleaners, cooks, receptionist, the manager) and the hotel building.


Output: A room for the night.

Instead of looking at every industry or firm in isolation, economists prefer to create general models that they can – in principle – apply to all industries and firms.

Here are the building blocks of the model:


Firms use inputs to produce outputs.


How they turn inputs into outputs depends on their technology.


Economists represent a firm’s technology with a production function, which tells them exactly how many units of output result from using a certain amount of inputs.


Firms use two inputs:


Capital: Things such as machines and factories

Labour: People hired to work the machines and in the factories

Figure 4-2 shows a firm using its technology to transform K units of capital and L units of labour into f(K,L) units of output. For example, if the firm can transform 2 units of capital and 3 units of labour into 4 units of output, we write f(2,3) = 4. The firm can then sell each unit of output for the price p, yielding it a total revenue of p × f(K,L).


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Figure 4-2: The production function.

The costs to the firm are those of hiring workers and renting capital. The firm can hire workers by paying them each a wage of w and it can rent each unit of capital at a cost of r. The total costs of the firm can then be expressed as wL + rK, that is, the cost of hiring the worker plus the cost of renting the capital.

Firms choose the quantity of capital (K) and labour (L) in order to maximise profits (π):