CHAPTER3 NationalIncome:WhereItComesFromandWhereItGoesQuestionsforReview1.Thefactorsofproductionandtheproductiontechnologydeterminetheamountofoutputaneconomycanproduce.Thefactorsofproductionaretheinputsusedtoproducegoodsandservices:themostimportantfactorsarecapitalandlabor.Theproductiontechnologydetermineshowmuchoutputcanbeproducedfromanygivenamountsoftheseinputs.Anincreaseinoneofthefactorsofproductionoranimprovementintechnologyleadstoanincreaseintheeconomy’soutput.2.Whenafirmdecideshowmuchofafactorofproductiontohireordemand,itconsidershowthisdecisionaffectsprofits.Forexample,hiringanextraunitoflaborincreasesoutputandthereforeincreasesrevenue;thefirmcomparesthisadditionalrevenuetotheadditionalcostfromthehigherwagebill.Theadditionalrevenuethefirmreceivesdependsonthemarginalproductoflabor(MPL)andthepriceofthegoodproduced(P).AnadditionalunitoflaborproducesMPLunitsofadditionaloutput,whichsellsforPdollarsperunit.Therefore,theadditionalrevenuetothefirmisPMPL.ThecostofhiringtheadditionalunitoflaboristhewageW.Thus,thishiringdecisionhasthefollowingeffectonprofits:ΔProfit=ΔRevenue–ΔCost=(PMPL)–W.Iftheadditionalrevenue,PMPL,exceedsthecost(W)ofhiringtheadditionalunitoflabor,thenprofitincreases.Thefirmwillhirelaboruntilitisnolongerprofitabletodoso—thatis,untiltheMPLfallstothepointwherethechangeinprofitiszero.Intheequationabove,thefirmhireslaboruntilΔProfit=0,whichiswhen(PMPL)=W.Thisconditioncanberewrittenas:MPL=W/P.Therefore,acompetitiveprofit-maximizingfirmhireslaboruntilthemarginalproductoflaborequalstherealwage.Thesamelogicappliestothefirm’sdecisionregardinghowmuchcapitaltohire:thefirmwillhirecapitaluntilthemarginalproductofcapitalequalstherealrentalprice.3.Aproductionfunctionhasconstantreturnstoscaleifanequalpercentageincreaseinallfactorsofproductioncausesanincreaseinoutputofthesamepercentage.Forexample,ifafirmincreasesitsuseofcapitalandlaborby50percent,andoutputincreasesby50percent,thentheproductionfunctionhasconstantreturnstoscale.Iftheproductionf