Lecture 3
The Production Function

1. Production Function

• Q = AF(K,L), where Q is output, K is capital, L is labor and A is technology.
• Example: Cobb-Douglas production function
  • Q = 20K^1/4L^3/4
  • Constant returns to scale
  • Diminishing marginal product of each factor (labor, capital):
    - As L increases, ceteris paribus, additional output decreases.
    - Alternatively: As L increases, ceteris paribus, MP_L decreases.

2. Labor force (L)

• Quantity and quality
• Human capital: Education, skills and health

3. Capital stock (K)

• Physical capital; accumulates over time as result of investment
• Link between national saving and investment
• National saving = Private saving (S) + Govt. saving (T-G)
• Role of foreign saving in boosting domestic investment
  • Private capital inflows
  • Official development assistance (ODA)

3. Technology (the 'A' parameter)

• Technical progress
• Innovation and imitation
• Labor productivity

4. Institutions

• Property rights, rule of law
• Rent-seeking activities: Corruption
• Threat of nationalization

5. International trade

• Imports
  • Need for imported inputs: Capital goods, oil, fertilizers
  • How to pay for them? Foreign-exchange earnings through:
    • Exports
    • Remittances from workers abroad
    • Foreign investment
    • Foreign aid
• Exports
  • Makes domestic firms more competitive
  • Speeds up adoption of new technology, management techniques

6. Macroeconomic environment

• Policy objectives: Low inflation and low unemployment
• Suitable fiscal and monetary policies

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