1 00:00:11,780 --> 00:00:14,370 JONATHAN GRUBER: All right, so we 2 00:00:14,370 --> 00:00:19,080 finished the first unit of the course, or consumer theory, 3 00:00:19,080 --> 00:00:21,672 and we've sort of gotten to the demand curve. 4 00:00:21,672 --> 00:00:23,880 Now we move onto the second year of the course, which 5 00:00:23,880 --> 00:00:25,547 is producer theory, and talk about where 6 00:00:25,547 --> 00:00:27,330 the supply curve comes from. 7 00:00:27,330 --> 00:00:30,840 Now the good news is that a lot of the tools and skills we 8 00:00:30,840 --> 00:00:32,947 developed in the first few lectures 9 00:00:32,947 --> 00:00:35,280 will translate quite nicely to thinking about the supply 10 00:00:35,280 --> 00:00:37,170 curve and production. 11 00:00:37,170 --> 00:00:39,177 The bad news is, supply is a lot harder. 12 00:00:39,177 --> 00:00:41,560 It's a lot harder, fundamentally, 13 00:00:41,560 --> 00:00:46,140 the big picture, because we did consumer theory. 14 00:00:46,140 --> 00:00:48,420 We sort of told you what your income was. 15 00:00:48,420 --> 00:00:50,880 We told you income and prices, and then we said, 16 00:00:50,880 --> 00:00:52,400 OK, here's how to optimize. 17 00:00:52,400 --> 00:00:54,900 With firms, they sort of get to decide what their income is. 18 00:00:54,900 --> 00:00:56,630 They get to decide how much they produce, 19 00:00:56,630 --> 00:00:59,130 and that means we're going to need an extra whole constraint 20 00:00:59,130 --> 00:01:01,520 we're going need to model, an extra other part 21 00:01:01,520 --> 00:01:02,840 of the process. 22 00:01:02,840 --> 00:01:05,190 So it's going to be an extra step with producer theory, 23 00:01:05,190 --> 00:01:07,270 but a lot of the tools will be the same. 24 00:01:07,270 --> 00:01:08,730 So let's dive in. 25 00:01:08,730 --> 00:01:11,010 We're going to start by talking about, 26 00:01:11,010 --> 00:01:14,610 just as consumers have a utility function, 27 00:01:14,610 --> 00:01:17,175 producers have a production function. 28 00:01:19,780 --> 00:01:25,730 So the first parallel is that producers 29 00:01:25,730 --> 00:01:27,430 have production function. 30 00:01:27,430 --> 00:01:32,370 Now here, their goal is not to maximize production. 31 00:01:32,370 --> 00:01:34,900 Their goal is to maximize profits. 32 00:01:34,900 --> 00:01:37,770 So as consumers want to maximize utility, 33 00:01:37,770 --> 00:01:43,260 producers want to maximize profits, which 34 00:01:43,260 --> 00:01:46,630 equals revenues minus costs. 35 00:01:46,630 --> 00:01:50,290 So the goal of a producer is to maximize profits, which 36 00:01:50,290 --> 00:01:53,530 equals revenues minus costs. 37 00:01:53,530 --> 00:01:55,360 And what that's going to mean, it's 38 00:01:55,360 --> 00:02:01,020 going to mean producing goods as efficiently as possible, 39 00:02:01,020 --> 00:02:03,110 maximizing your profits. 40 00:02:03,110 --> 00:02:06,150 We are going to focus for the first few lectures on the cost 41 00:02:06,150 --> 00:02:07,020 part. 42 00:02:07,020 --> 00:02:10,530 In particular, we're going to focus on maximizing profits 43 00:02:10,530 --> 00:02:12,630 through minimizing costs. 44 00:02:12,630 --> 00:02:15,210 And we minimize costs by producing 45 00:02:15,210 --> 00:02:18,000 as efficiently as possible, OK. 46 00:02:18,000 --> 00:02:23,280 And that's what we'll focus on in the next few lectures. 47 00:02:23,280 --> 00:02:24,800 Now, what firms can produce comes 48 00:02:24,800 --> 00:02:27,170 from their production function. 49 00:02:27,170 --> 00:02:31,100 A production function is of the general form q-- 50 00:02:31,100 --> 00:02:33,425 that's units of goods produced-- 51 00:02:33,425 --> 00:02:37,700 is a function of the amount of labor input and capital 52 00:02:37,700 --> 00:02:41,360 input used by the firm, so q, little q-- 53 00:02:41,360 --> 00:02:43,130 let me just highlight right here. 54 00:02:43,130 --> 00:02:44,510 I will hopefully get this right. 55 00:02:44,510 --> 00:02:46,718 I never in the semester have gotten it totally right. 56 00:02:46,718 --> 00:02:48,650 Little q refers to a firm. 57 00:02:48,650 --> 00:02:50,952 Big Q refers to a market, OK. 58 00:02:50,952 --> 00:02:52,660 We're going to try to keep this straight. 59 00:02:52,660 --> 00:02:54,920 So little q means a firm's production function. 60 00:02:54,920 --> 00:02:57,830 Big Q means a market production function, OK. 61 00:02:57,830 --> 00:03:00,550 So if I get that wrong, I'm sure you guys will tell me. 62 00:03:00,550 --> 00:03:05,030 OK, so basically what a production function does 63 00:03:05,030 --> 00:03:11,570 is it converts inputs, which are labor and capital, into output 64 00:03:11,570 --> 00:03:15,590 through some function, just like utility function converts goods 65 00:03:15,590 --> 00:03:18,750 into happiness through some function. 66 00:03:18,750 --> 00:03:22,310 It's the same idea here, but here, it's more tangible. 67 00:03:22,310 --> 00:03:25,140 Unlike utils, output can actually be measured. 68 00:03:25,140 --> 00:03:29,980 So literally, it's not some preference mapping. 69 00:03:29,980 --> 00:03:32,132 It's literally a technological function. 70 00:03:32,132 --> 00:03:34,715 OK, you get your hands around it more than a utility function. 71 00:03:34,715 --> 00:03:38,090 It's literally a technologial function by which inputs 72 00:03:38,090 --> 00:03:41,820 get converted to an output. 73 00:03:41,820 --> 00:03:48,330 Now, we call these inputs the factors of production, OK. 74 00:03:48,330 --> 00:03:51,530 Labor and capital, we call the factors of production. 75 00:03:51,530 --> 00:03:54,570 They're the inputs they get used to produce things. 76 00:03:54,570 --> 00:03:56,350 Now, what are labor and capital? 77 00:03:56,350 --> 00:03:57,630 Labor is pretty easy. 78 00:03:57,630 --> 00:04:00,630 Labor is workers, OK, either number 79 00:04:00,630 --> 00:04:02,120 of workers or hours of work. 80 00:04:02,120 --> 00:04:04,350 we'll use those interchangeably, but the bottom line 81 00:04:04,350 --> 00:04:05,340 is, labor is workers. 82 00:04:05,340 --> 00:04:06,460 It's you all. 83 00:04:06,460 --> 00:04:09,130 OK, that's sort of the easy part. 84 00:04:09,130 --> 00:04:10,720 Capital is harder. 85 00:04:10,720 --> 00:04:15,130 Capital is machines land, building, 86 00:04:15,130 --> 00:04:19,519 all the stuff that workers use to make things, OK. 87 00:04:19,519 --> 00:04:21,500 So capital's a vaguer concept. 88 00:04:21,500 --> 00:04:24,740 But for now, think of it as like machines and buildings, 89 00:04:24,740 --> 00:04:32,260 OK, the stuff that workers use to produce goods. 90 00:04:32,260 --> 00:04:37,620 And outputs are the goods and services that got produced. 91 00:04:37,620 --> 00:04:41,200 Now, when we talk about inputs or factors of production, 92 00:04:41,200 --> 00:04:46,640 we're going to talk about them being variable or fixed. 93 00:04:50,280 --> 00:04:55,140 Variable means changeable, fixed means not changeable, OK. 94 00:04:55,140 --> 00:04:58,320 So variable inputs are inputs that can be easily changed, 95 00:04:58,320 --> 00:05:00,180 like hours of work. 96 00:05:00,180 --> 00:05:01,175 You can easily work. 97 00:05:01,175 --> 00:05:03,300 You guys work different amounts of hours every day. 98 00:05:03,300 --> 00:05:05,460 You can easily change the hours that you work. 99 00:05:05,460 --> 00:05:07,960 You can pull an all nighter if something's due the next day. 100 00:05:07,960 --> 00:05:12,030 You can work less if there's something good on TV, OK. 101 00:05:12,030 --> 00:05:14,640 Fixed inputs are those which are harder to change quickly, 102 00:05:14,640 --> 00:05:16,405 like the size of a plant. 103 00:05:16,405 --> 00:05:18,030 Let's say you're siding a bigger plant. 104 00:05:18,030 --> 00:05:20,730 You can't just instantly do that. 105 00:05:20,730 --> 00:05:22,440 It takes a lot of production process. 106 00:05:22,440 --> 00:05:24,533 You can see by the giant production going on 107 00:05:24,533 --> 00:05:25,950 as you pass every day as you walk, 108 00:05:25,950 --> 00:05:29,220 if you come from east campus, you walk to this building, 109 00:05:29,220 --> 00:05:31,560 it's going to take years to build out those new MIT 110 00:05:31,560 --> 00:05:33,330 facilities, OK. 111 00:05:33,330 --> 00:05:34,650 So it's not simple. 112 00:05:34,650 --> 00:05:37,885 So fixed inputs are inputs that are hard to change quickly. 113 00:05:37,885 --> 00:05:39,260 And the key distinction we draw-- 114 00:05:39,260 --> 00:05:40,770 and we think about variable fixed-- 115 00:05:40,770 --> 00:05:46,050 is the short run versus the long run. 116 00:05:46,050 --> 00:05:50,520 And the way we define these is that basically, 117 00:05:50,520 --> 00:05:54,490 in the short run, some inputs are fixed 118 00:05:54,490 --> 00:05:56,140 and some are variable. 119 00:05:56,140 --> 00:05:58,320 In particular, we're going to stay in the short run, 120 00:05:58,320 --> 00:06:01,900 labor is variable and capital is fixed. 121 00:06:01,900 --> 00:06:06,310 So in the short run, you have labor and then some fixed level 122 00:06:06,310 --> 00:06:09,073 of capital, k bar. 123 00:06:09,073 --> 00:06:10,990 So in the short run, you've got some building. 124 00:06:10,990 --> 00:06:12,615 You can't change it, but you can always 125 00:06:12,615 --> 00:06:15,580 change how hard people work in that building. 126 00:06:15,580 --> 00:06:18,300 In long run everything's variable. 127 00:06:18,300 --> 00:06:21,670 Labor and capital are both variable, OK, 128 00:06:21,670 --> 00:06:22,762 so there's no k bar. 129 00:06:22,762 --> 00:06:24,220 Capital's variable in the long run. 130 00:06:27,530 --> 00:06:32,480 So the question then is, what is the short and the long run. 131 00:06:32,480 --> 00:06:35,480 Well, there's no good answer to that. 132 00:06:35,480 --> 00:06:36,980 Intuitively, think of the short run 133 00:06:36,980 --> 00:06:40,190 as a matter of days or weeks or months and the long run 134 00:06:40,190 --> 00:06:44,710 as a matter of years or decades, for your own intuition. 135 00:06:44,710 --> 00:06:47,140 But technically, the definition is, 136 00:06:47,140 --> 00:06:50,020 the long one is the period of time over which 137 00:06:50,020 --> 00:06:52,740 all inputs are variable. 138 00:06:52,740 --> 00:06:54,150 That's the technical definition. 139 00:06:54,150 --> 00:06:56,490 The long run is a period of time over which 140 00:06:56,490 --> 00:06:57,827 all inputs are variable. 141 00:06:57,827 --> 00:06:59,160 That's our technical definition. 142 00:06:59,160 --> 00:07:01,202 So think about how long it takes to build a plant 143 00:07:01,202 --> 00:07:03,330 or make new machines, OK. 144 00:07:03,330 --> 00:07:04,372 That's the long run. 145 00:07:04,372 --> 00:07:06,330 So I'm never going to ask you, is the short run 146 00:07:06,330 --> 00:07:08,880 8.3 days or 9.7 days, OK. 147 00:07:08,880 --> 00:07:10,395 There's no right answer. 148 00:07:10,395 --> 00:07:12,270 The right answer is, the technical answer is, 149 00:07:12,270 --> 00:07:14,770 the short run is a period of time over which some inputs are 150 00:07:14,770 --> 00:07:16,428 fixed and some are variable. 151 00:07:16,428 --> 00:07:18,220 The long run is the period of time in which 152 00:07:18,220 --> 00:07:20,770 all inputs are variable, OK. 153 00:07:20,770 --> 00:07:22,740 And it's not a clean distinction. 154 00:07:22,740 --> 00:07:25,180 Obviously, in reality, there's a whole range 155 00:07:25,180 --> 00:07:29,110 of inputs ranging from workers to the gas you pipe in 156 00:07:29,110 --> 00:07:31,870 to use for your thing, to the raw materials you have to buy 157 00:07:31,870 --> 00:07:33,610 to the machines, the buildings. 158 00:07:33,610 --> 00:07:36,580 Obviously, in reality, there's a whole range of variability. 159 00:07:36,580 --> 00:07:38,080 But once again, to make life easier, 160 00:07:38,080 --> 00:07:41,200 we're going to shrink this down to two dimensions, labor 161 00:07:41,200 --> 00:07:42,280 and capital. 162 00:07:42,280 --> 00:07:43,960 Labor is going to always be variable. 163 00:07:43,960 --> 00:07:46,210 Capital's going to be fixed in the short run, variable 164 00:07:46,210 --> 00:07:47,910 in the long run, OK. 165 00:07:47,910 --> 00:07:50,542 So that's how we'll boil this down to make life easy. 166 00:07:50,542 --> 00:07:51,097 Yeah. 167 00:07:51,097 --> 00:07:52,472 AUDIENCE: Can you give an example 168 00:07:52,472 --> 00:07:53,514 of what capital is again? 169 00:07:55,515 --> 00:07:58,320 JONATHAN GRUBER: Capital is the buildings, machines, the stuff 170 00:07:58,320 --> 00:08:02,105 that workers use to make things. 171 00:08:02,105 --> 00:08:04,860 Yeah, OK. 172 00:08:04,860 --> 00:08:07,180 Other questions? 173 00:08:07,180 --> 00:08:10,540 With these definitions in mind, let's talk 174 00:08:10,540 --> 00:08:12,880 about short run production. 175 00:08:12,880 --> 00:08:15,640 Let's start by talking about production in the short run. 176 00:08:19,420 --> 00:08:22,270 Someone needs to invent me some more indestructible chalk. 177 00:08:22,270 --> 00:08:29,530 OK, so let's start in the short run where labor is 178 00:08:29,530 --> 00:08:31,160 variable and capital's fixed. 179 00:08:31,160 --> 00:08:33,610 So in the short run production function, 180 00:08:33,610 --> 00:08:39,640 q equals f of L and k bar, OK. 181 00:08:39,640 --> 00:08:42,780 That's our short run production function. 182 00:08:42,780 --> 00:08:48,190 OK, now that means in the short run, the firm's only decision, 183 00:08:48,190 --> 00:08:49,780 the firm is given a stock of capital. 184 00:08:49,780 --> 00:08:52,060 So think of the short run as, you 185 00:08:52,060 --> 00:08:54,587 are hired to manage a plant. 186 00:08:54,587 --> 00:08:56,170 And the plant, you don't get to decide 187 00:08:56,170 --> 00:08:58,080 if the plant's big or small or what machines. 188 00:08:58,080 --> 00:08:59,050 It's there. 189 00:08:59,050 --> 00:09:01,633 Your only decision is how many workers to hire, 190 00:09:01,633 --> 00:09:03,050 how many hours of labor to employ. 191 00:09:03,050 --> 00:09:04,633 And once again, I'll go back and forth 192 00:09:04,633 --> 00:09:06,760 through a number of workers and hours of labor. 193 00:09:06,760 --> 00:09:12,070 The bottom line is the amount of labor being provided, OK. 194 00:09:12,070 --> 00:09:14,230 The way you're going to decide that is, 195 00:09:14,230 --> 00:09:15,900 you are going to look at when we're 196 00:09:15,900 --> 00:09:21,730 going to call the marginal product of labor, 197 00:09:21,730 --> 00:09:25,630 the marginal product of labor, which is simply 198 00:09:25,630 --> 00:09:31,240 the change in output for the next unit of labor input. 199 00:09:31,240 --> 00:09:33,417 This is very much like a marginal utility of a good. 200 00:09:33,417 --> 00:09:35,750 Once again, going back to our powerless consumer theory, 201 00:09:35,750 --> 00:09:38,290 the marginal utility of pizza was 202 00:09:38,290 --> 00:09:41,200 the delta in utility for the next unit of pizza. 203 00:09:41,200 --> 00:09:44,110 The marginal product of labor is the delta 204 00:09:44,110 --> 00:09:49,140 in the amount produced for the next unit of labor. 205 00:09:49,140 --> 00:09:52,320 And we are going to assume, much as we assume diminishing 206 00:09:52,320 --> 00:09:54,990 marginal utility, we are going to assume 207 00:09:54,990 --> 00:10:01,430 diminishing marginal product. 208 00:10:01,430 --> 00:10:03,040 Now, that's a little less intuitive 209 00:10:03,040 --> 00:10:04,340 than diminishing marginal utility was. 210 00:10:04,340 --> 00:10:06,632 At least, I hope you found diminishing marginal utility 211 00:10:06,632 --> 00:10:09,080 kind of intuitive, that the second slice of pizza 212 00:10:09,080 --> 00:10:11,750 would be worth less to you than the first slice of pizza. 213 00:10:11,750 --> 00:10:14,180 Hope you found that intuitive, OK. 214 00:10:14,180 --> 00:10:15,710 Now, this is less intuitive. 215 00:10:15,710 --> 00:10:17,570 Once again, like with utility, it's 216 00:10:17,570 --> 00:10:20,300 not saying the next worker doesn't help. 217 00:10:20,300 --> 00:10:21,590 The next worker does help. 218 00:10:21,590 --> 00:10:23,870 It's just that the next worker helps less 219 00:10:23,870 --> 00:10:27,290 than the previous worker, OK. 220 00:10:27,290 --> 00:10:29,660 Now, this isn't true everywhere. 221 00:10:29,660 --> 00:10:32,360 Obviously, there are tasks where having two workers 222 00:10:32,360 --> 00:10:35,930 together makes both better, and we'll talk about that later on. 223 00:10:35,930 --> 00:10:39,050 But we're going to focus on the range of production 224 00:10:39,050 --> 00:10:40,590 where this is true. 225 00:10:40,590 --> 00:10:43,880 Think about production functions as being non-monotonic, 226 00:10:43,880 --> 00:10:44,880 they can go up and down. 227 00:10:44,880 --> 00:10:47,005 But we're going to focus on the range of production 228 00:10:47,005 --> 00:10:49,370 where this is true, where the next worker is not 229 00:10:49,370 --> 00:10:52,760 as productive, OK, because eventually that's going 230 00:10:52,760 --> 00:10:55,080 to be true for every firm. 231 00:10:55,080 --> 00:10:56,970 And why is that going to be true? 232 00:10:56,970 --> 00:10:59,900 Because we're holding capital fixed. 233 00:10:59,900 --> 00:11:02,150 The reason eventually workers will get less productive 234 00:11:02,150 --> 00:11:04,483 is because there are only so many machines and buildings 235 00:11:04,483 --> 00:11:06,740 they can work in. 236 00:11:06,740 --> 00:11:08,690 The classic example we think is the example 237 00:11:08,690 --> 00:11:12,140 of digging a hole with one shovel. 238 00:11:12,140 --> 00:11:14,750 You've got one worker digging a hole. 239 00:11:14,750 --> 00:11:16,790 She can do a certain amount of effort. 240 00:11:16,790 --> 00:11:18,920 Then a second worker comes along. 241 00:11:18,920 --> 00:11:19,728 She can add value. 242 00:11:19,728 --> 00:11:20,520 The first can rest. 243 00:11:20,520 --> 00:11:21,978 They can trade off, and maybe she's 244 00:11:21,978 --> 00:11:24,275 almost as productive, or probably not quite. 245 00:11:24,275 --> 00:11:26,150 Then the third worker, and the fourth worker. 246 00:11:26,150 --> 00:11:27,410 By time you have six workers, they're 247 00:11:27,410 --> 00:11:29,202 mostly just standing around because there's 248 00:11:29,202 --> 00:11:30,407 only one shovel. 249 00:11:30,407 --> 00:11:32,240 Now, each one's more productive because they 250 00:11:32,240 --> 00:11:35,080 can help you optimize the shift and get rest and stuff, 251 00:11:35,080 --> 00:11:37,580 but the truth is, clearly the sixth worker's less productive 252 00:11:37,580 --> 00:11:40,600 the fifth worker given there's only one shovel. 253 00:11:40,600 --> 00:11:44,320 So the key to understanding the intuition of diminishing 254 00:11:44,320 --> 00:11:46,073 Marshall practice to remember that there's 255 00:11:46,073 --> 00:11:47,240 a limited amount of capital. 256 00:11:47,240 --> 00:11:49,190 There is a fixed amount of capital. 257 00:11:49,190 --> 00:11:51,760 So if there's a given building and you've got 1,000 workers 258 00:11:51,760 --> 00:11:53,510 and you try to shove the 1,001st in there, 259 00:11:53,510 --> 00:11:55,760 he's not going to do a whole lot of good, OK. 260 00:11:55,760 --> 00:11:58,900 So marginal product of labor comes from the notion 261 00:11:58,900 --> 00:12:00,610 that there's a fixed amount of capital, 262 00:12:00,610 --> 00:12:03,460 so each additional worker does less and less, 263 00:12:03,460 --> 00:12:06,310 adds less and less to the production, OK. 264 00:12:06,310 --> 00:12:08,197 That's the intuition for diminishing 265 00:12:08,197 --> 00:12:09,280 marginal product of labor. 266 00:12:11,830 --> 00:12:14,000 And that's pretty much it for short run production. 267 00:12:14,000 --> 00:12:17,120 That's sort of what you've got to know. 268 00:12:17,120 --> 00:12:19,400 The more interesting action comes when 269 00:12:19,400 --> 00:12:21,811 we go to long run production. 270 00:12:25,500 --> 00:12:27,810 That gets more interesting because now, you 271 00:12:27,810 --> 00:12:31,635 have an optimization decision over labor versus capital. 272 00:12:31,635 --> 00:12:33,010 In the short run, you just decide 273 00:12:33,010 --> 00:12:34,570 how many workers to hire. 274 00:12:34,570 --> 00:12:36,640 In the long run, now you're back to the kind 275 00:12:36,640 --> 00:12:38,440 of utility framework we used. 276 00:12:38,440 --> 00:12:40,360 We had to trade off pizza and cookies. 277 00:12:40,360 --> 00:12:43,120 Now, you get to trade off workers and machines. 278 00:12:43,120 --> 00:12:44,430 Now you own the firm. 279 00:12:44,430 --> 00:12:48,700 You're going to own it forever, OK, and you get to trade off. 280 00:12:48,700 --> 00:12:53,520 You get to think about workers versus machines. 281 00:12:53,520 --> 00:12:57,780 So now, you're going to have to make a decision on that. 282 00:12:57,780 --> 00:13:00,000 And that decision is going to be, 283 00:13:00,000 --> 00:13:02,760 just as your decision of how to trade off cookies and pizza 284 00:13:02,760 --> 00:13:06,060 is driven by utility function, your decision 285 00:13:06,060 --> 00:13:08,820 about whether to employ workers or machines it's being driven 286 00:13:08,820 --> 00:13:10,930 by your production function. 287 00:13:10,930 --> 00:13:12,190 So make life easy. 288 00:13:12,190 --> 00:13:13,950 Let's start a production function that 289 00:13:13,950 --> 00:13:16,770 looks just like the utility function we're using, q 290 00:13:16,770 --> 00:13:19,100 equals L times k. 291 00:13:19,100 --> 00:13:20,412 Familiar form. 292 00:13:20,412 --> 00:13:22,620 Before, we said how happy pizza and cookies made you. 293 00:13:22,620 --> 00:13:24,680 It was the square root of pizza times cookies. 294 00:13:24,680 --> 00:13:27,340 Now we're going to say how many goods you can produce 295 00:13:27,340 --> 00:13:30,130 is the square root of capital times labor. 296 00:13:30,130 --> 00:13:37,470 OK, and figure 5-1 shows you what that delivers 297 00:13:37,470 --> 00:13:39,750 in terms of graphically. 298 00:13:39,750 --> 00:13:42,900 Just as to graphically represent utility, 299 00:13:42,900 --> 00:13:47,700 we graft indifference curves, to graphically represent 300 00:13:47,700 --> 00:13:51,300 production, we are going to graph isoquants. 301 00:13:54,660 --> 00:13:57,670 Isoquants are like firm indifference curves, 302 00:13:57,670 --> 00:14:00,003 but once again, they're sort of more tangible. 303 00:14:00,003 --> 00:14:02,170 An indifference curve is this weird, intangible idea 304 00:14:02,170 --> 00:14:04,140 of points along which are indifferent. 305 00:14:04,140 --> 00:14:05,740 And isoquant's a tangible thing. 306 00:14:05,740 --> 00:14:08,110 It's the combinations of capital and labor 307 00:14:08,110 --> 00:14:11,100 that produce the same amount of output, OK. 308 00:14:11,100 --> 00:14:13,790 So for any given production function, 309 00:14:13,790 --> 00:14:16,100 there's different combination of capital and labor 310 00:14:16,100 --> 00:14:18,690 that produce the same amount of output. 311 00:14:18,690 --> 00:14:25,010 So for example, in our example, two units of capital 312 00:14:25,010 --> 00:14:29,300 and two units of labor produces two units of output. 313 00:14:29,300 --> 00:14:31,520 Four units of capital and one unit labor 314 00:14:31,520 --> 00:14:33,255 also produced two units of output, 315 00:14:33,255 --> 00:14:36,670 so they would be on the same isoquant. 316 00:14:36,670 --> 00:14:39,190 They're this combinations of inputs that deliver 317 00:14:39,190 --> 00:14:42,900 the same level of output, OK. 318 00:14:42,900 --> 00:14:45,680 And isoquants, all the stuff we learned about indifference 319 00:14:45,680 --> 00:14:47,530 curves apply here. 320 00:14:47,530 --> 00:14:50,120 More is better, so further out is better. 321 00:14:50,120 --> 00:14:53,210 They can't cross, OK. 322 00:14:53,210 --> 00:14:55,192 And they slope downwards. 323 00:14:55,192 --> 00:14:57,650 All the set of things we learned about indifference curves, 324 00:14:57,650 --> 00:15:01,790 that same set of intuitions applies here. 325 00:15:01,790 --> 00:15:04,930 The difference with production is 326 00:15:04,930 --> 00:15:08,980 it's more plausible to have extreme cases, OK. 327 00:15:08,980 --> 00:15:10,940 So let's consider two extreme cases. 328 00:15:10,940 --> 00:15:12,680 Let's first consider the case of inputs 329 00:15:12,680 --> 00:15:15,080 that are perfectly substitutable, so 330 00:15:15,080 --> 00:15:18,680 like a Harvard graduate and a Beanie Baby, OK, 331 00:15:18,680 --> 00:15:22,070 perfectly substitutable inputs. 332 00:15:22,070 --> 00:15:25,370 Those are goods where the production function would be 333 00:15:25,370 --> 00:15:30,920 of the form, q equals L plus k. 334 00:15:34,860 --> 00:15:36,610 That's perfectly substitute because you're 335 00:15:36,610 --> 00:15:38,860 indifferent between the unit value and the unit value. 336 00:15:38,860 --> 00:15:40,380 They're perfectly substitutable. 337 00:15:40,380 --> 00:15:43,780 So you can see that in figure 5-2a, 338 00:15:43,780 --> 00:15:47,510 I do x and y instead of L and k, but it's the same idea. 339 00:15:47,510 --> 00:15:51,920 If there's two inputs, x and y, then with that production 340 00:15:51,920 --> 00:15:53,420 function, a perfectly substitutable, 341 00:15:53,420 --> 00:15:57,630 that would lead to linear isoquants. 342 00:15:57,630 --> 00:16:01,550 Perfectly substitutable inputs will lead to linear isoqaunts 343 00:16:01,550 --> 00:16:04,230 with a slope of minus 1, you're perfectly 344 00:16:04,230 --> 00:16:08,370 indfiferent between one or the other at all levels. 345 00:16:08,370 --> 00:16:10,673 At any point in time, you're indifferent between 1 more 346 00:16:10,673 --> 00:16:12,840 unit of x and 1 more unit of y, 1 more unit of labor 347 00:16:12,840 --> 00:16:16,220 and 1 unit of capital, OK. 348 00:16:16,220 --> 00:16:21,410 At the other extreme would be perfectly non-substitutable 349 00:16:21,410 --> 00:16:28,910 inputs, inputs where you can't produce one more unit 350 00:16:28,910 --> 00:16:32,510 without one of each input, OK. 351 00:16:32,510 --> 00:16:35,690 That would look like figure 5-2b. 352 00:16:35,690 --> 00:16:39,260 We call this a Leontieff production function. 353 00:16:42,990 --> 00:16:45,300 A Leontieff production function is 354 00:16:45,300 --> 00:16:49,350 one where there's non-substitutable inputs, where 355 00:16:49,350 --> 00:16:53,010 the production function is the min of x and y, 356 00:16:53,010 --> 00:16:55,560 that one more unit of y does you no good 357 00:16:55,560 --> 00:16:58,080 unless you also get one more unit of x. 358 00:16:58,080 --> 00:16:59,020 So what's an example? 359 00:16:59,020 --> 00:17:01,645 What's a real world example of a Leontieff production function? 360 00:17:01,645 --> 00:17:04,040 What's a good which would have non-substitutable inputs? 361 00:17:04,040 --> 00:17:07,119 We'd need at least one of each. 362 00:17:07,119 --> 00:17:08,240 Yeah. 363 00:17:08,240 --> 00:17:11,030 AUDIENCE: If you have like programmers and computers, 364 00:17:11,030 --> 00:17:11,870 [INAUDIBLE]. 365 00:17:13,887 --> 00:17:16,470 JONATHAN GRUBER: Programmers and computers, that's a good one. 366 00:17:16,470 --> 00:17:19,230 AUDIENCE: It's like, you need like a right shoe. 367 00:17:19,230 --> 00:17:20,099 JONATHAN GRUBER: You need a right shoe and a left shoe. 368 00:17:20,099 --> 00:17:21,660 That's a classic example I would use. 369 00:17:21,660 --> 00:17:24,540 Cereal and cereal boxes stuff like that, you know, 370 00:17:24,540 --> 00:17:26,040 stuff where you basically need both. 371 00:17:26,040 --> 00:17:28,860 Shoes are the sort of classic example, OK. 372 00:17:28,860 --> 00:17:32,770 And that will give you sort of a Leontieff production function, 373 00:17:32,770 --> 00:17:33,780 OK. 374 00:17:33,780 --> 00:17:36,300 So basically, those extremes help 375 00:17:36,300 --> 00:17:40,510 you think about what isoquants are and what they mean. 376 00:17:40,510 --> 00:17:44,840 Now, continuing our parallel to consumer theory, 377 00:17:44,840 --> 00:17:48,580 what is the slope of the isoqaunt? 378 00:17:48,580 --> 00:17:50,770 What is the slope of the isoquant? 379 00:17:50,770 --> 00:17:52,810 The slope of the isoqaunt, just as we 380 00:17:52,810 --> 00:17:54,730 call the slope of the indifference 381 00:17:54,730 --> 00:17:57,520 curve the marginal rate of substitution, since we're not 382 00:17:57,520 --> 00:18:01,030 very creative in economics, we call the slope of the isoqaunt 383 00:18:01,030 --> 00:18:03,950 the marginal rate of technical substitution, 384 00:18:03,950 --> 00:18:06,370 because it's the same idea, but now it's technical. 385 00:18:06,370 --> 00:18:08,350 It come from a technical production function, 386 00:18:08,350 --> 00:18:11,480 not from your preferences, OK. 387 00:18:11,480 --> 00:18:13,580 So marginal rate of technical substitution 388 00:18:13,580 --> 00:18:25,190 is the slope of the isoquant, or delta k over delta L. 389 00:18:25,190 --> 00:18:28,160 And as with indifference curves, that slope 390 00:18:28,160 --> 00:18:31,610 varies along the isoquant. 391 00:18:31,610 --> 00:18:37,260 So we can see that in figure 5-3, OK. 392 00:18:37,260 --> 00:18:40,230 Figure 5-3 is once again drawn for our production function, 393 00:18:40,230 --> 00:18:47,540 q equals square root of k times L. 394 00:18:47,540 --> 00:18:51,260 So let's say for example, we start with one worker and four 395 00:18:51,260 --> 00:18:56,460 machines at point A, OK, and now we consider 396 00:18:56,460 --> 00:18:59,420 adding a second worker. 397 00:18:59,420 --> 00:19:02,630 Well, at point A, that second worker 398 00:19:02,630 --> 00:19:08,010 is so productive because of diminishing marginal products, 399 00:19:08,010 --> 00:19:08,510 OK. 400 00:19:08,510 --> 00:19:11,060 You already got four machines, only one guy to run them. 401 00:19:11,060 --> 00:19:12,518 Like, he's not doing a lot of good. 402 00:19:12,518 --> 00:19:15,110 So adding a second worker and two machines helps a lot. 403 00:19:15,110 --> 00:19:19,910 It's not perfectly Leontieff, but you can get the intuition 404 00:19:19,910 --> 00:19:23,240 that two workers and two machines 405 00:19:23,240 --> 00:19:25,320 are the same as one worker and four machines. 406 00:19:25,320 --> 00:19:25,750 You're not better off. 407 00:19:25,750 --> 00:19:26,670 You're the same off. 408 00:19:26,670 --> 00:19:28,193 You have the same isoquant. 409 00:19:28,193 --> 00:19:30,110 So the marginal rate of technical substitution 410 00:19:30,110 --> 00:19:31,550 is minus 2. 411 00:19:31,550 --> 00:19:36,690 That is, one worker substitutes for two machines, 412 00:19:36,690 --> 00:19:39,530 OK, one worker substitutes for two machines. 413 00:19:39,530 --> 00:19:43,280 But now, starting from point B and moving to point C, 414 00:19:43,280 --> 00:19:48,280 it takes two more workers to substitute for one machine 415 00:19:48,280 --> 00:19:49,780 because, if you go down one machine, 416 00:19:49,780 --> 00:19:52,060 you need a lot more workers to make up for it. 417 00:19:52,060 --> 00:19:55,380 So then the MRTS falls to minus 1/2. 418 00:19:55,380 --> 00:19:58,080 So, going from A to B, one worker 419 00:19:58,080 --> 00:20:00,060 makes up for two machines. 420 00:20:00,060 --> 00:20:02,100 Going from B to C, it takes two workers 421 00:20:02,100 --> 00:20:03,810 to make up for one machine. 422 00:20:03,810 --> 00:20:07,630 And that's because of diminishing marginal products, 423 00:20:07,630 --> 00:20:08,430 OK? 424 00:20:08,430 --> 00:20:10,430 That's because of diminishing marginal products. 425 00:20:13,430 --> 00:20:18,940 OK, indeed, there's a convenient way mathematically 426 00:20:18,940 --> 00:20:21,490 to relate the marginal rate of technical substitution 427 00:20:21,490 --> 00:20:23,440 to marginal products. 428 00:20:23,440 --> 00:20:25,810 Think of what the MRTS is asking. 429 00:20:25,810 --> 00:20:27,760 Think of what we're asking along the isoquant. 430 00:20:27,760 --> 00:20:31,870 We're saying what combinations of capital and labor 431 00:20:31,870 --> 00:20:33,730 yield the same output. 432 00:20:33,730 --> 00:20:36,160 That's what we're asking, OK? 433 00:20:36,160 --> 00:20:40,410 So another way to think about it is what change in capital 434 00:20:40,410 --> 00:20:42,690 plus an equivalent change in labor 435 00:20:42,690 --> 00:20:45,060 leads to the same level of output. 436 00:20:45,060 --> 00:20:49,580 So you can ask, well, the change in labor 437 00:20:49,580 --> 00:20:52,610 times the marginal product of a unit of labor, 438 00:20:52,610 --> 00:20:55,560 times the marginal product of a unit of labor, 439 00:20:55,560 --> 00:21:00,280 plus the change in capital times the marginal product of a unit 440 00:21:00,280 --> 00:21:01,530 of capital, which is the same. 441 00:21:01,530 --> 00:21:02,850 I didn't define marginal product of capital. 442 00:21:02,850 --> 00:21:05,220 It's the same idea as marginal product of labor. 443 00:21:05,220 --> 00:21:10,050 It's dq dk is the margin product of capital. 444 00:21:10,050 --> 00:21:13,350 That equals 0 along an isoquant. 445 00:21:13,350 --> 00:21:14,250 Think about it. 446 00:21:14,250 --> 00:21:17,670 Along an isoquant, the next unit of labor times 447 00:21:17,670 --> 00:21:21,180 how productive that labor is plus the next unit of capital 448 00:21:21,180 --> 00:21:23,347 times how productive that capital is 449 00:21:23,347 --> 00:21:25,430 equals 0 because you're staying along an isoquant. 450 00:21:25,430 --> 00:21:27,560 So, if you're taking away one unit of labor, 451 00:21:27,560 --> 00:21:31,730 if this is minus 1, and this is plus 1, 452 00:21:31,730 --> 00:21:33,500 then, based along the isoquant, you're 453 00:21:33,500 --> 00:21:37,840 choosing the point where the MPL equals the MPK. 454 00:21:37,840 --> 00:21:40,790 Or, more generally, if you reorganize this, 455 00:21:40,790 --> 00:21:45,230 you get that delta k over delta L, which is the slope, 456 00:21:45,230 --> 00:21:50,630 equals minus MPL over MPK. 457 00:21:50,630 --> 00:21:57,320 And that is the MRTS, OK? 458 00:21:57,320 --> 00:22:00,600 The marginal rate of technical substitution 459 00:22:00,600 --> 00:22:04,660 is the negative of the ratio of the marginal product of labor 460 00:22:04,660 --> 00:22:07,040 and the marginal product of capital. 461 00:22:07,040 --> 00:22:09,648 Once again, should look familiar. 462 00:22:09,648 --> 00:22:11,690 It's just like the marginal rate of substitution. 463 00:22:11,690 --> 00:22:13,910 It's the negative of the marginal utility 464 00:22:13,910 --> 00:22:16,130 of the good on the x-axis for the marginal utility 465 00:22:16,130 --> 00:22:19,010 of the good on the y-axis, same idea. 466 00:22:19,010 --> 00:22:21,320 I derived it in a slightly different way here, 467 00:22:21,320 --> 00:22:23,738 but it's the same idea. 468 00:22:23,738 --> 00:22:25,280 And it comes from the notion that you 469 00:22:25,280 --> 00:22:27,920 wanted to stay-- that you're staying constant production, 470 00:22:27,920 --> 00:22:32,060 as you change labor and capital along this curve. 471 00:22:32,060 --> 00:22:32,560 Yeah? 472 00:22:32,560 --> 00:22:37,900 AUDIENCE: [INAUDIBLE] MPK over MPL [INAUDIBLE] 473 00:22:37,900 --> 00:22:41,393 give you the same ratio or no? 474 00:22:41,393 --> 00:22:43,560 JONATHAN GRUBER: Well, MPK over MPL would give you-- 475 00:22:43,560 --> 00:22:44,880 I mean, basically, we're defining 476 00:22:44,880 --> 00:22:47,005 the marginal rate of technical substitution the way 477 00:22:47,005 --> 00:22:49,080 we define-- 478 00:22:49,080 --> 00:22:51,810 the way we define the marginal rate of substitution. 479 00:22:51,810 --> 00:22:54,600 You basically want-- because you want it to be downward sloping. 480 00:22:54,600 --> 00:22:57,468 If you define that, the inverse would be upward sloping. 481 00:22:57,468 --> 00:22:59,760 So what we're defining is the downward-sloping concept, 482 00:22:59,760 --> 00:23:01,380 which is the marginal product of the good 483 00:23:01,380 --> 00:23:02,560 on the x-axis and marginal product 484 00:23:02,560 --> 00:23:03,662 of the good on the y-axis. 485 00:23:03,662 --> 00:23:04,620 So it's not invertible. 486 00:23:04,620 --> 00:23:06,670 It's not freely invertible. 487 00:23:06,670 --> 00:23:07,590 Yeah? 488 00:23:07,590 --> 00:23:09,007 AUDIENCE: What's the marginal rate 489 00:23:09,007 --> 00:23:11,603 of technical substitution for a Leontief production function? 490 00:23:11,603 --> 00:23:13,770 JONATHAN GRUBER: Ah, great question, great question. 491 00:23:13,770 --> 00:23:15,770 So, the marginal rate of technical substitution, 492 00:23:15,770 --> 00:23:18,730 so let's go back to Leontief. 493 00:23:18,730 --> 00:23:22,640 OK, the marginal rate of technical substitution 494 00:23:22,640 --> 00:23:25,070 actually sort of depends on-- 495 00:23:25,070 --> 00:23:26,870 it sort of depends on where you are. 496 00:23:26,870 --> 00:23:28,470 It's sort of a nonlinear marginal rate 497 00:23:28,470 --> 00:23:30,680 of technical substitution, right? 498 00:23:30,680 --> 00:23:34,130 So, basically, it's going to very much depend-- 499 00:23:34,130 --> 00:23:35,540 depend on where you are. 500 00:23:35,540 --> 00:23:37,790 So, basically, it can be negative infinity or positive 501 00:23:37,790 --> 00:23:40,082 infinity or 0, depending on where you are on the curve. 502 00:23:40,082 --> 00:23:42,457 So we'll actually-- I don't want to give you more on that 503 00:23:42,457 --> 00:23:43,640 because this problem may-- 504 00:23:43,640 --> 00:23:45,557 I'm not giving anything away-- could obviously 505 00:23:45,557 --> 00:23:47,010 be a problem set problem. 506 00:23:47,010 --> 00:23:49,177 So I don't want to give more answers than that away, 507 00:23:49,177 --> 00:23:51,560 but, certainly, it's going to be-- 508 00:23:51,560 --> 00:23:55,100 it's not going to be constant, OK? 509 00:23:55,100 --> 00:23:56,700 Other questions? 510 00:23:56,700 --> 00:23:57,640 Yeah? 511 00:23:57,640 --> 00:23:59,780 AUDIENCE: It's just like a line, right? 512 00:23:59,780 --> 00:24:01,280 JONATHAN GRUBER: The marginal rate-- 513 00:24:01,280 --> 00:24:03,863 if the curve is just a line, the marginal rate of substitution 514 00:24:03,863 --> 00:24:05,220 would be constant. 515 00:24:05,220 --> 00:24:08,330 For perfectly substitutable inputs, it would be constant. 516 00:24:08,330 --> 00:24:11,117 That's right, just like the marginal rate of substation 517 00:24:11,117 --> 00:24:12,700 would be constant if your indifference 518 00:24:12,700 --> 00:24:15,690 curves were linear, OK? 519 00:24:15,690 --> 00:24:16,920 Good questions. 520 00:24:16,920 --> 00:24:20,740 OK, so that's production, OK? 521 00:24:20,740 --> 00:24:23,370 Other questions about production? 522 00:24:23,370 --> 00:24:25,625 OK, that's the basics, and we went fast 523 00:24:25,625 --> 00:24:27,000 because, basically, a lot of it's 524 00:24:27,000 --> 00:24:30,660 just parallel to what we did with consumer theory, OK? 525 00:24:30,660 --> 00:24:34,800 Now but I want to talk about two other aspects of production 526 00:24:34,800 --> 00:24:38,460 that we need to keep in mind as we move forward. 527 00:24:38,460 --> 00:24:41,340 The first and the fourth topic for today 528 00:24:41,340 --> 00:24:54,280 is returns to scale, returns to scale, OK? 529 00:24:54,280 --> 00:24:56,560 This is what returns to scale are 530 00:24:56,560 --> 00:25:01,390 asking is what happens to production when you increase 531 00:25:01,390 --> 00:25:04,310 all inputs proportionally. 532 00:25:04,310 --> 00:25:07,820 So, if you double all inputs or triple all inputs or whatever, 533 00:25:07,820 --> 00:25:12,110 cut all inputs by 73%, what happens to production? 534 00:25:12,110 --> 00:25:14,590 So it's not about K versus L. It's 535 00:25:14,590 --> 00:25:20,250 about a scale, a scaling up or down of the operation, OK? 536 00:25:20,250 --> 00:25:22,860 Now we know, obviously, if you double inputs, 537 00:25:22,860 --> 00:25:24,420 production will go up. 538 00:25:24,420 --> 00:25:25,860 More is better. 539 00:25:25,860 --> 00:25:28,630 The question is by how much. 540 00:25:28,630 --> 00:25:31,350 So our baseline we can think about 541 00:25:31,350 --> 00:25:33,810 as what we call a constant returns to scale production 542 00:25:33,810 --> 00:25:35,070 function. 543 00:25:35,070 --> 00:25:45,033 That would be one where f of 2L, 2K equals 2 times f of L, K. 544 00:25:45,033 --> 00:25:46,950 So a constant returns to scale function means, 545 00:25:46,950 --> 00:25:50,730 if you double inputs, you double output. 546 00:25:50,730 --> 00:25:53,490 If you double inputs, you double output. 547 00:25:53,490 --> 00:25:56,770 That's a constant returns to scale production function. 548 00:25:56,770 --> 00:25:59,380 But you could also define increasing returns 549 00:25:59,380 --> 00:26:03,460 to scale, where doubling inputs leads to more than double 550 00:26:03,460 --> 00:26:06,700 the output, or decreasing returns 551 00:26:06,700 --> 00:26:08,950 to scale where doubling the inputs 552 00:26:08,950 --> 00:26:11,260 leads to less than double the output. 553 00:26:11,260 --> 00:26:12,760 So constant returns to scale means 554 00:26:12,760 --> 00:26:15,640 doubling the inputs leads to double the output. 555 00:26:15,640 --> 00:26:17,890 Increasing returns to scale means more 556 00:26:17,890 --> 00:26:21,363 than doubling the inputs more than doubles the output-- 557 00:26:21,363 --> 00:26:23,530 I'm sorry, means double the inputs more than doubles 558 00:26:23,530 --> 00:26:24,750 the output. 559 00:26:24,750 --> 00:26:28,480 Decreasing returns the scale means doubling the inputs less 560 00:26:28,480 --> 00:26:31,480 than doubles the output, OK? 561 00:26:31,480 --> 00:26:33,310 And that gives you-- 562 00:26:33,310 --> 00:26:35,830 that's your definition of returns to scale. 563 00:26:35,830 --> 00:26:38,427 Now where could these come from? 564 00:26:38,427 --> 00:26:40,510 So increasing returns to scale, for example, where 565 00:26:40,510 --> 00:26:42,302 could increasing-- that's the world's worst 566 00:26:42,302 --> 00:26:45,850 S. Where could increasing returns to scale come from, OK? 567 00:26:45,850 --> 00:26:48,450 So, for example, one reason for increasing returns to scale 568 00:26:48,450 --> 00:26:50,200 is that, basically, as a firm gets bigger, 569 00:26:50,200 --> 00:26:52,370 it might learn to specialize. 570 00:26:52,370 --> 00:26:56,080 So maybe a firm with two workers and two computers, 571 00:26:56,080 --> 00:26:58,580 and you double, and you get four workers and four computers, 572 00:26:58,580 --> 00:27:00,710 and then you could specialize the tasks more. 573 00:27:00,710 --> 00:27:02,960 And each worker is more efficient in their specialized 574 00:27:02,960 --> 00:27:04,040 task. 575 00:27:04,040 --> 00:27:06,302 That could lead to increasing returns to scale. 576 00:27:06,302 --> 00:27:07,760 That's an example of something that 577 00:27:07,760 --> 00:27:10,430 could lead to increasing returns to scale. 578 00:27:10,430 --> 00:27:13,530 Decreasing returns to scale could come through something 579 00:27:13,530 --> 00:27:15,185 like difficulty of coordination. 580 00:27:15,185 --> 00:27:17,310 Maybe, when I've got two workers and two computers, 581 00:27:17,310 --> 00:27:20,160 I can keep an eye on them and make sure they don't slack off. 582 00:27:20,160 --> 00:27:21,540 But, with four workers and four computers, 583 00:27:21,540 --> 00:27:22,998 there's more slacking off because I 584 00:27:22,998 --> 00:27:25,060 can't keep an eye on them all the time 585 00:27:25,060 --> 00:27:26,790 and more so with 8 and 16, et cetera. 586 00:27:26,790 --> 00:27:27,456 Yeah? 587 00:27:27,456 --> 00:27:30,360 AUDIENCE: So, when-- I have to ask, 588 00:27:30,360 --> 00:27:34,010 why is doubling the inputs greater than two times 589 00:27:34,010 --> 00:27:34,773 the outputs? 590 00:27:34,773 --> 00:27:37,190 JONATHAN GRUBER: Yeah, so, basically, doubling the input-- 591 00:27:37,190 --> 00:27:39,070 so, when I move to two workers and two computers 592 00:27:39,070 --> 00:27:40,530 to four workers and four computers, 593 00:27:40,530 --> 00:27:42,173 I more than double my output. 594 00:27:42,173 --> 00:27:43,840 And that's because maybe they specialize 595 00:27:43,840 --> 00:27:44,915 and get more productive. 596 00:27:44,915 --> 00:27:50,620 AUDIENCE: Oh, so f of L, K equals the original output. 597 00:27:50,620 --> 00:27:53,310 JONATHAN GRUBER: Yeah, so, well, it's one function. 598 00:27:53,310 --> 00:27:54,880 f of L, it's literally one function. 599 00:27:54,880 --> 00:27:56,463 It's literally-- so I'll write it out. 600 00:27:56,463 --> 00:27:59,590 It's literally saying doubling my inputs leads 601 00:27:59,590 --> 00:28:03,490 to more than twice what I get with just-- 602 00:28:03,490 --> 00:28:05,630 without doubling the outputs, OK? 603 00:28:05,630 --> 00:28:07,542 Is that another way to think about it? 604 00:28:07,542 --> 00:28:08,504 Yeah? 605 00:28:08,504 --> 00:28:10,800 AUDIENCE: So, when we're talking about the returns 606 00:28:10,800 --> 00:28:14,430 of our-- our return to scale, is that 607 00:28:14,430 --> 00:28:16,615 how much product is being produced 608 00:28:16,615 --> 00:28:17,990 or how much profit is being made? 609 00:28:17,990 --> 00:28:18,560 JONATHAN GRUBER: How much product. 610 00:28:18,560 --> 00:28:20,435 We're only-- we haven't gotten to profit yet. 611 00:28:20,435 --> 00:28:22,203 We're only talking about quantity. 612 00:28:22,203 --> 00:28:23,620 We're only talking about quantity. 613 00:28:23,620 --> 00:28:25,960 f is-- remember, f is the function 614 00:28:25,960 --> 00:28:28,880 that translates inputs to q. 615 00:28:28,880 --> 00:28:29,883 Yeah? 616 00:28:29,883 --> 00:28:31,300 AUDIENCE: Are things intrinsically 617 00:28:31,300 --> 00:28:33,310 like increasing return to scale functions 618 00:28:33,310 --> 00:28:34,240 or decreasing return to scale functions? 619 00:28:34,240 --> 00:28:34,840 JONATHAN GRUBER: Well, great question. 620 00:28:34,840 --> 00:28:36,070 So what do you think? 621 00:28:36,070 --> 00:28:38,920 What's the right answer? 622 00:28:38,920 --> 00:28:40,850 What do we think in reality? 623 00:28:40,850 --> 00:28:42,570 AUDIENCE: I mean, like, perhaps, maybe 624 00:28:42,570 --> 00:28:44,800 there could be ways to shift it or not. 625 00:28:44,800 --> 00:28:47,140 Like, going back to the whole example you gave about 626 00:28:47,140 --> 00:28:49,015 decreasing-- like, if there's more computers, 627 00:28:49,015 --> 00:28:50,963 people can start slacking off-- 628 00:28:50,963 --> 00:28:52,755 if he set like-- if you set some parameters 629 00:28:52,755 --> 00:28:56,705 or like you deactivated social media on those computers 630 00:28:56,705 --> 00:28:58,080 that they couldn't go on Facebook 631 00:28:58,080 --> 00:28:59,730 when like you weren't watching them, 632 00:28:59,730 --> 00:29:02,065 you could make them be more productive per se. 633 00:29:02,065 --> 00:29:03,940 JONATHAN GRUBER: Well, it's a great question. 634 00:29:03,940 --> 00:29:06,870 Let's start by looking at figure 5-4 and show 635 00:29:06,870 --> 00:29:09,100 some examples of what we think about like decreasing, 636 00:29:09,100 --> 00:29:10,267 increasing returns to scale. 637 00:29:10,267 --> 00:29:15,722 So figure 5-4 has some examples of the kind of industries 638 00:29:15,722 --> 00:29:18,180 people think are potentially decreasing, increasing returns 639 00:29:18,180 --> 00:29:20,010 to scale, OK? 640 00:29:20,010 --> 00:29:23,550 So, for example, we think the production of tobacco 641 00:29:23,550 --> 00:29:26,250 is a decreasing returns to scale activity. 642 00:29:26,250 --> 00:29:28,110 That is you're kind of farming tobacco. 643 00:29:28,110 --> 00:29:28,860 You're growing it. 644 00:29:28,860 --> 00:29:30,000 You're producing it. 645 00:29:30,000 --> 00:29:32,460 Then, if you kind of double it up, 646 00:29:32,460 --> 00:29:35,550 there's still a certain amount of land you're working on. 647 00:29:35,550 --> 00:29:38,400 You can't-- there's still sort of a certain amount of crop. 648 00:29:38,400 --> 00:29:40,108 You're not going to produce twice as much 649 00:29:40,108 --> 00:29:42,440 by having twice as many threshers and workers, 650 00:29:42,440 --> 00:29:46,430 whereas, maybe something like producing primary metal, 651 00:29:46,430 --> 00:29:49,563 OK, you could basically maybe work a lot more efficiently 652 00:29:49,563 --> 00:29:51,230 by having more machines and more workers 653 00:29:51,230 --> 00:29:54,600 together producing that metal. 654 00:29:54,600 --> 00:29:56,430 So what is the right answer? 655 00:29:56,430 --> 00:29:58,100 The right answer is we don't know, 656 00:29:58,100 --> 00:30:01,640 but the one thing we do know is there can never be forever 657 00:30:01,640 --> 00:30:03,410 increasing returns to scale. 658 00:30:03,410 --> 00:30:04,910 And why is that? 659 00:30:04,910 --> 00:30:07,720 Well, at least, we used to think this maybe 15 years ago. 660 00:30:07,720 --> 00:30:08,220 Why is that? 661 00:30:08,220 --> 00:30:11,690 Why can there-- what would happen in an economy 662 00:30:11,690 --> 00:30:15,080 if a firm had forever increasing returns to scale? 663 00:30:15,080 --> 00:30:15,580 Yeah? 664 00:30:15,580 --> 00:30:16,840 AUDIENCE: You'd get a monopoly. 665 00:30:16,840 --> 00:30:18,548 JONATHAN GRUBER: It would own the economy 666 00:30:18,548 --> 00:30:21,130 because, the bigger I got, the more productive I'd get. 667 00:30:21,130 --> 00:30:23,980 So I would just eventually grow and own the whole economy. 668 00:30:23,980 --> 00:30:26,030 Now, actually, that may be happening. 669 00:30:26,030 --> 00:30:29,600 So maybe it's not as weird as we thought it was 15-- 670 00:30:29,600 --> 00:30:32,740 maybe Google and the big five have increasing returns 671 00:30:32,740 --> 00:30:33,790 to scale. 672 00:30:33,790 --> 00:30:36,340 But, eventually, we think returns to scale must decrease. 673 00:30:36,340 --> 00:30:37,715 We think your scale of production 674 00:30:37,715 --> 00:30:40,730 must get so unwieldy that doubling it 675 00:30:40,730 --> 00:30:43,660 means you just can't manage it as effectively. 676 00:30:43,660 --> 00:30:46,623 Eventually, we think returns to scale must decrease. 677 00:30:46,623 --> 00:30:48,290 That's sort of the one sort of principle 678 00:30:48,290 --> 00:30:50,750 we have that we don't know-- 679 00:30:50,750 --> 00:30:53,480 we think, generally, probably, in the life cycle of firms, 680 00:30:53,480 --> 00:30:56,312 returns to scale are probably increasing and then decreasing. 681 00:30:56,312 --> 00:30:57,770 But we don't know where it happens. 682 00:30:57,770 --> 00:30:59,780 And, certainly, companies like Google and Amazon 683 00:30:59,780 --> 00:31:01,405 are showing us that point of decreasing 684 00:31:01,405 --> 00:31:05,830 may happen a lot later than we thought, OK? 685 00:31:05,830 --> 00:31:08,230 And that's because I think what we didn't account 686 00:31:08,230 --> 00:31:11,250 for in our traditional producer theory 687 00:31:11,250 --> 00:31:13,440 is networks, the fact that networks 688 00:31:13,440 --> 00:31:14,533 get ever more productive. 689 00:31:14,533 --> 00:31:16,450 We always thought about buildings and workers, 690 00:31:16,450 --> 00:31:18,060 and there's a limit to how productive they can get. 691 00:31:18,060 --> 00:31:20,143 But networks, by bringing in more and more people, 692 00:31:20,143 --> 00:31:21,720 can get ever more productive. 693 00:31:21,720 --> 00:31:24,210 But, at some point, we think these things have to decrease. 694 00:31:24,210 --> 00:31:25,800 At least, we traditionally thought so, 695 00:31:25,800 --> 00:31:28,650 but maybe, in 10 years when Google owns everything, 696 00:31:28,650 --> 00:31:31,130 I'll change my tune, OK? 697 00:31:31,130 --> 00:31:33,140 But that's sort of the one sort of rule of thumb 698 00:31:33,140 --> 00:31:35,485 we have in thinking about this, OK? 699 00:31:35,485 --> 00:31:36,610 Other questions about that? 700 00:31:39,270 --> 00:31:43,880 OK, let's talk about the last topic then, 701 00:31:43,880 --> 00:31:48,650 which is productivity, how this stuff 702 00:31:48,650 --> 00:31:50,000 all matters in the real world. 703 00:31:52,573 --> 00:31:54,240 So we're going to come back next lecture 704 00:31:54,240 --> 00:31:57,690 and come back to maximizing profits and all that stuff, 705 00:31:57,690 --> 00:31:59,190 but I want to sort of step aside now 706 00:31:59,190 --> 00:32:02,430 and ask why does this all matter. 707 00:32:02,430 --> 00:32:05,430 And, to do so, let's step way back 708 00:32:05,430 --> 00:32:10,050 to the original dismal scientist, Thomas Malthus. 709 00:32:10,050 --> 00:32:18,170 Thomas Malthus in 1798 wrote a book, which said-- 710 00:32:18,170 --> 00:32:20,682 which was really pretty depressing. 711 00:32:20,682 --> 00:32:23,140 He said, look, let's think about how basic economics works. 712 00:32:23,140 --> 00:32:24,240 Now he didn't do the math. 713 00:32:24,240 --> 00:32:25,460 This is pre-math. 714 00:32:25,460 --> 00:32:27,810 So let's get the basic intuition. 715 00:32:27,810 --> 00:32:29,860 Think about the production of food. 716 00:32:29,860 --> 00:32:36,950 OK, the production of food has two inputs, labor and land. 717 00:32:36,950 --> 00:32:39,380 There's workers, and then-- you know, there's machines, 718 00:32:39,380 --> 00:32:41,350 but they're pretty simple machines. 719 00:32:41,350 --> 00:32:45,590 OK, you sort of till the land, and there's land. 720 00:32:45,590 --> 00:32:48,320 Well, in the long run-- 721 00:32:48,320 --> 00:32:49,820 in the short run, labor is variable. 722 00:32:49,820 --> 00:32:51,410 In the long run, labor is variable. 723 00:32:51,410 --> 00:32:53,210 But land is never variable. 724 00:32:53,210 --> 00:32:55,700 Land is a forever fixed input. 725 00:32:55,700 --> 00:32:56,790 There's no long run. 726 00:32:56,790 --> 00:32:59,030 Unless we discover a new planet, there's 727 00:32:59,030 --> 00:33:02,210 no long run over which land is variable. 728 00:33:02,210 --> 00:33:04,850 What that means is that there will be ever diminishing 729 00:33:04,850 --> 00:33:06,330 marginal product to farming. 730 00:33:06,330 --> 00:33:09,880 He didn't say it this way, but this was sort of his intuition 731 00:33:09,880 --> 00:33:12,220 that more and more workers will try to cram 732 00:33:12,220 --> 00:33:13,510 on a given acre of land. 733 00:33:13,510 --> 00:33:15,868 Each additional worker can only do so much. 734 00:33:15,868 --> 00:33:17,410 And, eventually, the marginal product 735 00:33:17,410 --> 00:33:20,110 will be diminishing, OK? 736 00:33:20,110 --> 00:33:23,740 The result is that productivity will fall, the marginal product 737 00:33:23,740 --> 00:33:27,930 of labor, when each additional worker will be less and less. 738 00:33:27,930 --> 00:33:31,345 And, as a result, we'll starve because, basically, we 739 00:33:31,345 --> 00:33:32,970 have all these people looking for work. 740 00:33:32,970 --> 00:33:35,570 There's nothing to do because only a certain amount of land. 741 00:33:35,570 --> 00:33:36,660 They won't have anything to do, and, eventually, 742 00:33:36,660 --> 00:33:37,770 they'll starve. 743 00:33:37,770 --> 00:33:39,420 So Malthus actually predicted we would 744 00:33:39,420 --> 00:33:43,560 see cycles of mass starvation through history, fun guy 745 00:33:43,560 --> 00:33:44,680 to have at a party. 746 00:33:44,680 --> 00:33:47,268 OK, he'd basically say we're going to get overpopulated. 747 00:33:47,268 --> 00:33:49,560 These guys will have nothing to do because there's only 748 00:33:49,560 --> 00:33:50,910 so much land they can work on. 749 00:33:50,910 --> 00:33:52,140 They'll die off. 750 00:33:52,140 --> 00:33:53,900 We'll eventually grow overpopulated again. 751 00:33:53,900 --> 00:33:55,950 We'll get these cycles of mass starvation. 752 00:33:55,950 --> 00:33:57,630 That was his prediction. 753 00:33:57,630 --> 00:34:01,260 Now, since he wrote that book, world population 754 00:34:01,260 --> 00:34:04,690 has increased about 1,000%. 755 00:34:04,690 --> 00:34:08,370 And, yet, we're fatter than ever. 756 00:34:08,370 --> 00:34:10,409 I'm not saying food deprivation isn't 757 00:34:10,409 --> 00:34:12,659 a problem around the world, but, certainly, the world 758 00:34:12,659 --> 00:34:17,830 is much better fed that it was in 1798, OK? 759 00:34:17,830 --> 00:34:20,000 What did Malthus miss? 760 00:34:20,000 --> 00:34:21,440 What did Malthus miss? 761 00:34:21,440 --> 00:34:23,414 What did we get wrong? 762 00:34:23,414 --> 00:34:24,312 Yeah? 763 00:34:24,312 --> 00:34:25,979 AUDIENCE: The classic example against it 764 00:34:25,979 --> 00:34:27,745 is like he didn't account for innovations. 765 00:34:27,745 --> 00:34:30,120 JONATHAN GRUBER: He didn't account for innovation or what 766 00:34:30,120 --> 00:34:32,940 we call productivity-- 767 00:34:32,940 --> 00:34:35,871 productivity, or you can also call it innovation-- 768 00:34:38,820 --> 00:34:41,360 and neither have we so far. 769 00:34:41,360 --> 00:34:46,040 We have written production functions of the form q 770 00:34:46,040 --> 00:34:51,630 equals f of L and K, but, in reality, the production 771 00:34:51,630 --> 00:34:57,100 function is actually q equals A times f of L and K, 772 00:34:57,100 --> 00:34:59,680 maybe A of t, A sub t. 773 00:34:59,680 --> 00:35:02,980 And that's a production factor that, basically, for a given 774 00:35:02,980 --> 00:35:06,583 amount of labor and capital, as you get more productive, 775 00:35:06,583 --> 00:35:07,750 you can produce more things. 776 00:35:07,750 --> 00:35:10,330 The production function itself changes. 777 00:35:10,330 --> 00:35:14,630 You get more productive over time, OK? 778 00:35:14,630 --> 00:35:18,390 In agriculture, how did we do this? 779 00:35:18,390 --> 00:35:20,420 Well, we did it in lots of ways. 780 00:35:20,420 --> 00:35:25,310 We invented cool new ways to harvest the crop, tractors. 781 00:35:25,310 --> 00:35:28,480 We invented fertilizer, chemical fertilizer. 782 00:35:28,480 --> 00:35:31,090 We invented seed-resistant crops. 783 00:35:31,090 --> 00:35:33,730 We invented lots of things that Malthus didn't see coming. 784 00:35:33,730 --> 00:35:36,850 So, as a result, even though the land is just as fixed as it was 785 00:35:36,850 --> 00:35:39,308 in Malthus' time-- we still haven't discovered a new planet 786 00:35:39,308 --> 00:35:40,360 we can farm on-- 787 00:35:40,360 --> 00:35:43,080 we produce a lot more food because of the factor A. 788 00:35:43,080 --> 00:35:46,160 The production function itself has changed. 789 00:35:46,160 --> 00:35:49,110 We've become more productive. 790 00:35:49,110 --> 00:35:52,460 So productivity is the factor that 791 00:35:52,460 --> 00:35:54,980 allows us-- or innovation is the factor that 792 00:35:54,980 --> 00:35:58,790 allows us to produce more and more with a given 793 00:35:58,790 --> 00:36:01,170 amount of inputs. 794 00:36:01,170 --> 00:36:04,320 So, actually, food consumption per capita is rising. 795 00:36:04,320 --> 00:36:10,420 Since 1950, food consumption per person in the world is up 40%, 796 00:36:10,420 --> 00:36:11,370 OK? 797 00:36:11,370 --> 00:36:14,080 So, while we have starvation, and it's terrible, it's up. 798 00:36:14,080 --> 00:36:15,570 One side note, some of you may have 799 00:36:15,570 --> 00:36:20,118 heard of a very famous economist named Amartya Sen. 800 00:36:20,118 --> 00:36:21,660 He's a Nobel Prize winning economist. 801 00:36:21,660 --> 00:36:24,510 His biggest-- one of his main contributions 802 00:36:24,510 --> 00:36:28,440 was he studied famines, and he said famines are not 803 00:36:28,440 --> 00:36:29,440 a technological problem. 804 00:36:29,440 --> 00:36:31,380 He said there's never been in history a famine 805 00:36:31,380 --> 00:36:33,940 in a democracy. 806 00:36:33,940 --> 00:36:36,370 No democratic nation has ever had a famine. 807 00:36:36,370 --> 00:36:38,080 Famines are not about technology. 808 00:36:38,080 --> 00:36:40,028 Famines are about politics and corruption 809 00:36:40,028 --> 00:36:42,070 and the things that get in the way of proper food 810 00:36:42,070 --> 00:36:43,650 distribution. 811 00:36:43,650 --> 00:36:46,950 So really we have enough food, OK? 812 00:36:46,950 --> 00:36:48,720 The food is there. 813 00:36:48,720 --> 00:36:49,470 Malthus was wrong. 814 00:36:53,070 --> 00:36:55,220 This is not just true in agriculture. 815 00:36:55,220 --> 00:36:56,750 It's true all over the world. 816 00:36:56,750 --> 00:37:00,600 Let's look at car production, one of most famous examples, 817 00:37:00,600 --> 00:37:01,790 OK? 818 00:37:01,790 --> 00:37:05,150 Cars have been around since the late 1800s, OK? 819 00:37:05,150 --> 00:37:07,400 And they're basically-- when cars were first invented, 820 00:37:07,400 --> 00:37:09,320 they were essentially craftsmanship. 821 00:37:09,320 --> 00:37:11,960 Someone would sit down and make a car if you can believe it. 822 00:37:11,960 --> 00:37:13,460 They'd literally make all the parts. 823 00:37:13,460 --> 00:37:16,730 They'd make a car or a couple people together. 824 00:37:16,730 --> 00:37:20,330 In the early 1900s, Henry Ford introduced 825 00:37:20,330 --> 00:37:22,498 the idea of mass production-- 826 00:37:22,498 --> 00:37:24,290 it seems sensible now, but it's not the way 827 00:37:24,290 --> 00:37:25,520 they used to do it-- 828 00:37:25,520 --> 00:37:29,060 a series of workers who each did a discrete task along the way, 829 00:37:29,060 --> 00:37:30,280 constructing a car. 830 00:37:30,280 --> 00:37:32,030 So no worker did a whole bunch of the car. 831 00:37:32,030 --> 00:37:34,280 Each worker did a little piece, which 832 00:37:34,280 --> 00:37:35,780 massively led to increasing returns 833 00:37:35,780 --> 00:37:39,590 to scale by specialization. 834 00:37:39,590 --> 00:37:43,700 He did that, and, basically, this was radical at the time. 835 00:37:43,700 --> 00:37:47,240 It seems obvious to us now, but he cut the price of building 836 00:37:47,240 --> 00:37:49,490 a car more than in half almost overnight 837 00:37:49,490 --> 00:37:52,910 and basically wiped out all his rivals 838 00:37:52,910 --> 00:37:54,995 through the introduction of mass production. 839 00:37:54,995 --> 00:37:56,620 Now you might think that's pretty cool, 840 00:37:56,620 --> 00:37:58,780 but, you know, that's and old-time story. 841 00:37:58,780 --> 00:38:00,160 But it's not over. 842 00:38:00,160 --> 00:38:02,883 Innovation in car production continues. 843 00:38:02,883 --> 00:38:05,050 The Indian company Tata, you may have heard of them. 844 00:38:05,050 --> 00:38:06,190 They do a lot of MIT-- 845 00:38:06,190 --> 00:38:08,140 they finance a lot of stuff at MIT. 846 00:38:08,140 --> 00:38:13,030 They have a car called the Nano that they produce for $2,500, 847 00:38:13,030 --> 00:38:13,950 OK? 848 00:38:13,950 --> 00:38:15,840 It's a tiny car. 849 00:38:15,840 --> 00:38:16,410 It's lighter. 850 00:38:16,410 --> 00:38:18,870 They use extra light materials. 851 00:38:18,870 --> 00:38:20,880 It's smaller because they do things 852 00:38:20,880 --> 00:38:23,220 like putting wheels on the extreme outside of the car, 853 00:38:23,220 --> 00:38:27,150 rather than sort of underneath the car, OK? 854 00:38:27,150 --> 00:38:28,680 And they minimize the parts that are 855 00:38:28,680 --> 00:38:30,680 used to make it easily fixed and interchangeable 856 00:38:30,680 --> 00:38:32,135 with other cars. 857 00:38:32,135 --> 00:38:33,760 So innovation is going on all the time. 858 00:38:33,760 --> 00:38:34,470 Look at hybrid. 859 00:38:34,470 --> 00:38:37,140 Look at the innovation in the fuel space with hybrid cars 860 00:38:37,140 --> 00:38:38,840 and electric cars and Tesla. 861 00:38:38,840 --> 00:38:43,360 OK, innovation is happening all the time. 862 00:38:43,360 --> 00:38:46,502 Now what's key about this, besides the fact, 863 00:38:46,502 --> 00:38:48,960 technically, what this means is that, when you write-- when 864 00:38:48,960 --> 00:38:50,290 we think about production-- now we're not 865 00:38:50,290 --> 00:38:51,210 going to talk about this a lot. 866 00:38:51,210 --> 00:38:53,710 We'll assume that there's constant production functions. 867 00:38:53,710 --> 00:38:54,910 But what that means technically is, 868 00:38:54,910 --> 00:38:56,620 when we think about over time production, 869 00:38:56,620 --> 00:38:58,750 innovation is a key factor. 870 00:38:58,750 --> 00:39:03,190 But what this means, in terms of all of us sitting in this room, 871 00:39:03,190 --> 00:39:06,400 is that productivity innovation is fundamentally 872 00:39:06,400 --> 00:39:09,610 what determines the standard of living in a country. 873 00:39:13,060 --> 00:39:20,190 Our standard of living is determined by productivity, OK? 874 00:39:20,190 --> 00:39:26,395 So, basically, if you think about us as workers, 875 00:39:26,395 --> 00:39:27,853 if we're going to get richer, we're 876 00:39:27,853 --> 00:39:30,310 going to have to make more stuff, OK? 877 00:39:30,310 --> 00:39:34,870 We're going to have to make more q or more valuable q, OK? 878 00:39:34,870 --> 00:39:37,510 Now, given our amount of labor, that's 879 00:39:37,510 --> 00:39:41,860 either going to happen through more K, through more capital, 880 00:39:41,860 --> 00:39:47,230 or through a faster A, through faster innovation. 881 00:39:47,230 --> 00:39:51,250 So, ultimately, what determines our standard of living-- 882 00:39:51,250 --> 00:39:53,800 that is what determines how much shit we have 883 00:39:53,800 --> 00:39:56,350 for a given amount of work-- 884 00:39:56,350 --> 00:39:59,560 is going to be how much we save and how innovative we are. 885 00:39:59,560 --> 00:40:01,960 I'm sorry, back, how much capital we have 886 00:40:01,960 --> 00:40:03,075 and how innovative we are. 887 00:40:03,075 --> 00:40:05,200 Capital it turns out is going to come from savings. 888 00:40:05,200 --> 00:40:06,200 I sort of cheated there. 889 00:40:06,200 --> 00:40:08,110 We're going to talk about that in about-- 890 00:40:08,110 --> 00:40:11,100 about maybe 12 lectures from now. 891 00:40:11,100 --> 00:40:12,850 We'll talk about where capital comes from. 892 00:40:12,850 --> 00:40:15,370 The hint is capital comes from how much we save, 893 00:40:15,370 --> 00:40:17,140 and I'll explain why that is. 894 00:40:17,140 --> 00:40:18,070 But our standard of living is determined 895 00:40:18,070 --> 00:40:19,180 of how much capital we have, which 896 00:40:19,180 --> 00:40:20,597 is a function of how much we save, 897 00:40:20,597 --> 00:40:23,140 but it's mostly determined by how innovative we are, 898 00:40:23,140 --> 00:40:26,890 how productive we are, how much more we can produce for a given 899 00:40:26,890 --> 00:40:29,080 level of inputs, OK? 900 00:40:29,080 --> 00:40:30,370 And, if you look at-- 901 00:40:30,370 --> 00:40:33,370 if you ask how does production go up 902 00:40:33,370 --> 00:40:35,680 given an amount of capital and labor, 903 00:40:35,680 --> 00:40:39,810 we call that total factor productivity. 904 00:40:39,810 --> 00:40:42,800 That is, conditioning on all the factors, 905 00:40:42,800 --> 00:40:47,150 how much does productivity go up? 906 00:40:47,150 --> 00:40:50,960 Now it turns out we have seen a massive shift in productivity 907 00:40:50,960 --> 00:40:53,030 in the US. 908 00:40:53,030 --> 00:40:58,970 From 1947, after World War II, to 1973, 909 00:40:58,970 --> 00:41:00,890 productivity growth in the US was very rapid, 910 00:41:00,890 --> 00:41:03,243 about 2 and 1/2% a year. 911 00:41:03,243 --> 00:41:05,410 What that meant-- let's think about what that meant. 912 00:41:05,410 --> 00:41:08,050 That meant, not doing anything else, 913 00:41:08,050 --> 00:41:10,450 working just as hard as we were working, 914 00:41:10,450 --> 00:41:14,145 we could get 2 and 1/2% more stuff every year, OK? 915 00:41:14,145 --> 00:41:16,020 That's what I mean by our standard of living. 916 00:41:16,020 --> 00:41:19,350 Literally, it's saying, working the same 40-hour week, 917 00:41:19,350 --> 00:41:25,160 every year, we got 2 and 1/2% more stuff, OK? 918 00:41:25,160 --> 00:41:29,210 However, from 1973 until the early 1990s, 919 00:41:29,210 --> 00:41:33,050 productivity growth slowed down massively down to about 1% 920 00:41:33,050 --> 00:41:34,840 a year. 921 00:41:34,840 --> 00:41:37,810 It dropped massively, OK? 922 00:41:37,810 --> 00:41:40,610 Now what happened? 923 00:41:40,610 --> 00:41:44,360 Well, one thing that happened is we started saving less. 924 00:41:44,360 --> 00:41:45,625 K went down. 925 00:41:45,625 --> 00:41:47,750 K is driven by savings, and we started saving less. 926 00:41:47,750 --> 00:41:50,760 We save a lot less than other nations. 927 00:41:50,760 --> 00:41:52,423 But, in fact, that's not much of it 928 00:41:52,423 --> 00:41:54,090 because, even though we don't save much, 929 00:41:54,090 --> 00:41:56,150 productivity jumped again in the-- 930 00:41:56,150 --> 00:41:59,520 about from 1995 to 2005, productivity 931 00:41:59,520 --> 00:42:03,890 jumped again and went up again to about 2 and 1/2% a year. 932 00:42:03,890 --> 00:42:07,250 And, essentially, we felt, ah, this is the IT boom. 933 00:42:07,250 --> 00:42:10,410 OK, computers were around since the 1970s. 934 00:42:10,410 --> 00:42:12,670 And, throughout the late 1980s and early 1990s, 935 00:42:12,670 --> 00:42:14,462 people kept saying where's the productivity 936 00:42:14,462 --> 00:42:15,360 gain from computers. 937 00:42:15,360 --> 00:42:18,540 And it appeared to show up in the mid 1990s. 938 00:42:18,540 --> 00:42:21,195 Suddenly, things got more productive in the mid 1990s 939 00:42:21,195 --> 00:42:24,860 to the mid 2000s, OK? 940 00:42:24,860 --> 00:42:27,260 Productivity rose to about 2.3% a year. 941 00:42:27,260 --> 00:42:30,230 But, much to our chagrin, productivity 942 00:42:30,230 --> 00:42:32,690 has stopped growing rapidly, and it's back to about 1 943 00:42:32,690 --> 00:42:34,130 and 1/2% a year. 944 00:42:34,130 --> 00:42:35,960 So we're not as slow as we were. 945 00:42:35,960 --> 00:42:41,885 So we were-- so, from 1947, '47 to '73, we grew 946 00:42:41,885 --> 00:42:44,140 at about 2 and 1/2% a year. 947 00:42:44,140 --> 00:42:47,117 '73 to '95, it was about 1% a year. 948 00:42:47,117 --> 00:42:48,950 So that meant, with the same amount of work, 949 00:42:48,950 --> 00:42:51,790 we only got 1% more stuff, OK? 950 00:42:51,790 --> 00:42:56,330 '95 to '05, we went up to about 2.3%. 951 00:42:56,330 --> 00:42:57,860 We jumped back up. 952 00:42:57,860 --> 00:43:02,727 But, since '05, we're down at about 1.5%, 953 00:43:02,727 --> 00:43:04,310 so better than we were at our minimum, 954 00:43:04,310 --> 00:43:09,850 but not nearly as high as we were at our peak, OK? 955 00:43:09,850 --> 00:43:12,540 So, basically, this raises three key questions. 956 00:43:12,540 --> 00:43:13,504 Yeah? 957 00:43:13,504 --> 00:43:15,640 AUDIENCE: How is that productivity measured? 958 00:43:15,640 --> 00:43:17,140 JONATHAN GRUBER: Oh, great question. 959 00:43:17,140 --> 00:43:20,560 So, basically, we look at, essentially, a way-- 960 00:43:20,560 --> 00:43:22,388 roughly speaking, we look at how much 961 00:43:22,388 --> 00:43:24,430 stuff gets produced given how many hours of labor 962 00:43:24,430 --> 00:43:26,380 there are submitted to the economy. 963 00:43:26,380 --> 00:43:27,760 Roughly speaking, we say how much do people work. 964 00:43:27,760 --> 00:43:28,802 How much stuff gets made? 965 00:43:28,802 --> 00:43:30,830 Boom, that's productivity, nothing super fancy. 966 00:43:30,830 --> 00:43:31,330 Yeah? 967 00:43:31,330 --> 00:43:32,240 AUDIENCE: I might have missed it, 968 00:43:32,240 --> 00:43:33,520 but what does TFP stand for? 969 00:43:33,520 --> 00:43:35,312 JONATHAN GRUBER: Total factor productivity. 970 00:43:35,312 --> 00:43:37,365 That's productivity controlling for capital. 971 00:43:37,365 --> 00:43:38,740 But the productivity numbers here 972 00:43:38,740 --> 00:43:40,157 are not total factor productivity. 973 00:43:40,157 --> 00:43:42,710 They're just labor productivity, allowing capital to change. 974 00:43:42,710 --> 00:43:43,210 Yeah? 975 00:43:43,210 --> 00:43:45,835 AUDIENCE: You said that K would decrease when people save less. 976 00:43:45,835 --> 00:43:48,290 But, if you save less, isn't your spending someone else's 977 00:43:48,290 --> 00:43:48,840 likely [INAUDIBLE]? 978 00:43:48,840 --> 00:43:49,210 JONATHAN GRUBER: You know what? 979 00:43:49,210 --> 00:43:50,380 I don't want to go there. 980 00:43:50,380 --> 00:43:52,030 We're going to spend a whole lecture on that. 981 00:43:52,030 --> 00:43:52,980 So I don't want to go there. 982 00:43:52,980 --> 00:43:54,000 K depends on savings. 983 00:43:54,000 --> 00:43:55,140 Just take that as a given for now, 984 00:43:55,140 --> 00:43:56,307 and we'll come back to that. 985 00:43:56,307 --> 00:43:58,710 We'll spend two lectures on it actually, OK? 986 00:43:58,710 --> 00:44:00,800 Now I want to raise three questions, 987 00:44:00,800 --> 00:44:03,840 before we go, about these facts, OK? 988 00:44:03,840 --> 00:44:08,295 The first question is why didn't the IT revolution 989 00:44:08,295 --> 00:44:10,920 and the computer revolution lead to longer lasting productivity 990 00:44:10,920 --> 00:44:11,950 gains? 991 00:44:11,950 --> 00:44:16,290 Why did productivity slow back down after 2005, OK? 992 00:44:16,290 --> 00:44:17,820 We don't really know. 993 00:44:17,820 --> 00:44:20,340 Folks thought that computers would be the next Industrial 994 00:44:20,340 --> 00:44:21,330 Revolution. 995 00:44:21,330 --> 00:44:22,955 This was going to be a-- this was going 996 00:44:22,955 --> 00:44:24,930 to transform our lives, OK? 997 00:44:24,930 --> 00:44:28,440 It looks like what it mostly did is transform how we watch porn, 998 00:44:28,440 --> 00:44:29,700 OK? 999 00:44:29,700 --> 00:44:34,020 And, basically, it looks like, in terms of productivity, 1000 00:44:34,020 --> 00:44:37,020 it did not actually change things that much. 1001 00:44:37,020 --> 00:44:40,043 And we don't quite know why, but it is still a bit worrisome 1002 00:44:40,043 --> 00:44:42,210 that, in terms of the long run, that, in some sense, 1003 00:44:42,210 --> 00:44:46,621 there wasn't longer lasting gains from innovation. 1004 00:44:46,621 --> 00:44:48,788 If it's a question about porn, I'm not answering it. 1005 00:44:48,788 --> 00:44:51,180 [LAUGHTER] 1006 00:44:51,180 --> 00:44:53,430 AUDIENCE: Maybe with like how, if you pull more people 1007 00:44:53,430 --> 00:44:55,508 into like a team, working on team projects, 1008 00:44:55,508 --> 00:44:58,050 the rate at which the project is worked on tends to decrease. 1009 00:44:58,050 --> 00:44:59,920 JONATHAN GRUBER: You know, there's lots of theories. 1010 00:44:59,920 --> 00:45:01,470 We could hypothesize all day about why it is. 1011 00:45:01,470 --> 00:45:02,845 I'm just going to state the facts 1012 00:45:02,845 --> 00:45:05,870 and say that it's disappointing. 1013 00:45:05,870 --> 00:45:10,030 And we need to figure out what to do about it. 1014 00:45:10,030 --> 00:45:14,760 The second question this raises is how do we spend increases 1015 00:45:14,760 --> 00:45:15,480 in productivity. 1016 00:45:15,480 --> 00:45:16,840 What do I mean by that? 1017 00:45:16,840 --> 00:45:19,590 What I mean by that is, if there's 1018 00:45:19,590 --> 00:45:21,750 an increase in productivity of 2 and 1/2%, 1019 00:45:21,750 --> 00:45:24,420 that means we have 2 and 1/2% more stuff 1020 00:45:24,420 --> 00:45:26,250 for the same amount of work. 1021 00:45:26,250 --> 00:45:28,410 But why do we have the same amount of work? 1022 00:45:28,410 --> 00:45:31,490 Another way to say that is we can work 2 and 1/2% less 1023 00:45:31,490 --> 00:45:34,335 and have the same amount of stuff, roughly speaking, OK? 1024 00:45:34,335 --> 00:45:36,710 So I have assumed we work the same, and we get 2 and 1/2% 1025 00:45:36,710 --> 00:45:39,690 more stuff, but why is that the right answer, OK? 1026 00:45:39,690 --> 00:45:44,510 And, in fact, the US and Europe, since World War II, 1027 00:45:44,510 --> 00:45:47,390 have taken very different paths in this dimension. 1028 00:45:47,390 --> 00:45:49,770 In the US, we've taken all our productivity 1029 00:45:49,770 --> 00:45:53,760 and put it into cooler stuff, and we work harder than ever. 1030 00:45:53,760 --> 00:45:55,800 In Europe, they work less hard. 1031 00:45:55,800 --> 00:45:58,980 I mean, starting jobs in Europe have six weeks vacation, OK? 1032 00:45:58,980 --> 00:46:02,007 Nothing gets done in August in Europe, OK? 1033 00:46:02,007 --> 00:46:04,090 They've said-- and, you know, if you go to Europe, 1034 00:46:04,090 --> 00:46:06,398 it's a little bit more rundown, OK? 1035 00:46:06,398 --> 00:46:08,190 It's not quite as gleaming and cutting edge 1036 00:46:08,190 --> 00:46:10,395 as the US in many places, OK? 1037 00:46:10,395 --> 00:46:13,020 Basically, Europe has decided to take some of that productivity 1038 00:46:13,020 --> 00:46:15,268 increase and put it into more leisure time. 1039 00:46:15,268 --> 00:46:17,310 We've decided take all that productivity increase 1040 00:46:17,310 --> 00:46:21,420 and put it into better phones and gadgets, OK? 1041 00:46:21,420 --> 00:46:22,740 So the question is who's right. 1042 00:46:22,740 --> 00:46:23,700 We don't know. 1043 00:46:23,700 --> 00:46:25,980 But the important point is that's an open question. 1044 00:46:25,980 --> 00:46:27,030 Just because we're more productive 1045 00:46:27,030 --> 00:46:28,470 doesn't mean we should just consume more stuff. 1046 00:46:28,470 --> 00:46:30,928 There's an open question of how you spend your productivity 1047 00:46:30,928 --> 00:46:32,185 gains. 1048 00:46:32,185 --> 00:46:34,060 And then there's the final question and maybe 1049 00:46:34,060 --> 00:46:38,010 the most important, which is who actually gains 1050 00:46:38,010 --> 00:46:40,510 from productivity increases. 1051 00:46:40,510 --> 00:46:46,050 So, from 1947 to 1973, productivity went up 2.5%, 1052 00:46:46,050 --> 00:46:48,480 and virtually every group in society 1053 00:46:48,480 --> 00:46:52,340 saw their incomes go up 2 and 1/2% a year. 1054 00:46:52,340 --> 00:46:55,070 Since 1973, on average, productivity growth 1055 00:46:55,070 --> 00:46:58,130 has been about 1.5%, 1.6% on average. 1056 00:46:58,130 --> 00:47:02,150 You average these three series, about 1.6%. 1057 00:47:02,150 --> 00:47:04,760 And average incomes have only gone up 0.4%. 1058 00:47:07,430 --> 00:47:10,010 So productivity has gone up 1.6%, 1059 00:47:10,010 --> 00:47:12,470 but average income has only gone up 0.4%. 1060 00:47:12,470 --> 00:47:14,000 The difference is the gains have all 1061 00:47:14,000 --> 00:47:16,960 gone to the top of the income distribution. 1062 00:47:16,960 --> 00:47:19,800 So, basically, virtually all of the gains from 1973 until 1063 00:47:19,800 --> 00:47:22,050 a couple of years ago-- it's started to get better-- 1064 00:47:22,050 --> 00:47:24,690 essentially, the bottom 80% of people 1065 00:47:24,690 --> 00:47:27,210 saw no improvement of their standard of living 1066 00:47:27,210 --> 00:47:30,687 over a 45-year period, whereas the top 20% 1067 00:47:30,687 --> 00:47:31,770 saw a massive improvement. 1068 00:47:31,770 --> 00:47:33,605 And, even within that, the top 1% 1069 00:47:33,605 --> 00:47:34,980 saw a really massive improvement. 1070 00:47:34,980 --> 00:47:37,770 And, even within that, the top 0.1% and 0.01%, 1071 00:47:37,770 --> 00:47:40,230 et cetera, saw massive improvements. 1072 00:47:40,230 --> 00:47:44,340 So, as a result, in 1995, the richest 10%-- 1073 00:47:44,340 --> 00:47:47,400 or the richest 10% of the population 1074 00:47:47,400 --> 00:47:49,380 earned 15% of the income. 1075 00:47:49,380 --> 00:47:52,700 Today, it's close to 25% of the income. 1076 00:47:52,700 --> 00:47:53,700 It's getting even worse. 1077 00:47:53,700 --> 00:47:58,080 Since 2009, if you look from 2009 to 2016-- 1078 00:47:58,080 --> 00:47:59,340 I don't have it updated-- 1079 00:47:59,340 --> 00:48:00,840 and you look at all the money that 1080 00:48:00,840 --> 00:48:05,790 was made in society, on net, all of it went to the top 1%. 1081 00:48:05,790 --> 00:48:06,810 What do I mean by that? 1082 00:48:06,810 --> 00:48:10,680 The top 99% were, in 2016, in the same place 1083 00:48:10,680 --> 00:48:14,220 they were in 2009, even though the economy had grown. 1084 00:48:14,220 --> 00:48:17,320 And all the growth went to the top 1%. 1085 00:48:17,320 --> 00:48:19,360 So we're actually in an interesting world 1086 00:48:19,360 --> 00:48:21,100 here where productivity gains by itself 1087 00:48:21,100 --> 00:48:23,440 may not be enough if we care about what 1088 00:48:23,440 --> 00:48:25,210 it does to the average standard of living. 1089 00:48:25,210 --> 00:48:26,877 And that leads to a very interesting set 1090 00:48:26,877 --> 00:48:28,400 of issues around equity and fairness 1091 00:48:28,400 --> 00:48:30,730 that we'll spend time on later in the semester. 1092 00:48:30,730 --> 00:48:33,220 But I want to raise that issue, both that productivity 1093 00:48:33,220 --> 00:48:35,953 gains can be spent in different ways on goods and leisure, 1094 00:48:35,953 --> 00:48:37,870 and they can be distributed in different ways. 1095 00:48:37,870 --> 00:48:38,800 And those are the sorts of things 1096 00:48:38,800 --> 00:48:40,467 we need to be thinking about as we think 1097 00:48:40,467 --> 00:48:42,070 about economic policy, OK? 1098 00:48:42,070 --> 00:48:43,520 So let me stop there. 1099 00:48:43,520 --> 00:48:45,010 We'll come back-- 1100 00:48:45,010 --> 00:48:46,510 I guess no section on Friday, right? 1101 00:48:46,510 --> 00:48:47,770 It's an MIT holiday. 1102 00:48:47,770 --> 00:48:49,650 And we'll come back on Monday and talk more 1103 00:48:49,650 --> 00:48:51,600 on producer theory.