The Structure of Production

0:00Okay, we have to get going here because the term is suddenly approaching its end and I've got a lot of stuff to cover. And so the next step is to talk about prices of consumer goods and prices in general. We talked about the theory of the firm, competition, and alleged monopoly, etc. And the last phase here is to talk about prices of factors of production and the different factor markets. Prices, factors of production, of course, are different kinds of labor, different kinds of land and different kinds of capital goods. So everything has a price, wage rates are the price of labor, price of machines, price of raw materials, etc., etc., price of land, rents of land, all these things are prices per unit of factors of production.

0:53Of course, the prices of factors of production are determined by demand and supply just like consumer goods. In other words, you have the price on the y-axis, quantity on the x-axis, in this case quantity purchased or hired, so we now have alpha, alpha meaning any of the, remember alpha, beta, and gamma, dot, dot, dot are the factors of production, so we have prices So these are the factors of any factor, quantity here. And we have a falling demand curve and a supply line, which is vertical in the short run. Except that for labor, as we'll see, it doesn't really go down on the x-axis because nobody's going to work for one-half a penny per hour, so it goes something like that.

1:43So at any rate, so we have a supply curve and we have a demand curve and the intersection of supply and demand again determine the price at any given time because like with consumer goods the price is higher than the equilibrium point, then you have a surplus, unsold surplus of labor or land or capital, unsold surplus of labor is unemployment we've seen with minimum and if the price is below the free market level there will be a shortage of labor, land or capital and the price will be driven up to the equilibrium point where supply and demand are equal. So it works just like consumer goods. The difference is try to find out what determines the falling demand curve, the shape of it.

2:31What determines the falling demand curve, the shape of the demand curve of consumer goods we know is the lower diminishing marginal utility. What determines the fact that there's a production? That's the next step. In other words, we know it's falling. We know that if a worker asks for 20 cents an hour, it's going to be more if the worker is going to be higher than if he asks for 50 dollars an hour. So the question is what exactly determines the shape of the demand curve, because it's not the utility to the consumer here. In this case, the bottom line is how much the employer thinks he will Okay, so our next task is to figure out the demand curve for factors of production, specifically we know it's falling, we now have to integrate it into the rest of the system here, and how it's related to prices and production and productivity and demand for consumer goods.

3:30Okay, remember the production function, and we go back to the production function, alpha of x combined with beta of y combined with gamma of z yields a certain quantity of the product r. We used this before to show that the production function is linear and homogeneous and that If you multiply each one by n, you get n times the product, so you think you'd have a constant average cost curve, but it's not really constant because you can't, because of indivisibility, you can't multiply everything by n. You can't multiply railroad tracks the same way you can multiply pins and gears and whatever, and paper clips.

4:16As a result, you had a falling average cost curve, or a U-shaped average cost curve. So that's how we used the production function before. We're not going to use it in a different way. What we're going to do now is to freeze beta, gamma, etc. and see what happens when alpha is varied. What happens to quantity? What happens to product? When you vary one factor of production, keeping the others constant. In other words, this is a different use of the production function. We're now taking, this is a variable factor, these are given, frozen, so to speak, and whatever quantity you freeze it at and see what happens to the product when you do that. Classically, when English economics more or less begins in late 18th century, when Britain was agricultural, the usual example is you take a fixed amount of land, fixed amount of capital goods, say wheat farm, and you vary the number of laborers and see what happens to production.

5:16You don't have to go out and test it because it's really, it's a question of logic, we'll see. It's pure logic. It's a logic of cause and effect. Okay, the So now we start, we have alpha, the variable factor on the x-axis, quantity, a variable factor. We have quantity produced on the y-axis, physical production, units, whatever it is, year shifts, cars, loaves of bread, wheat, whatever it happens to be. B. Okay, and we freeze, then, beta, gamma, except for a constant. These are given. We're varying alpha. Well, if there's zero, again, we start at the point of origin. There's no workers. If you have a wheat field with lots of acres of fertilizer and capital equipment, you know, machines, agricultural machines, and no workers, nothing's going to happen.

6:06It'd be zero product. Zero alpha, zero product. You start at the point of origin. You can't You can't produce negative bushes of wheat. Obviously you have to go up from here. So it goes up. As you increase the number of workers, using workers is the classical way to do it, easy way to do it. You have one worker on 100 acres with all the equipment and you produce more than zero. You keep going. What you're measuring here in particular is So the quantity per unit, per worker, in other words, you start, this is physical units. So you're interested now in particular in how many bushes of wheat per worker you're producing.

6:53At zero, you produce zero, of course. At one, you produce a certain amount and keep going up. And this is also called average physical product, in other words, product per acre or product per worker or whatever happens to be. to be the physical product per the variable factor. So you go up and the basic law of economics in this case, technology or economics, really law of cause and effect, is that at some point Q over alpha will reach a maximum. This is known as the law of returns, a law of physical productivity, law of diminishing In other words, as you increase alpha, starting with zero, at some point, APP falls, you know, starts falling, reaches a peak, starts falling.

7:55In other words, you can't increase APP forever. You're not saying when this is going to happen, but at some point this is going to turn down. Now how do you prove this? How do you prove this law here that at some point, as alpha increases, average product starts flowing. If it didn't start flowing, you do it by proving the opposite, showing the opposite is absurd. If it didn't start flowing at some point, it means you can increase average product forever. In other words, you can take, let's say you have 100 acres, you want to have more wheat, you're stuck with 100 acres and you're stuck with the same amount of capital and fertilizer and whatever, you know, raw material, et cetera. You can keep increasing the number of wheat as much as you want, but just by pouring more workers in.

8:44Two million workers on 100 acres of land, you can still just keep increasing. Obviously it's ridiculous, you can't do it. You reach a point, everybody's falling all over themselves, they can't even walk, okay? So, it starts turning down. This is APT, or Q over alpha. Now, if it didn't happen, look at the implications, if it didn't start turning down, it would mean that there's no such thing that all factors are perfectly substitutable for other factors. In other words, if you don't have much land, you don't have much capital, you could turn out the same amount of product forever by simply pouring in more workers. Or the other way, if you have only Only one worker can keep adding more land and somehow get more, get more, wait forever. So this would imply that all factors are perfectly, perfect substitutes for each other.

9:31Obviously, they're not perfect substitutes, otherwise you'd have only one factor in the whole world. You don't have only one factor, you've got lots of factors, lots of things which are partially substitutes. You can have less workers and more capital and still have the same equipment. You can't have no workers and all capital. In other words, you get to the point where many things are fairly close substitutes but they're not perfect substitutes. If they were perfect substitutes, they would be the same thing. So the fact that there's more than one factor in the world of production means that there are no perfect substitutes. And therefore, you get to the point where the productivity goes down as you freeze the amount of, as you keep changing the proportion, as you freeze beta, gamma, etc. and keep pouring So this is the law of cause and effect, the basic philosophic law applied to all production.

10:24Some economists don't realize this, they keep trying to test this, they go out and they actually add more workers, they have a little experiment, of course experiment always works because it has to, it's a law of logic, it's really a law of reality, it doesn't need to be confirmed all the time, it's the way life is. Okay, so the average productivity keeps falling, at one point it starts falling. It can never get negative, okay? You can never have minus one or minus five bushels, but it can get pretty low as you keep going.

10:58Now let's look at our, remember our old average marginal relationship here. For every average there's a marginal. Marginal. For every average of height, there's a marginal guy coming in, a marginal basketball player, a marginal midget, that changes the average. In other words, at the point when average is going up, marginal is higher than average. Marginal physical product, which is defined as delta Q divided by delta alpha. In other words, if you add one more worker, how many more bushes of wheat will it bring in? So, average productivity is Q divided by Alpha, bushes of wheat divided by number of workers in this case. Marginal physical product is the increased amount of wheat, or they've decreased in some cases, for adding one more worker. So marginal, when average is increasing, you remember, when average goes up, increases, marginal is always higher than average. So we have, it goes something When an average is falling, the marginal is below the average.

12:03When the average is at a peak, the marginal is equal to the average. So it cuts in like something like this. This will be the marginal physical product, delta Q divided by delta alpha. A marginal product can get negative. If you keep going, and you have two million people trying to produce wheat and a hundred Bakers. If you add one more work, you'll have less product. In other words, you'll wind up with even less product than you had before. So, MPP can get below zero. You can cut the x-axis. APP can't. In other words, you can't have negative bushels for the whole product, but you can produce less bushels than you did before. So, eventually, it goes below it. So, this is our, these are the productivity curves. They don't have to be smooth or whatever.

12:54We're not assuming that. We're simply assuming it goes up, reaches a peak and has to reach a peak because it eventually starts falling, and marginal then goes up faster and earlier, cuts down, and the same as the average at the peak of the average. Okay, now if you're looking at where an employer will tend to use factors of production, a wheat farmer or a computer producer or whatever, where are they going to tend to use these people or these factors? They're obviously not going to use, nobody, quiet please, nobody worth as, nobody with any smarts at all is going to employ people, hire another worker In order to produce less wheat, obviously idiotic, you're paying somebody, you're winding up a few less pushes of wheat than you had before, so nobody is going to produce in this zone here.

13:52We mark out the zones, let me make this a little larger. Here's physical units, Q, here's alpha, it starts at the point of origin, goes down like that, it's really about the same, anyway. Nobody's going to produce in this zone here, zone three, in other words, nobody's going Nobody's going to produce in a zone where MPP is negative.

14:45So this is a verboten area, in other words, this is an area where nobody's going to employ any factors of production. You hire one, you pay money and get less production. In the same way, nobody's going to produce on the line here. If they know what the line is, nobody's going to hire another worker and get zero increase in product. That's obviously ridiculous, too. You're paying out good money and getting no benefit for it. So, this means that the line here, plus the zone three, is a forbidden zone. Nobody's going to employ factors of production, land, labor, or capital in that area. Now, I'm going to try to demonstrate. This is much more tricky. This is pretty obvious. Zone 3 is a forbidden zone and we're trying to demonstrate, which is much trickier, is in the same way this zone here is also forbidden.

15:35The problem in Zone 3 is you've got too many workers in relation to the amount of capital and land you've got. You've got an excess amount of workers per other factors. Similarly here, you've got, still you have an excess, you have the marginal physical productivity of workers is negative here and zero here. So you're not going to produce in that area. In the same way, in this zone here, you have so few workers, there's too few workers and too much, you have an excess amount of land and capital compared to the number of workers. So in this zone, zone one, you have a negative marginal physical productivity for the fixed factors, for land, capital, etc. And here you have zero physical productivity, fixed factors. So in the same way, nobody's gonna produce in this area either. This would be tougher to demonstrate. But it's the other side of the coin. In other words, here you have like one worker and 10,000 acres and lots of equipment.

16:26If you're operating in this area, you have two workers or whatever, one worker. Everybody's going to be rushing around trying to use everything. You'll wind up with less production if you had half the number of land or half the number of machines. Everybody's going to be racing around trying desperately to use it. You decrease your productivity by doing that. and doing that. If you had half the number of machines and half the amount of land, you have a higher physical product. So, to try to demonstrate this, I'm going to take an example I just made up this morning. It's easy to do it. Just take your own example. I'm going to have a table in the area of this area here, which is rising average physical product. Well, average physical product is rising, or is it a peak?

17:15So, let's take a typical table here. Here's alpha, here's the quantity, the product. Zero, zero, you start with a point of origin. So we want to have a zone, describe a zone, figures for a zone of rising average physical product. This is Q over alpha, which is APP, and so let's make this 1, let's say this is 2, 6, 3, 12, 4, 16, 5, 18. In other words, what I'm describing here is an average physical product which starts going up, this is 2 here, 6 divided by 2 is 3, 4, reaches a peak here and then starts falling.

18:03Now here's 3.6. This is our Q over alpha curve. So what I'm saying is this zone here is a forbidden zone. No factor is going to be employed in this zone. The MPP, which is delta Q over So delta alpha is 2 minus 0 is 2, 4, 6 minus 2 is 4, 12 minus 6 is 6, 6 minus 12 is 4, 18 minus 6 is 2. Here we see the marginal physical product reaches an earlier peak, which is a peak here instead of here, which is more or less a peak there, at least a secondary peak. And it starts falling and intersects here and goes below it.

18:52Okay, let's demonstrate the craziness of this zone here, this whole system of why nobody's going to be employed and no factors are going to be employed in this zone. What we're saying here is this, we're taking, take this. We're saying if you take four of alpha, four units of four workers and combine it with fixed factors, whatever they are, beta, gamma, etc. Then, you wind up with 16 units of the product, 16 bushes of wheat or whatever it is. So, and we're also saying that 2 units of alpha, combined with beta, gamma, etc. will yield 6 units.

19:45But, if you take these, if you take, remember our Law of Linear Homogeneous Factors of Home Production Function, if you take two units of alpha here and combine it with all this divided by two, beta, gamma, etc. divided by two, 2, you should get 8. In other words, you cut everything in 2. And you'll then get 2 units of alpha divided by, the fixed factors over 2 gives you 8 units, whereas 2 units of alpha divided by beta, I mean, combined with beta, gamma, etc. gives you 6 units. In other words, you increase your production by cutting the amount of fixed units in half. It's obviously crazy. You're not going to do that. You're not going to be in this area where you have, you're hiring or buying fixed units and using them, which decreases your production by 2, by two units. In other words, what you're doing is you have an excess amount of fixed units.

20:39If you cut the fixed units in half, you'll have more production than you had before. So this is a way of describing this situation. Going on the linear homogeneous production function, you're overloaded with fixed units. You cut them in half, you get more with two alpha than you do with twice as much. So therefore, nobody will operate in this zone. You just Eliminate, get out of the zone fast, we have a negative marginal productivity of fixed units, fixed factors. So this means that all factors will be employed in this zone here, zone 2. It's also why it's called the law of diminishing returns. Every factor will be employed in an area where it's average productivity, what's the definition of the area?

21:27It's the area of the zone where APP is falling, it's declining, and where MPP is greater than zero, this means in this area here where the average physical production is declining, marginal physical production is also declining but greater than zero, you're not going to go into this area where zero or negative. So these are the two definitions or conditions of zone two. You're producing Using enough of a variable factor, so that the APP is declining, but not too much of the marginal MPP gets zero or below it. All factors of production, all labor, all land, all capital goods, whatever, will be employed in zone two.

22:17Given, of course, the technological knowledge and all the other conditions, this is all using the maximum, you're trying to use your maximum productivity, which is the same thing is using a minimum cost, we're trying to keep the average cost envelope, excuse me, the total cost envelope as low as possible. So then we've now established that every factor will be employed on zone two. Now we're trying to get to the, so every factor will be employed on the area of diminishing Diminishing Marginal Physical Productivity and Diminishing Average Physical Productivity Now we're trying to get from this, from average physical product, marginal physical product, to revenue product.

23:12In other words, remember the whole purpose of producing something is not to produce the actual wheat, but also for the employer or the businessman to make money out of it, to get income. So he's interested in taking the weed and selling it, so therefore the demand curve now comes in, the demand curve for weed now comes into the picture. We integrate this whole thing, we have, so what we have now, we have the falling demand curve, we know there's a falling demand curve for the actual product, for weed or whatever happens to be the fellow selling. And marginal revenue, of course, is also falling below it. and uh... we're now interested in the marginal and average revenue product they take marginal revenue product the marginal revenue product is defined as how much money we brought in, how much revenue we brought into the firm for one more hiring, one more worker or one more acre of land, renting out one more acre of land or whatever, so

24:07this is delta TR divided by delta alpha I'm trying to get at this what you do is You take, now delta TR over delta alpha depends on how much money, in other words, how much money, how much revenue one more worker will add to the, bring into the firm, whether it's a wheat firm or a computer firm or whatever, it depends on how much you'll produce and how much the thing will be sold for. So, we have a marginal physical product is delta Q divided by delta alpha.

24:54Marginal revenue is how much the next unit of wheat or computers or whatever will bring in total revenue. That's delta to the firm, delta TR divided by delta Q. In other words, we already talk about marginal revenue, that's underneath the demand curve. The demand curve is average revenue, that's TR divided by Q, and marginal revenue is how how much more revenue is brought in by one more bushel of wheat or one more loaf of Wonderbread or one more computer or whatever that's being sold. So we take then the marginal physical product, our new concept, multiply it by marginal revenue and we'll get the marginal revenue product as a factor, in other words, these things, this cancels out and we wind up with delta TR divided by delta alpha.

25:50So, the marginal revenue product of each worker, the same way with average revenue products, I'm not that interested in average revenue products, same thing. Average revenue product is ARP is squared by alpha, that will equal APP, which is Q Q over alpha times average revenue, which of course is a man curve, which is TR divided by Q. Let's cancel that and we have TR over Q, or average revenue product. So we do it in other words, we multiply the physical product by the revenue and we get the revenue product. So in the case of marginal revenue product, multiply marginal physical Now, since, now we have the thing with the employer's interest in finding that, if he buys one more machine or rents one more piece of land or hires one more worker, how much money will he get out of this?

26:57How much income will this bring in? How much revenue will it bring in? And now we at least conceptually know what it is. We multiply the physical product by the revenue, by the marginal revenue. And we know the marginal revenue is falling, okay, at all times, because the average revenue is falling. We know the demand curve is falling, we know the marginal revenue is falling, we also know at this point the marginal physical product is falling, because everything is employed in that zone, okay. So if this is falling and that's falling, then the total must fall. In other words, you have two falling curves, you multiply them and you wind up with another falling curve. We now have another set of curves here.

27:44We have in Zone 2, which is now what we're interested in, the relevant zone in which all factors will be employed, we have falling average revenue product and falling marginal revenue product. for every factor and for every product. Alpha is going to be dollars now. So we've established now why the MRP curve is falling and what it's composed of, namely the physical product, MPP, times the marginal revenue, The physical product is determined by the technology and the smarts of the manager and that sort of stuff and the demand curve, the marginal revenue curve is determined by the consumer, how much the consumer values the product, how much he's willing to spend on it.

28:39This integrates the consumer and physical production, the whole law of the physical production. The final thing to demonstrate here is the NYP curve will be the demand curve for the factor, the final step here. In other words, I've established so far that the physical product, what happens to the average APP and MPP curves, why the APP has to go down, turn downward eventually, and then why every factor is going to be employed in a zone two and not in one and three, and then what determines MRP, which would be the falling MPP curve times the falling marginal revenue curve. The next, the final step is to show that this will be the demand curve for the factor for So this reason, here's an employer, let's say this is, let's say it's wage rate, but it could also apply to capital goods, prices, machine prices, machines, or rent of land, and here's wage rate, what the heck is that, why is this on, is that on, what's going on,

29:48There's some noise coming from it.

29:54The ghost machine.

30:02Here's our M-E-M-R-P curve. Marginal Revenue Product Curve for every factor, which we've seen now, has to be falling in the relevant zone. If this is a wage rate, let's say this was a given wage rate, so it was established on the market, whatever it is, say $5 an hour, and the question then is how much will the employer hire at that wage rate, say $5? I'm going to demonstrate now, he's going to hire this amount. In other words, this is 200 people. He'll be hiring 200 workers at $5 an hour for this reason. If he hires like 100 workers, the wage rate is still $5. I'm assuming the wage rate is $5 now. That's the market wage rate.

30:47At that point, the marginal revenue product for every worker, in other words, the worker will bring in to every firm, say, $7 in MRP, and it costs only $5, which means he's getting a $2 profit per worker. Well, he'll keep hiring more workers then. In other words, remember, the goal of every employer is to maximize their profits. The goal of every businessman. So if he's getting $2 for work, he's going to keep hiring more people. He's hiring more people. If he hires more, he still gets more profit, but now it's going down a little bit. Instead of $2, it's down $1.95. And he keeps going, he keeps hiring people until the surplus is eliminated. In other words, pretty good to the point where he's getting no more. He's getting, actually let's assume he's getting $5 now from each worker and he's hiring $5. That's a little peculiar because he should be getting a wee bit more.

31:34So, for the purpose of simplicity, let's assume he comes up right up to the point here, the intersection, the tangency, intersection, so that, in other words, this doesn't mean he's making no profits, it means he's getting the maximum profit, he's hiring workers until the MRP has fallen to the wage rate, then he stops, actually he'll be a little bit to the left of that, he's forgetting about that for the simplicity. So, if he doesn't hire 200, he's going to lose profits, because he's making $22 per worker until he keeps going and going, finally he's making almost nothing per worker, extra or profit, and he stops. Conversely, if he's hiring $300, let's say, he's paying out $5 an hour, he's only making $4 an hour in revenue, he's losing a buck an hour.

32:20Obviously he's not going to do that, his fire workers are not hiring him. Go quickly to the left here until he stops losing money. It's pretty obvious. So then he gets back now again to the $200. In other words, market forces will impel any employer to hire almost exactly 200 workers at a $5 wage rate, in other words, at the MRP point. If the wage rate goes up, you can hire only 100, but if he still hires 200, he can be paying out $7 an hour and making only $5, so he can be losing $2 an hour, how quickly So in other words, if you say that given the wage rate, you can hire as many workers exactly equal to the MRP, almost exactly equal, like that, that means you're defining the MRP curve as the demand curve for labor.

33:16That's what it is. Remember what the demand curve is. The demand curve of the locus is the expression of how much people will buy at any given price. The prices of a chess set of seven bucks, you buy this many chess sets, consumers. The price of six bucks, you buy this many. If it's five bucks, you buy that many. That's what a demand curve means. That's the definition of a demand curve. It's how much will be like a freeze-frame situation where you determine how much people will buy at any given price. Similarly, if the NYP curve will give you how much people will hire at any given wage, this means this is the demand curve for labor or any other factor. If this is the price This is the price of a machine, this is the demand curve for a machine, this is the rent of land, this is the demand curve for land. So in other words, the marginal revenue product curve of any factor will be the demand curve

34:04for that factor by employers, or by businessmen I should say, because anybody who uses, hires equipment or labor or buys machines or rents land or whatever. So the factor goods, the demand curve for factors will be the marginal revenue product curve of the factor. Supply curve of the factor is whatever it is, an immediate, short one or something like that, and therefore the wage rate or the price of any factor will be the intersection, as usual, of supply and demand. We're determining what the demand curve is. Supply curve is determined by what's existed. So, I don't know if you understand, you start out with $2.00 a worker. What do you mean start out? You mean down here? Well, the rate we made was $5.00.

34:50Yeah, okay. And then you hired plenty of people. Right. Do you think that we're making a profit of $2.00 a worker? Well, no, at this point you're making a profit of $2.00 a worker, extra profit. And you keep hiring people, you finally get down to the point where you're going to make no further profit than hiring one more worker. At this point here, you're making a marginal profit of $2 a worker. This is a margin. In other words, this is how much you make per worker. So you keep hiring people until you absorb and get the maximum amount of profit. In other words, here you're making $2 extra profit per worker. If you hire another worker, you're making $1.90 per worker. You keep going until you have the maximum profit. In other words, totally MRP and the wage rate are the same. The Profit is an asset, the additional profit is zero, for the next worker.

35:43This is a margin, in other words, if you stop here you are losing all of the money you could be making. How much are you getting for the next worker from this marginal unit? In other words, you're losing out of the $1.90 or $80 or $70, or the rest of it if you don't keep hiring people. Your object is not to maximize the marginal difference, marginal profit. Your object is to maximize the total profit. You can only get the largest total profit by absorbing all of this profit. That's probably the most important sticking point for students. The important thing is this is the marginal rate. This is the profit per unit worker you're getting as you keep going, as you add one more.

36:33This is not the total. Remember that. This is the margin. This point is the marginal product, the marginal wage worker or the marginal machine that you're getting.

36:47So the intersection point, supply and demand, then gives you what the wage rate actually is. So we've talked about a fulling demand curve for labor and for everything else, but we haven't decided what it is. Now we know what it is. The Marginal Revenue Product Curve for each worker or each machine or each unit. This is the so-called marginal productivity theory, it's called the marginal productivity theory of wages. What it really is, is the marginal productivity theory of all factors of production. In other words, the reason why factor of production might spend a certain amount for a machine or a rent of land, because you think it will benefit you in producing stuff for the self, the consumers. I think W. Stanley Jevin, the famous economist of the late 19th century pointed out the reason why the rent of land in Champagne country in France is very, very high, producing top quality Champagne is about $10,000 an acre or something. The rent of land in some ways

37:41in the desert is a couple of dollars an acre. The reason you're paying so much land in the Champagne country is not because, well, let's put it this way, the reason the price of Champagne is so high is not because you're paying a higher rent than Champagne land. The reason This is why you're paying such a high-rent champagne land. If you know that that champagne is worth a lot to the consumers, they'll pay a lot for it. In other words, it's the fact that this particular little area of France, the grapes grown there are of very high quality, very high-quality, great demand by the consumers. Because of that, employers and farmers, et cetera, bid up the land a great deal, bid up the rent to a very high level. So most people think that people charge a high price, let's say, because they're paying a higher That's not the reason. There's no god-given reason. There's no divine mandate that the rent has to be high in the Champaign country.

38:25It's high in the Champaign country because the product is so expensive, so high-quality, because the product has such great demand, people pay high rents for it. If the crumbier wine is somewhere else, 15 miles away, which is very cheap, the rent is low because the product is cheap. It's not the other way around. In other words, the rent is determined. The rent doesn't cause the price. But it's not a cost theory of prices. Because you have to pay a higher rent, you have to be charging a high price for the wine. You only get the high price for the wine because the consumers want it, because there's a high demand. Because there's a high demand, the scarce resources it produces, such as land, are bid up very high. So, in other words, the demand curve for this land goes way up, the price goes way up, etc., etc. So the price of the factor is determined by the marginal, by the product, by how much the product is worth to the consumer.

39:17The man curve of the consumer for the product, which then bids it up, makes a very high marginal revenue product. So price determines rent, that was the price of the product determines the rent, not the other way around. Rent is the expectation to be able to charge a high price for the product. And if, for example, these Italian wines where there was a big scandal recently, they put Poison of Italian wines My very clear prediction is that not only will the price of these wines go way down, but the rent of the land of producing them will go way down as a result. So the rent is fluctuation in accordance with how much people can get for the product. Okay, that's enough for the day. We have a lot of stuff. I'm going to spend some time recapping this stuff.

40:05And one thing is, we're having a very peculiar term as terms, you know. Next Thursday, we don't meet, because that's a Jewish holiday. What? Next Thursday. So, that's the 20th, what's today? 24th we don't meet. So Tuesday after that and Thursday after that we meet, and then, the following Monday becomes a Thursday, and a magic transformation will be engaged here at Poly, so that we will meet Monday the 5th, the 5th, is it? Yeah, Monday, May the 5th, that will be our last two hour class, no, yeah, last two hour class, which will also be our exam. In other words, our final exam will be in the last two hour class, Monday, May the 5th.

40:56Now, this is, I don't know if this is strictly kosher, but I'm doing it anyway, so you know See, there's no reason not to. This is a two hour class and the exams are a three hour exam. I never get more than a two hour exam anyway. Monday, May the 5th will be the final. Remember, that's a so-called Thursday. Thursday will be transformed magically into Monday and May the 5th. And we'll meet in this room. That will be the final. I haven't made up the final yet, but the final, one, will cover the whole term. and two, it'll be some kind of objective test, I'm not sure yet, it'll be no long essays, it'll be either multiple choice, fill in the blanks, something like that, some combination or short identification questions perhaps, like marginal, you know, in one brief paragraph what is the identifier, what's the significance of marginal utility, something like that.

41:52There'll be some, there won't be any long essays and we'll cover the whole term. So, okay, that's all I can say about it now. Any rate, so, I also have blue books, I think blue books, they stopped making blue books for a while, but I think I've now got another cache of them. I hoarded some blue books over the years, I suspected something like that would happen. Someday they'll crack down on blue books, but anyway, there's a new supply, a new supply I like the boob books. I don't know if the quality is down or not. Boob books to me. At any rate, to go through some length last Tuesday stuff, we're trying to find out, We know that all prices are formed by equaling supply and demand.

42:53In other words, the falling demand curve is a given supply line for everything. For consumer goods, for capital goods, for raw materials, for labor. Any price on the market is determined by the stock of the product, supply, a given supply at any time, and the demand for them in the minds of the buyers. In other words, the valuations, how much the buyers are willing to pay, And of course, any maximum or minimum price control will cause shortages or surpluses. So we dealt with consumer goods mostly in the first half of the term and how the demand curve has formed, the diminishing marginal utility, et cetera, et cetera. Now we're getting to producers' goods, in other words, factors of production, prices of Labor, Land, Capital Goods, Machinery, etc. We know they have a falling demand curve, we know they have a given supply, and we know also if the demand curve goes up and the prices and profits increase will be more, greater supply in a few years. The same works for

43:56labor too, of course. We'll see the labor market today. If there's a big increase in demand for plumbers, let's say, as compared to carpenters, the wage rates for plumbers will go up and people will see that, youngsters coming up and want to go into something with The plumber's wage rates start going into the plumbing occupation and the supply of plumber increases and the wage rate will fall relatively to some extent and will reach another equilibrium point. So the whole thing works for labor as well as capital goods. Of course, there are different time lags here. In other words, some occupations will take just a few months to get into it. Others will take many years, like positions or whatever. But at any rate, if you assume that the increased demand is permanent, people go into it.

44:45For example, around the late 60s and 70s, everybody and his brother and sister went to law school. It was a big craze to go to law school. I'm not knocking law school, but everybody went into it, including old pickets, former pickets and SDS pickets in college, they all wind up in law school. So of course the result was an over supply of lawyers, meaning that they were not getting the income they'd like to become accustomed to. And so, the law boom, law craze began to fall, all people started going to other stuff, computers or whatever. So, there are different waves of occupation that people got attracted to. When I was going to college, everybody went to nuclear physics, that was the big occupation. So at any rate, and it's a response basically, of course it's a response to the interest of each person, but it's also a response of the demand for it, the jobs and the wage rates, the salaries you can get.

45:36At any rate, so another question we dealt with on Tuesday is, given the factors of following demand curve for factors of production, what determines it? It's not the utility, it's not marginal utility, but that's the consumers. In other words, consumers evaluate wonder of bread or high-fi sets. Producers, businessmen, they don't buy it for their own sake. They don't hire workers to sit there and look at them. They're trying to produce a product which they hope consumers will buy. So in other words, demand for factors of production is what's called derived demand, derived from consumer demand for the product. And some, of course, some raw material is going to different products, steel and aluminum can go into dozens of different final products for the consumer. So the derived demand gets passed down from the consumer to the various stages of production, to the various factors in the demand curve.

46:28And derived demand is not automatic. It's not sort of a, you don't push a button and increase the demand. It goes, it's derived by the fact that entrepreneurs or businessmen always looking for profitable investments will say, hey, I think consumers are going to buy a lot of computers, a personal computer in the next few years, let's say. So we'll start going into the personal computer business and they start hiring engineers or whatever and building a plant and so forth and so on to produce it. Expecting, in other words, rive demand is really expected, this expectation that consumers will want to buy it, that you're catching the wave, you're catching the big wave, sometimes you catch it too late. If you're a lousy entrepreneur, you get into the business just as it's sinking into the West, just as it's declining, you enter the business. Those who have an ear to the ground and intuitively can grasp the situation will be one of the first people to be a personal computer manufacturer or whatever,

47:21and whatever the next big wave is and you have to first you have to know the market you have to have insight there's no way to teach it what's going to be the next thing ten years from now at any rate so if you expect the demand you try to catch it you're an entrepreneur and you go into the business and you hope that this will reflect the increased demand of consumers so whatever it's going to be personal something or other at least the compact disc or whatever the next thing after the Compact Disc, there's a big laser, whatever the hell it is. At any rate, so this is how the demand has arrived. It's not automatic. Many economists sort of think it was automatic. You push a button, the demand gets passed down to the structure of production. It relies on the businessmen, entrepreneurs to see, look at what's going on, to forecast correctly and to then hire the workers and build the plants and factories and everything

48:10to make this possible, to meet the demand. They don't meet it correctly, they make losses. If they meet it correctly, they make profits, inspire them to do more, have more resources going into the hands of the successful entrepreneurs and fewer resources in the hands of those who funk out and go bankrupt. At any rate, so the demand, the derived demand, the demand curve for factors of production, the derivation is through these various formulas I gave you on Tuesday, in other words, we If we look again at the production function, the fact that, and this is sort of a philosophic truth, a mathematical philosophic truth for all actions, for all uses of means to achieve ends, But a certain amount of x, factor x, combined with in a certain way, combined with in whatever way it's going to be, a certain amount of factor y, combined with a certain amount of z, will bring a dot dot dot, in other words, will bring about a certain quantity of product, Q of r, I use r because I can't use P, P usually means prices, so I'm just using r as a symbol of, do you have a question?

49:19So, that's the so-called production function, an abstract function relating means to ends. In other words, relating factors of production, combined in certain ways by managers or entrepreneurs to yield a certain amount of product. So we saw before, we used this before to show that it's linear and homogeneous by definition. Equal causes always yield equal effects. N times each amount will yield n times the product. And then we said, well this is, if that's true, how come you don't have constant average costs? Why isn't the average cost curve horizontal and flat? And the reason is because you can't multiply everything by n in practice. And in practice, these things have different degrees of indivisibility. In other words, paper clips are very divisible, you can always order twice as many paper clips. You can't have twice as many railroads very easily. You can't have twice as many factories. That's much more indivisible. So what you have is different degrees of divisibility, a small machine will be divisible, a big machine will be much less

50:23divisible, et cetera, et cetera, and you therefore wind up, you're tapping indivisibility as you increase production and therefore you have the declining cost curve and then going up because you're getting, you're eliminating a lot of these indivisibilities, you're getting to the point where you're making full use of your fixed equipment. So now what we do is, instead of multiplying everything by n, we're trying to look at each factor. What's the productivity of each factor? What does each factor contribute to the product? And the way we do it is we freeze all factors except one, we freeze beta, gamma, etc., make them as given, and we vary alpha and see what happens to the product. The alpha can be any given product, you can take any laborer, any machine, or any piece of land, vary that, we're doing this conceptually.

51:10This is what's done on the market almost automatically, interplay of the market. We're doing it conceptually. We're taking, okay, assume we freeze all the variables except one and see what happens when you vary one of them, what happens to the product. So then what we have is, on the y-axis, instead of dollars or price, we now have physical units. Bushels of wheat, high-fives, loaves of bread, whatever happens to these. The Q is on the y-axis, or physical units, I should say. And what you have in the x-axis is whatever the variable factor is, units of the variable factor, from zero up to n. So quantity of alpha is on the x-axis, and physical unit is on the y-axis, which is a leap, or loads of whatever it happens to be.

52:00You have no variable factor, then you have no product. When you start, therefore, at the point of origin, no workers, lots of land and lots of machines and lots of nothing is going to happen. As you vary the fact, if you increase the factors from zero up, product will go up, of course. You start getting some product and you keep going. This is the average product line now. Average physical product is the finest product per variable factor. In other words, you're producing wheat, you have lots of, you have workers, you have machinery, have land, you're freezing land for the moment, you're keeping those as given, keeping the equipment, machinery, the tractors, the fertilizer, all the rest of it, and the land you're keeping given, you vary the number of laborers, you start with zero, you get no product, and then this is our product per labor, in other words, what we're saying is, lately, product, average physical product will start going up from zero to something, okay?

53:00The Law of Diminishing Returns, the basic law, technological, philosophic law, so to speak, is that average physical product will eventually turn down, cannot go up forever. That's the law. In other words, the Law of Diminishing Returns is that, not that returns always diminish, but that eventually the average physical product turns downward as you keep increasing the variable factor. In other words, as As alpha increases, APP eventually declines. And the reason for that is that products are different. In fact, every factor is different. There's no perfect substitutability of factors. You can substitute to some extent.

53:45If you can have more capital goods and less workers, you can have more workers and less machines. You can have more aluminum and less steel, whatever. But the substitution is not perfect. can't be perfect because if it were perfect, it would be the same thing, only the same thing can be perfectly substitutable for itself, so to speak. Even Wonder Bread, those of us who are Wonder Bread fans, there's no perfect substitute for Wonder Bread. I mean, I can eat tasty bread, it's a substitute, but it's an imperfect substitute, it's not the same yumminess as Wonder Bread. So, as a result, there's a lot of substitutes in the world, but they're imperfect, not perfect. So, if they weren't perfect, in other words, if you had only 100 acres of land and a certain number of fertilizer machines, you could increase the amount of wheat indefinitely by just adding more workers.

54:38You have 2 million workers on 100 acres, so each produces an increasing wheat. Of course, you can't do that. One thing, the workers will get into each other's way, there will be no room to stand or walk, so the production will start declining very rapidly. So what we're saying is that, in the same way, if you have the same amount of workers, if you have 10 workers and 2 million acres, then I won't be able to use this stuff. It'll be running around like crazy, trying to sow the wheat or whatever, and as a result the whole thing will collapse. So what you have, in other words, is as you increase the variable factor and freeze the other factor, given beta, gamma, etc., as constant, and you keep increasing the variable factor, eventually APP will turn downward, start declining. It's a law which is derived from the basic knowledge of reality.

55:24It doesn't have to be confirmed empirically. Economists try to confirm empirically. Of course, it always has to be confirmed empirically. There's no way you cannot have this law. And to try to test it by going out to an agricultural experimental station, some of these guys, if you don't waste your time, it's okay, and you don't have to do it. So, now we have our basic average marginal relationship, if you remember, which is simply a mathematical relationship. For every average there's a marginal. In other words, if you have, as I said before a couple of weeks ago, if you're averaging the height of this class for whatever reason, if two basketball players walk in, you're going to raise the average height. In other words, the margin, for average to go up, if the average of x is increasing, that means that the marginal x, If the marginal of X is greater than the average of X, the same way if two midgets walk in, two three-footers or four-footers walk in, it's going to drag down the average.

56:26In other words, if the average is decreasing, then the marginal of X is less than the average. I talked about this when we dealt with cost, but the same thing applies to product. It's just a simple mathematical dash falls off of a relationship. And, so therefore, if these two things are true, and it's obviously true then, if the average reaches, it becomes flat for a minute, in other words, if the average is at a peak and turning, just about to turn downward, like so, or if it's at a trough and just about to turn up, like so, in other words, if the average is constant for a moment, then the The marginal has to equal the average, the only way to get from one to the other.

57:11So to look at it another way, if the average height of this class is 5'8", and two 5'8 guys walk in, the average will remain the same, in other words, the marginal is then equal to the average. So, in other words, in the case, so with costs, remember the average cost was going like that, Let's think of the U-shape for a second. The marginal cost is below it when it's decreasing, above it when it's increasing, therefore it has to cut, it intersects with the trough point when it's constant. And similarly now with, of course if you have a flat like that, it's going to intersect, you know, for the whole range. Average will equal marginal, that whole plateau, the whole flat bottom.

57:57Similarly, here, in the case of productivity, as it's called, average productivity and marginal productivity, marginal physical productivity product, which is defined as delta Q divided by delta alpha. In other words, you add one more worker, how many new brushes of wheat are you going to get? While average product is going up, it's going to be higher. It's going to go like this, MPP. And then when it's declining it's going to be lower, and when it's at its peak point it's going to be equal. So here you have your two curves, average physical product, marginal physical product, which intersects at its peak point. And if you keep going, eventually marginal physical product will cut the x-axis and be negative.

58:47The average is not, obviously, you can't have a negative average product. and all those things producing minus 20% of the week, but you can reduce, you can have, you can produce less than you did before, keep adding workers and fix the amount of capital and land, you know, wind up by adding one more worker, you get less wheat produced. Marginal product can be, and that can be negative.