Investment, Productivity, and
Profit
Learning Plan 5
Investment, Productivity, and
Profit
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Objectives:
Review definitions of factors of production
and returns to factors.
Extend the definitions of supply and demand
to the factor markets.
Predict the effects of technological change
on factor costs.
Explain what productivity and labor
productivity mean
Investment, Productivity, and
Profit
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Describe the relationship between
productivity, hourly earnings, and real
income.
Discuss those factors that will cause the
growth in labor productivity to decline.
Discuss those factors that will cause labor
productivity to increase.
Investment, Productivity, and
Profit
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Describe how changes in productivity affect
the standard of living and the
competitiveness of American products in
world markets.
Explain what profit is and explain the four
functions of profits in a market economy.
Calculate accounting profit, normal profit,
and pure economic profit and explain how
they differ.
Productivity
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Productivity: how efficiently resources are
used.
A. A measure of output per unit of input.
B. Labor productivity: measures the value of
the output produced per worker hour of input.
1. Easily measured
2. Labor accounts for about 75% of the cost
of production.
Productivity
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C. Labor productivity: is equal to GDP
divided by total employment.
Productivity, Earnings, And Real
Income
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Productivity puts an upper limit on hourly
earnings and real income.
IfMB>MC, then do it!
A. If we want to earn more per hour worked,
then we must produce more per hour.
B. Real income: what you can buy with your
money income.
Productivity Growth
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A.
B.
C.
D.
1948-1973: 2.8%
1973-1981: .7%
1981-1990: 1.0%
1990-199_: ?
Slowdown in Growth of
Productivity
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A. Slowdown in rate of capital formation.
B. Changing composition of the labor force.
1. Baby boom generation.
a. Large increase in entrants into the
labor force.
b.Fewer skills and little experience.
Slowdown in Growth of
Productivity
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2. Many women entering labor force for first
time.
3. As supply of labor increases, wages and
benefits tend to fall
a. Labor is relatively cheap.
b. Employers have relatively little incentive
to increase the productivity per worker.
Slowdown in Growth of
Productivity
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4. As labor becomes more scare, employers
have an incentive to increase productivity.
C. Declining student achievement
D. Change in composition of output.
1. Labor productivity easier to increase in
manufacturing sector than in the service
sector.
Slowdown in Growth of
Productivity
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2. Shift of demand from high productivity
manufacturing to lower productivity services
has occurred.
E. Growing government regulation.
1. Resources diverted from direct
production of goods and services to things
like pollution abatement and workplace
safety.
Slowdown in Growth of
Productivity
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2. Tax laws and regulations may
discourage innovation.
F. Drop in saving and investment.
Ways To Increase Productivity
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A. Development and application of new
production technologies
1. New processes
2. New raw materials
3. New machines
B. Better organization of production and
distribution.
Ways To Increase Productivity
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1. Group machines by function.
2. Computer aided design, computer aided
manufacturing,
3. Reduce size and complexity of
bureaucracy.
4. Cluster manufacturing.
Ways To Increase Productivity
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C. Improve labor quality.
1. More and better education and skill
training.
2. Use of work groups.
3. On-the-job training
D. Simplification of work rules and reduction
in number of job classification.
Ways To Increase Productivity
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E. Improved incentives to work and excel.
1. Workers have greater responsibility for
control over work sites and jobs.
2. Pay for knowledge system.
3. Tie pay to productivity and profit.
F. Invest more in people and equipment.
Productivity, Standard of Living,
and World Competition
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A . Higher productivity growth.
1. Production costs/units are lower.
A. Product prices are lower
2. Benefits consumers and businesses
a. Consumers: higher standard of living.
B. Businesses: better able to compete in
world markets.
Investment Spending
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A. Expected returns on investment.
1. Marginal efficiency of capital (MEC)
B. Interest rate: price businesses pay to
borrow money used to carry out an
investment project.
Factors That Influence Marginal
Efficiency of Capital
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A. MEC UP: investors optimistic.
B. MEC DOWN: investors pessimistic
C. Factors affecting MEC
1. Expectations about the level of sales
a. Sales up: increase capacity
b. Sales down: decrease capacity
2. New products: investments needed to
produce them.
Factors That Influence Marginal
Efficiency of Capital
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3. New production processes
a. Robotics and computerization
b. Fully automated production process
4. New raw materials
a. Ceramics
b. Fiber optics
c. Super conductors
d. Fiber reinforced composites
Factors That Influence Marginal
Efficiency of Capital
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5. Change in population growth rates
6. Change in tax laws
7. Change in government policy
Real Rate of Interest
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A. Stated or nominal rate of interest minus
the rate of inflation.
1. Nominal rate of interest is 8%
2. Rate of inflation is 5%
3. Real rate of interest is 3%
B. If the MEC (expected return) is high
compared to rate of investment,
businesspeople will borrow and invest.
Real Rate of Interest
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C. If the MEC (expected return) is low
compared to rate of investment,
businesspeople will not invest.
D. Businesspeople do not borrow just
because the interest rate is low, they borrow
and invest because of profit expectations.
Sources of Funds for Investment
Spending
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A. Savings
1. Personal savings
2. Business savings
a. Depreciation fund
b. Retained earnings
B. Business acquire funds through:
1. Business Savings
2. Selling bonds and stocks
3. Borrowing from banks
Crowding-Out Effect
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A. Large amount of government borrowing
reduces the funds available to private
business borrowers.
B. As U.S. Treasury sells government
securities (bonds), the sales of private
securities (stocks and bonds) are crowded
out of the financial markets.
Crowding-Out Effect
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1. U.S. government pays the higher interest
rate by raising taxes.
2. Some private firms are forced out of the
financial markets because they cannot afford
to pay the higher interest rates.
A. Private firms have a “bottom line”.
B. Government does not have to make a
profit; it just raises taxes.
Profit
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A. Share of national income by
entrepreneurs and investors.
B. Factor payment needed to draw forth the
entrepreneurial talents needed to produce
goods.
C. Cost involved in getting people to take
risks.
Four Functions of Profits
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A. Provide capital needed to maintain
existing production.
B. Attract new capital investment to firms
that need to expand.
C. Encourage risk taking
D. Encourage efficient production
Pure Economic Profit
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Pure Economic Profit equals Revenues
minus Explicit and Implicit Costs
1. Explicit costs: outlay costs associated
with purchasing or hiring resources that the
firm needs to produce a good or service.
A. Examples:
Wages and salaries
Payments for raw materials
Rent payments
Payment for power, transportation, communications
Pure Economic Profit
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b. Recorded by the firm’s accountants in
the firm’s books.
Pure Economic Profit
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2. Implicit Costs: Firm’s resources that are
not hired or not purchased and thus require
no payment to be made to anyone outside
the firm.
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A. Examples:
Self-owned resources
a. buildings
b. real estate
Self-employed resources
a. money invested
b. human energy
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Pure Economic Profit
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B. The firm’s accountants do not enter these
costs in the firm’s books.
Pure Economic Profit
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Economist versus Accountant
1. The economist’s perspective concerns the
allocation of resources.
2. The accountant’s perspective concerns an
accounting of explicit payments and receipts.
3. Economists measure costs and revenues to
decide if resources have been allocated in an
efficient manner of if gains could be realized through
reallocation of the resources.
Pure Economic Profit
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4. Explicit Costs + Implicit Costs = Economic Costs
a. When all resources used in a production process
are paid what they could earn in their next best
alternative use(opportunity cost), then accounting
and economic costs are the same.
b. When resources are not being paid their
opportunity cost, then accounting costs and
economic cost differ.
Economic Versus Accounting
Cost
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Total Revenue
$138,200
Less Explicit Costs
Parts and lubricants $80,000
Assistant’s Wages $15,000 $95,000
Accounting Profit
$43,200
Less Implicit Costs
Foregone salary:
$35,000
Foregone interest: $ 7,000
Foregone rent:
$ 1,200
Economic Profit
$0
Normal Profit
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Normal profit: Pure economic profit is zero
1. The total revenue generated by the firm is
just equal to the economic opportunity costs
of production.
2. Given a normal profit, all resources used
are being rewarded at least as well as they
would be in their best alternative uses.
Normal Profit
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3. A normal profit is the least amount of
income that a firm needs to continue its
operation in the long run.
4. Without a normal profit (an economic loss
exits), everything else remaining constant,
the owner(s) of a firm will withdraw their
resources (labor, capital, managerial effort)
and put them to use somewhere else.
Psychic Value
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Psychic value means people enjoy some
types of work more than others.
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1. If you are running a business and experiencing
an economic loss of $2,000, then using only
economic decision making, you should reallocate
your resources to some other area.
2. BUT!! If it is worth $2,000 or more to you to be
your own boss, then you are better off not
reallocating.
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Profit
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1. Accounting Profit
2. Normal Profit
3. Pure Economic Profit
Normal Profit
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When firms in an industry are earning pure
economic profits, then new firms and
resources will enter the industry as
competitors try “to get in on the action”.
Eventually, the pure economic profit (also
referred to as excess profits) will cease to
exist.
Normal Profit
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When firms in an industry are experiencing
economic losses, then firms and resources
will exit that industry.
When firms in an industry are earning normal
profits, then there is neither the entry of
additional resources into the industry nor the
exit of firms and resources from the industry.