Chapter 3: National Income: Where it Comes From and Where it Goes. CHAPTER 3 National Income. slide 0

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1 Chapter 3: National Income: Where it Comes From and Where it Goes slide 0

2 In this chapter, you will learn what determines the economy s total output/income how the prices of the factors of production are determined how total income is distributed what determines the demand for goods and services how equilibrium in the goods market is achieved slide 1

3 Figure 3.1 The Circular Flow of Dollars Through the Economy Mankiw: Macroeconomics, Sixth Edition Copyright 2007 by Worth Publishers slide 2

4 Flow of dollars among the economic actors. Market for goods and services represents total production (=GDP). Note that Y=C+I+G (we assume a closed economy for simplicity). Recall that in the simplified circular flow, we assumed Y=C. slide 3

5 Any excess tax revenue over government spending is called public saving If public saving > 0 budget surplus (or fiscal surplus) Public saving < 0 budget deficit (or fiscal deficit) This chapter develops a model to explain the interactions depicted in this figure. slide 4

6 Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C, I, and G Equilibrium goods market loanable funds market slide 5

7 Factors of production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers slide 6

8 The production function denoted Y = F(K, L) shows how much output (Y ) the economy can produce from K units of capital and L units of labor reflects the economy s level of technology exhibits constant returns to scale slide 7

9 Returns to scale: A review A production function has constant returns to scale property if an increase of an equal percentage in all factors of production causes the output to increase by the same percentage. slide 8

10 Returns to scale: A review Initially Y 1 = F (K 1, L 1 ) Scale all inputs by the same factor z: K 2 = zk 1 and L 2 = zl 1 (e.g., if z = 1.25, then all inputs are increased by 25%) What happens to output, Y 2 = F (K 2, L 2 )? If constant returns to scale, Y 2 = zy 1 If increasing returns to scale, Y 2 > zy 1 If decreasing returns to scale, Y 2 < zy 1 slide 9

11 Example 1 Suppose you produce 10 pizzas/hour with 2 ovens and 6 workers Let s increase each factor of production by 50%: 2 + 2(0.5) = (0.5) = 9 Output increases by 50% under CRS: 15 pizzas/hr. Here z = 1.5 (for a 50 % increase) slide 10

12 Example 2 F( K, L) KL F( zk, zl) ( zk)( zl) 2 z KL z 2 KL z KL z F( K, L) constant returns to scale for any z > 0 slide 11

13 Example 3 F( K, L) K L F( zk, zl) zk zl z K z L z K L z F( K, L) decreasing returns to scale for any z > 1 slide 12

14 Example 3 F( K, L) K L 2 2 F( zk, zl) ( zk) ( zl) 2 2 z K L z 2 increasing returns F( K, L) to scale for any z > 1 slide 13

15 Now you try Determine whether constant, decreasing, or increasing returns to scale for each of these production functions: 2 (a) K F( K, L) L (b) F( K, L) K L slide 14

16 Answers (a) Constant returnds to scale for any z>0 (b) Constant returnds to scale for any z>0 slide 15

17 Assumptions of the model 1. Technology is fixed. 2. The economy s supplies of capital and labor are fixed at K K and L L slide 18

18 Assume that the factors of production are fully utilized (i.e. noting is wasted) the entire capacity of the economy is used in production. Assume the factors of production are owned by households. slide 19

19 Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: Y F( K, L) slide 20

20 The distribution of national income determined by factor prices, the prices per unit that firms pay for the factors of production wage = price of L rental rate = price of K slide 21

21 Notation W R P = nominal wage = nominal rental rate = price of output W /P = real wage (measured in units of output) R /P = real rental rate slide 22

22 Notes The nominal wage & rental rate are measured in currency units. The real wage is measured in units of output. To see this, suppose W = $10/hour and P = $2 per unit of output. Then, W/P = ($10/hour) / ($2/unit of output) = 5 units of output per hour of work. It s true, the firm is paying the workers in money units, not in units of output. But, the real wage is the purchasing power of the wage - the amount of stuff that workers can buy with their wage. slide 23

23 How factor prices are determined Factor prices are determined by supply and demand in factor markets. Recall: Supply of each factor is fixed. What about demand? slide 24

24 Demand for labor Assume markets are competitive (i.e. there are many other firms producing the same product) : Hence, the firm s market share is very small : the firm is a price taker (i.e. cannot influence the prices). each firm takes W, R, and P as given. Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit. cost = real wage benefit = marginal product of labor slide 25