Chapter 3 A Classical Economic ModelEconomic modelsEndogenous vs. Exogenous VariablesSlide Number 4Model EquilibriumThe Use of Multiple ModelsA Simplified Structure of the EconomySlide Number 8Outline of the model - IOutline of the Model - IIFactors of ProductionThe production function: Y = F(K,L)The Determination of InputsNotationDemand for laborMarginal product of labor (MPL )MPL and the production function Example: Diminishing marginal returnsMPL and the Demand for LaborHow factor prices are determinedThe equilibrium real wageDetermining the rental rateThe equilibrium real rental rateDetermining GDPThe Neoclassical Theory of DistributionHow income is distributed to L and KThe ratio of labor income to total income in the U.S., 1960-2007The Cobb-Douglas Production FunctionThe Cobb-Douglas Production FunctionLabor productivity and wagesOutline of modelDemand for goods & servicesConsumption, CThe consumption functionInvestment, IThe investment functionGovernment spending, GThe market for goods & servicesThe loanable funds marketDemand for funds: InvestmentLoanable funds demand curveSupply of funds: SavingTypes of savingBudget surpluses and deficitsLoanable funds supply curveLoanable funds market equilibriumThe special role of rCASE STUDY: The Reagan deficitsCASE STUDY: The Reagan deficitsAre the data consistent with these results?Chapter SummaryChapter SummaryChapter Summary0 CHAPTER 3 National Income Chapter 3 A Classical Economic Model  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 achieved1 CHAPTER 3 National Income Economic models …are simplified versions of a more complex reality  irrelevant details are stripped away  assumptions are made …are used to  show relationships between variables  explain the economy’s behavior  devise policies to improve economic performance2 CHAPTER 3 National Income Endogenous vs. Exogenous Variables  The values of endogenous variables are determined in the model.  The values of exogenous variables are determined outside the model: the model takes their values & behavior as given.  In the model of supply & demand for pizza, endogenous: P, Qd, Qs exogenous: Pm3 CHAPTER 3 National Income Figure 1.4 How Models Work Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers4 CHAPTER 3 National Income Model Equilibrium  There are usually two elements of model equilibrium  Optimization  Market clearing  Examples  Supply and demand  Inflow and outflow5 CHAPTER 3 National Income The Use of Multiple Models  No one model can address all the issues we care about.  For each new model, you should keep track of  its assumptions  which variables are endogenous, which are exogenous  the questions it can help us understand, those it cannot6 CHAPTER 3 National Income A Simplified Structure of the Economy  Households  Work and get paid  Consume and save  Pay taxes to the government  Firm  Decide on inputs and produce  Pay out factor income  Government  Collect tax revenues and pay for government purchases7 CHAPTER 3 National Income Figure 3.1 The Circular Flow of Dollars Through the Economy Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers8 CHAPTER 3 National Income Outline of the model - I  Key Assumptions:  A closed economy  Flexible prices (long-run)  Factors in fixed supply and fully utilized  Perfect competition  Market-clearing9 CHAPTER 3 National Income Outline of the Model - II  Supply side  determination of Inputs  Demand side  determinants of C, I, and G  Equilibrium  goods market  factor markets  loanable funds market10 CHAPTER 3 National Income Factors of Production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers11 CHAPTER 3 National Income The production function: Y = F(K,L)  shows how much output (Y ) the economy can produce from K units of capital and L units of labor capital: tools, machines, and structures used in production labor: the physical and mental efforts of workers  reflects the economy’s level of technology12 CHAPTER 3 National Income The Determination of Inputs 13 CHAPTER 3 National Income Notation W = nominal wage R = nominal rental rate P = price of output W /P = real wage (measured in units of output) R /P = real rental rate14 CHAPTER 3 National Income Demand for labor  Assume markets are competitive: each firm takes W, R, and P as given.  Basic idea: A firm hires an extra unit of labor if the cost does not exceed the benefit.  cost = real wage  benefit = marginal product of labor15 CHAPTER 3 National Income Marginal product of labor (MPL ) 16 CHAPTER 3 National Income Y output MPL and the production function L labor FKL( ,)1 MPL 1 MPL 1 MPL As more labor is added, MPL ↓ Slope of the production function equals MPLExample: 0246810120 1 2 3 4 5 6 7 8 9 10MPL (units of output) Labor (L) Marginal Product of Labor18 CHAPTER 3 National Income Diminishing marginal returns  As a factor input is increased, its marginal product falls (other things equal).  Intuition: Suppose ↑L while holding K fixed ⇒ fewer machines per worker ⇒ lower worker productivity19 CHAPTER 3 National Income MPL and the Demand for Labor Each firm hires labor up to the point where MPL = W/P. Units of output Units of labor, L MPL, Labor demand Real wage Quantity of labor demanded20 CHAPTER 3 National Income How factor prices are determined  Factor prices are determined by supply and demand in factor markets.  Recall: Supply of each factor is fixed.21 CHAPTER 3 National Income The equilibrium real wage The real wage adjusts to equate labor demand with supply. Units of output Units of labor, L MPL, Labor demand equilibrium real wage Labor supply L22 CHAPTER 3 National Income Determining the rental rate  We have just seen that MPL = W/P.  The same logic shows that MPK = R/P:  diminishing returns to capital: MPK ↓ as K ↑  The MPK curve is the firm’s demand curve for renting capital.  Firms maximize profits by choosing K such that MPK = R/P.23 CHAPTER 3 National Income The equilibrium real