February 17th-February 26th, 2015 Chapter 3: National Income Basic Concept of Things - Our job in this chapter is to develop a basic idea about how the economy works. In this Chapter…- We shift from economic measurement to economic analysis - Goal: understand how the macroeconomy works in the long run - Where does GDP come from? - What determines the level of GDP a country can produce? - Where does GDP go? - Long run: no frictions, no market failures - One particular friction that we talked about: sticky price - In the long run no sticky price. All prices are flexible Determination of Output - The more GDP an economy produces, the more people are able to consume and enjoy a higher living standard. - What determines the quantity of goods and services a country can produce? - A country’s productive capacity. o Quantity of inputs-factors of production o The effectiveness with which inputs are used- productivity The Production Function - Reflects the economy’s level of technology - Exhibits constant returns to scale Returns to Scale: A Review - If constant returns to scale, Y2 = zY1- If increasing returns to scale, Y2 > zY1 - If decreasing returns to scale, Y2 < zY1A Model - The production function only tells us how much an economy can produce; it does not tell us how much an economy will produce - The actual output of an economy involves several markets - Next we develop a model to help us think about the issue - This is a long-run model: o All prices are flexible o All markets can reach equilibrium- Recall: chapter 1o These assumptions are not true in the short run - A long-run model helps us understand how the economy generally works; the possibility of short-run fluctuations (booms and recessions) is ignored Assumptions of the Model - We start with what we just learned: production capacity o Technology is fixed o The economy’s supplies of capital and labor are given as K = Kbar and L = LbarDetermining GDP - Fixed supply of inputs: no capital is wasted; all workers are willing to work. They supply all available labor to the market - Output is determined by the factor supplies and the state of technology: Ybar = F(Kbar, Lbar) Distribution of National Income - How is national income distributed to factors of production? - How much goes to employees as wages and salaries? - How much is paid to owners of capital? - Why do doctors make more money than store keepers? Marginal Product of Labor (MPL) - To answer these questions, we need to start with the concept of marginal product- MPL = F(K,L+1) – F(K,L)Exercise: Marginal Product - Consider the kitchen at Mel’s Hot Dogs, a restaurant that sells hot dogs, French fries, andsoft drinks. - It has a fixed amount of capital- it has one gas range for cooking the hot dogs, one deep-fryer for cooking French fries, and one soft drink dispenser 1. Calculate the marginal product for each additional cook. 2. What happens to the marginal product as more and more cooks are hired? 3. Suppose the market wage for cooks is $50 per hour. If one meal costs $5, how many cooks would you hire if you were the manager? 4. Given your answer in question 3, what is the total profit made by the restaurant in one hour?Cooks Meals Marginal Product 0 0 -1 15 152 35 203 60 254 80 205 95 156 105 107 100 -5- If the wage for cooks is $50 an hour, and one meal costs $5, then the real wage of a cookis 10 meals per hour - This restaurant should hire 6 cooks - The 6th cook’s marginal product = 10 meals, equal to the real wage - Profit = 105-60=45 meals, or $5x45 = $225- Another way to get profit o Profit from cook 1: 15-10 = 5 meals o Profit from cook 2: 20-10 = 10 meals - Total profit = 5+10+15+10+5+0=45 meals, or $225 Diminishing Marginal Returns - Intuition: Suppose L increases while holding K fixed o Fewer machines per worker o Lower worker productivity Check Your Understanding - The marginal product of labor is the derivative of the production function with respect to labor - To find out the answers: o Take the derivative o Check if the resulting function is a decreasing function. If it is, then the law of diminishing returns holds Factor Prices- Wage = price of L - Rental Rate = price of K Rental Rate - Who owns capital? Some firms - But who owns those firms? Households - Private ownership is another underlined assumption of the modelNotation - W = nominal wage - R = nominal rental rate - P = price of output - W/P = real wage (measured in units of output) - R/P = real rental rate How factor prices are determined - Factor prices are determined by supply and demand in factor markets - Recall: Supply of each factor is given (by assumption)- What about demand? Demand for Labor - Assume markets are competitive: each firm takes W, R, and P as given - From exercise 1 we already learned the basic idea: A firm hires each unit of labor if the cost does not exceed the benefit o Cost = real wage o Benefit = marginal product of labor- Since firms always make sure price (real wage) = marginal product, the two curves coincide MPL and the Demand for Labor - Each firm hires labor up to the point where MPL = W/PThe Equilibrium Real Wage - The real wage adjusts to equal labor demand with supply Assumption - Note how this result is affected by our assumption that wages are flexible - Due to flexible wages, the labor market always reaches an equilibrium - There is no unemployment - Short-run imperfections are stripped away Determining the Rental Rate - We have just seen that MPL = W/P- The same logic shows that MPK = R/Po Diminishing returns to capital: MPK decreases as K increases o The MPK curve is the firm’s demand curve for renting capital o Firms maximize profits by choosing K such that MPK = R/P The Equilibrium Real Rental Rate - The real rental rate adjusts to equate demand for capital with supplyThe Neoclassical Theory of Distribution - States that each factor input is paid its marginal product - Is accepted by most economists How Income is distributed - Total Labor Income = W/P(Lbar) = MPL x Lbar - Total Capital Income = R/P(Kbar) = MPK x Kbar - If production function has constant returns to scale, then Y (national income) = MPL x Lbar (labor income) + MPK x Kbar (capital income) - We now have answers to our question about income distribution- Each factor of production is paid its marginal product - In other words, the more productive a factor is, the more income that factor receives- If the theory is right, then as labor becomes more productive, the average