Chapter 3 National Income Where It Comes From and Where It Goes CHAPTER 3 National Income 1 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 CHAPTER 3 National Income 2 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 CHAPTER 3 National Income 3 Factors of production K capital tools machines and structures used in production L labor the physical and mental efforts of workers CHAPTER 3 National Income 4 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 reflects the economy s level of technology exhibits constant returns to scale CHAPTER 3 National Income 5 Returns to scale a review Initially Y1 F K1 L1 Scale all inputs by the same factor z K2 zK1 and L2 zL1 e g if z 1 2 then all inputs are increased by 20 What happens to output Y2 F K2 L2 If constant returns to scale Y2 zY1 If increasing returns to scale Y2 zY1 If decreasing returns to scale Y2 zY1 CHAPTER 3 National Income 6 Returns to scale Example 1 F K L KL F zK zL zK zL z 2KL z 2 KL z KL z F K L CHAPTER 3 National Income constant returns to scale for any z 0 7 Returns to scale Example 2 F K L K L F zK zL zK zL z K z L z K L z F K L CHAPTER 3 National Income decreasing returns to scale for any z 1 8 Returns to scale Example 3 F K L K 2 L2 F zK zL zK 2 zL 2 z 2 K 2 L2 2 z F K L CHAPTER 3 National Income increasing returns to scale for any z 1 9 NOW YOU TRY Returns to scale Determine whether each of these production functions has constant decreasing or increasing returns to scale a b CHAPTER 1 F K L K L The Science of Macroeconomics 10 ANSWERS Returns to scale part a CHAPTER 1 The Science of Macroeconomics 11 ANSWERS Returns to scale part b CHAPTER 3 National Income 12 Assumptions 1 Technology is fixed 2 The economy s supplies of capital and labor are fixed at K K CHAPTER 3 National Income and L L 13 Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology Y F K L CHAPTER 3 National Income 14 The distribution of national income determined by factor prices the prices per unit firms pay for the factors of production wage price of L rental rate price of K CHAPTER 3 National Income 15 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 rate CHAPTER 3 National Income 16 How factor prices are determined Factor prices determined by supply and demand in factor markets Recall Supply of each factor is fixed What about demand CHAPTER 3 National Income 17 Demand for labor Assume markets are competitive 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 CHAPTER 3 National Income 18 Marginal product of labor MPL definition The extra output the firm can produce using an additional unit of labor holding other inputs fixed MPL F K L 1 F K L CHAPTER 3 National Income 19 NOW YOU TRY Compute graph MPL a Determine MPL at each value of L b Graph the production function c Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis CHAPTER 1 The Science of Macroeconomics L 0 1 2 3 4 5 6 7 8 9 10 Y 0 10 19 27 34 40 45 49 52 54 55 MPL n a 8 20 ANSWERS Compute graph MPL CHAPTER 1 The Science of Macroeconomics 21 MPL and the production function Y output As As more more labor labor is is added added MPL 1 F K L MPL MPL 1 MPL 1 CHAPTER 3 National Income Slope of the production function equals MPL L labor 22 Diminishing marginal returns As an input is increased its marginal product falls other things equal Intuition Suppose L while holding K fixed fewer machines per worker lower worker productivity CHAPTER 3 National Income 23 NOW YOU TRY Identifying Diminishing Returns Which of these production functions have diminishing marginal returns to labor a F K L 2K 15L b F K L KL c F K L 2 K 15 L CHAPTER 1 The Science of Macroeconomics 24 ANSWERS Identifying Diminishing Returns a F K L 2K 15L b F K L KL c F K L 2 K 15 L CHAPTER 1 The Science of Macroeconomics 25 NOW YOU TRY MPL and labor demand Suppose W P 6 If L 3 should firm hire more or less labor Why If L 7 should firm hire more or less labor Why CHAPTER 3 National Income L 0 1 2 3 4 5 6 7 8 9 10 Y MPL 0 n a 10 10 19 9 27 8 34 7 40 6 45 5 49 4 52 3 54 2 55 1 26 ANSWERS MPL and labor demand If L 3 should firm hire more or less labor Answer If L 7 should firm hire more or less labor Answer CHAPTER 3 National Income L 0 1 2 3 4 5 6 7 8 9 10 Y MPL 0 n a 10 10 19 9 27 8 34 7 40 6 45 5 49 4 52 3 54 2 55 1 27 MPL and the demand for labor Units of output Each firm hires labor up to the point where MPL W P Real wage MPL Labor demand Units of labor L Quantity of labor demanded CHAPTER 3 National Income 28 The equilibrium real wage Units of output Labor supply equilibrium real wage L CHAPTER 3 National Income The real wage adjusts to equate labor demand with supply MPL Labor demand Units of labor L 29 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 CHAPTER 3 National Income 30 The equilibrium real rental rate Units of output Supply of capital equilibrium R P K CHAPTER 3 National Income The real rental rate adjusts to equate demand for capital with supply MPK demand for capital Units of capital K 31 The Neoclassical Theory of Distribution states that each factor input is paid …