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macroeconomics fifth edition N Gregory Mankiw PowerPoint Slides by Ron Cronovich 2003 Worth Publishers all rights reserved CHAPTER THREE National Income Where it Comes From and Where it Goes Econ 101 Intermediate Macro Theory Lecture notes Professor Cetorelli UC Davis Fall 2003 Lecture 3 1 Reality check of the day internet Slowing Stream of New Jobs Helps to Explain Slump htm Website s 01JOBS html hp 2 CHAPTER 3CHAPTER 3National IncomeNational Income slide 3 In this chapter you will learn 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 CHAPTER 3CHAPTER 3National IncomeNational Income slide 4 Outline of modelOutline 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 Note because of the assumption of closed economy there are no imports and exports later on we will study open economies as well Equilibrium goods market loanable funds market CHAPTER 3CHAPTER 3National IncomeNational Income slide 5 Factors of productionFactors of production K capital tools machines and structures used in production restricted definition of capital no inventories or housing but good enough for our purposes L labor the physical and mental efforts of workers Also no consideration to land as additional factor of production again harmless simplifying assumption here CHAPTER 3CHAPTER 3National IncomeNational Income slide 6 The production functionThe production function denoted Y F K L shows how much output Y the economy can produce from Kunits of capital and Lunits of labor F reflects the economy s level of technology We assume that function exhibits constant returns to scale CHAPTER 3CHAPTER 3National IncomeNational Income slide 7 Returns to scale a reviewReturns to scale a review Initially Y1 F K1 L1 Scale all inputs by the same factor z K2 zK1 and L2 zL1 If z 1 25 then all inputs are increased by 25 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 3CHAPTER 3National IncomeNational Income slide 8 Exercise Exercise determine returns to scaledetermine returns to scale Determine whether each of the following production functions has constant increasing or decreasing returns to scale a F K LKL 2 b K F K L L c 215 F K LKL CHAPTER 3CHAPTER 3National IncomeNational Income slide 9 Constant Returns to Scale CRS Constant Returns to Scale CRS One convenience of CRS It allows us to look at production function in per capita terms L K k L Y ykfy L K F L K F L L L K F L Y L z LKFY 1 1 CRS property CHAPTER 3CHAPTER 3National IncomeNational Income slide 10 Assumptions of the modelAssumptions of the model 1 Technology is fixed 2 The economy s supplies of capital and labor are fixed at and KKLL CHAPTER 3CHAPTER 3National IncomeNational Income slide 11 Determining GDPDetermining GDP Output is determined by the fixed factor supplies and the fixed state of technology YF K L CHAPTER 3CHAPTER 3National IncomeNational Income slide 12 Determining GDPDetermining GDP This is the simplest model The assumption of fixed supply of factors of production is such that total production is determined by whatever combination available of K and L and by the kind of technology the function F which mixes together the two factors A model like this could allow us to compare two economies at the same point in time Why is that one has higher Y than the other It must depend on the economies endowment of K and L and by the quality of the technology F More on this later CHAPTER 3CHAPTER 3National IncomeNational Income slide 13 The distribution of national incomeThe distribution of national income determined by factor prices the prices per unit that firms pay for the factors of production The wage is the price of L the rental rate is the price of K Recall from Chapter 2 the value of output equals the value of income The income is paid to the workers and capital owners We now explore a simple theory of income distribution CHAPTER 3CHAPTER 3National IncomeNational Income slide 14 NotationNotation 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 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 3CHAPTER 3National IncomeNational Income slide 15 NotationNotation The nominal wage rental rate are measured in currency units dollars The real wage and real rental price 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 CHAPTER 3CHAPTER 3National IncomeNational Income slide 16 How factor prices are determinedHow factor prices are determined Since the distribution of income depends on factor prices we need to see 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 CHAPTER 3CHAPTER 3National IncomeNational Income slide 17 Demand for laborDemand for labor Assume markets are competitive each firm takes W R and Pas 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 3CHAPTER 3National IncomeNational Income slide 18 Marginal product of labor Marginal product of labor MPLMPL def 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 3CHAPTER 3National IncomeNational Income slide 19 Exercise Exercise compute graph MPLcompute graph MPL LYMPL 00n a 110 219 3278 434 540 645 749 852 954 1055 a Determine MPLat each value of L b Graph the production function c Graph the MPLcurve with MPLon the vertical axis and Lon the horizontal axis CHAPTER 3CHAPTER 3National IncomeNational Income slide 20 answers answers Production function 0 10 20 30 40 50 60 012345678910 Labor L Output Y Marginal Product of Labor 0 2 4 6 8 10 12 0123456789 10 Labor L MPL units of output CHAPTER 3CHAPTER 3National IncomeNational Income slide 21 The MPL and the production functionThe MPL and the production function Y output L labor F K L 1 MPL 1 MPL 1 MPL As more labor is added MPL Slope of the production function equals MPL CHAPTER 3CHAPTER 3National IncomeNational Income slide 22 Diminishing marginal returnsDiminishing marginal returns As a factor input is increased its marginal product falls other things equal Intuition Lwhile holding Kfixed fewer machines per worker lower productivity CHAPTER 3CHAPTER 3National IncomeNational Income slide 23 Check your understanding Check your understanding Which of these production functions have diminishing marginal returns to labor a 215F K LKL b F K LKL c 215F K LKL CHAPTER 3CHAPTER 3National IncomeNational Income slide 24 Exercise part 2 Exercise part 2 LYMPL 00n a 11010 2199 3278 4347 5406 6455 7494 8523 9542 10551 Suppose W P 6 d If L 3 should firm hire more or less labor Why e If L 7 should firm hire more or less labor Why CHAPTER 3CHAPTER 3National IncomeNational Income slide 25 MPLMPL and the demand for laborand the demand for labor Each firm hires labor up to the point where MPL W P 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 demanded CHAPTER 3CHAPTER 3National IncomeNational Income slide 26 The equilibrium real wageThe equilibrium real wage Units of output Units of labor L MPL Labor demand equilibrium equilibrium real wagereal wage Labor supply L The real wage adjusts to equate labor demand with supply The real wage adjusts to equate labor demand with supply CHAPTER 3CHAPTER 3National IncomeNational Income slide 27 Determining the rental rateDetermining the rental rate In our model it s easiest to think of firms renting capital from households the owners of all factors of production R P is the real cost of renting a unit of K for one period of time In the real world of course many firms own some of their capital But for such a firm the market rental rate is the opportunity cost of using its own capital instead of renting it to another firm Hence R P is the relevant price in firms capital demand decisions whether firms own their capital or rent it CHAPTER 3CHAPTER 3National IncomeNational Income slide 28 Determining the rental rateDetermining 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 MPKcurve is the firm s demand curve for renting capital Firms maximize profits by choosing K such that MPK R P CHAPTER 3CHAPTER 3National IncomeNational Income slide 29 The equilibrium real rental rateThe equilibrium real rental rate The real rental rate adjusts to equate demand for capital with supply The real rental rate adjusts to equate demand for capital with supply Units of output Units of capital K MPK demand for capital equilibrium equilibrium R PR P Supply of capital K CHAPTER 3CHAPTER 3National IncomeNational Income slide 30 The Neoclassical Theory of Distribution The Neoclassical Theory The Neoclassical Theory of Distributionof Distribution states that each factor input is paid its marginal product accepted by most economists states that each factor input is states that each factor input is paid its marginal productpaid its marginal product accepted by most economistsaccepted by most economists CHAPTER 3CHAPTER 3National IncomeNational Income slide 31 How income is distributed How income is distributed W L P MPLL total labor income R K P MPKK total capital income If production function has constant returns to scale then YMPLLMPKK labor income capital income national income CHAPTER 3CHAPTER 3National IncomeNational Income slide 32 Outline of modelOutline 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 DONE DONE Next CHAPTER 3CHAPTER 3National IncomeNational Income slide 33 Demand for goods servicesDemand for goods services Components of aggregate demand C consumer demand for g s I demand for investment goods G government demand for g s closed economy no NX CHAPTER 3CHAPTER 3National IncomeNational Income slide 34 Demand for goods servicesDemand for goods services For each component of demand we have to specify behavioral hypotheses what drives households consumption What makes firm decide to invest in new capital How does the government decide on spending and taxation CHAPTER 3CHAPTER 3National IncomeNational Income slide 35 Consumption Consumption C C def disposable income is total income minus total taxes Y T Consumption function C C Y T Shows that Y T C def The marginal propensity to consume is the increase in Ccaused by a one unit increase in disposable income CH