Economics Chapter on Long-Run Activity

Long-Run Economic Activity

• Economic activity is determined by the supply side.
• The circular flow of income illustrates:
  • Households provide factors of production to firms.
  • Firms use these factors to produce goods and services.
  • Households buy goods and services using income generated from selling factors to firms.
  • Government is a demander of goods and services paid for by taxes.
  • All markets are in equilibrium with flexible prices.
  • In equilibrium, all factors of production are employed and supply matches demand.

Aggregate Production Function

• Two factors of production are labor (N) and capital (K).
• Aggregate production function: Y = F(N, K).
• Positive and diminishing marginal product is assumed:
  • dY/dN > 0, dY/dK > 0
  • d2Y/dN2 < 0, d2Y/dK2 < 0
  • Partial derivatives are useful for calculations, especially with respect to N while K is held constant.

Marginal Product of Labor (MPL)

• Differentiate output (Y) with respect to labor (N) to find MPL.
• MPL represents the change in output when labor increases by one unit, holding capital constant.
• MPL initially increases and then diminishes.

Competitive Firm's Decision

• Firms operate according to the same production function, under competitive markets.
• Profit = (Price * Output) - (Wage * Labor) - (Rental Rate * Capital).
• Firms maximize profit.
• Optimization problem: choose N and K to maximize: PF(N,K) - WN - RK.
• Solutions: P(dY/dN) = W and P(dY/dK) = R

Labor Market Equilibrium

• Real prices of factors are flexible, ensuring all resources are used.
• Total output (Y*) is a function of full employment (N* and K*).
• Real wage (W/P) and real rental price (R/P) are determined by the supply and demand of labor/capital.

Cobb-Douglas Production Function

• A specific production function: Y = AN^αK^1-α
• A = total factor productivity, 0<α<1
• α=share of labor in output.
• The function demonstrates positive and diminishing returns.
• Marginal products of labor and capital can be derived.

This quiz covers key concepts of long-run economic activity, including the circular flow of income, the aggregate production function, and the marginal product of labor. Test your understanding of how supply side factors influence economic equilibrium and production. Dive into the details of labor and capital's roles in the economy.