Lecture 2 - Chapter 3 (Part 1) PDF

Macroeconomics N. Gregory Mankiw National Income: Where it Comes From and Where It Goes Presentation Slides © 2022 Worth Publishers, all rights reserved  IN THIS CHAPTER, YOU WILL LEARN:...

Macroeconomics N. Gregory Mankiw National Income: Where it Comes From and Where It Goes Presentation Slides © 2022 Worth Publishers, all rights reserved  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 3 National National Income Income  Primary Goals of this Chapter 1. To introduce students to some of the basic terms and concepts such as the production function, the consumption function, and the investment function. 2. To provide long-run answers to four questions: a. What determines the level of GDP and national income? b. What determines how national income is distributed to labor and owners of capital? c. What determines how GDP is allocated to consumption, investment, and government purchases? d. What ensures equilibrium of the flows in the circular flow diagram? 3. To develop a model that is both a basis for further analysis and a benchmark for comparison as the lecture goes on to consider topics such as the open economy (Chapter 6), and the IS–LM model (Chapters 11 and 12). CHAPTER 3 National National Income Income  INTRODUCTION... the meaning and measurement of the most important macroeconomic statistics: Gross Domestic Product (GDP) - Total expenditure on domestically produced final goods and services. Total income earned by domestically located factors of production. The expenditure components of GDP = Y= C + I + G + NX ( An important identity) The Consumer Price Index (CPI) - A measure of the overall level of prices The Unemployment Rate - Unemployment rate percentage of the labor force that is unemployed Labor-force participation rate fraction of the adult population that “participates” in the labor force—that is, is working or looking for work CHAPTER 3 National National Income Income  NEOCLASSICAL MODEL The Macroeconomy has three (3) markets: 1. The Goods Market 2. The Factor Market or Labour Market, to produce goods and services 3. The Financial Market There are three (3) agents in the economy: 1. Households 2. Firms 3. Government CHAPTER 3 National National Income Income  The Circular Flow CHAPTER 3 National National Income Income  Agents interact in markets where they may be demanders in one (1) market and suppliers in another. A closed economy, market-clearing model Goods market Supply: Firms produce the goods Demand: by households for consumption, government spending, and other firms demand them for investment Labour Market ( factors of production) Supply: Households sell their labor services. Demand: Firms need to hire labor to produce the goods Financial Market Supply: households supply private savings: income less consumption Demand: firms borrow funds for investment; government borrows funds to finance expenditures CHAPTER 3 National National Income Income What Determines the Total Production of Goods and Services? - The Factors of Production The economy has certain resources (inputs): K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers Firms in the economy use labor and capital as inputs to produce goods and services (GDP). To keep things simple, we take K and L as fixed and exogenous(K= K, L= L ) ie. We assume the economy has fixed amounts of K and L. What Determines the Total Production of Goods and Services? - The Production Function We express the economy’s ability to produce goods and services from its resources as 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 return to scale For example of a production function: Y = (𝐾𝐿)1/2 If K = 40 and L = 10, thus Y = 20 What Determines the Total Production of Goods and Services? - Returns to scale: A review Initially Y1 = F (K1 , L1 ) If the amount of all inputs is increased by some constant percentage, output should be changed by the same percentage. This means that the production function should exhibit constant returns to scale, which can be written as: zY = F(zK, zL) - Scale all inputs by the same factor z, K2 = zK1 and L2 = zL1 or any positive number z. Doubling the amount of inputs from the earlier example, so that K =80 and L = 20, gives Y = (1,600)1/2 = 40. 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 The Supply of Goods and Services: Determining GDP We are supposing that K and L are fixed, it follows that we can calculate GDP immediately from the production function Y = F(K,L) Y is called the natural rate of output. At any point in time, the long-run or natural rate of output is determined by the available resources and technology. How Is National Income Distributed to the Factors of Production? – Factor Prices determined by factor prices, the prices per unit firms pay for the factors of production. The two factor prices are: ▪ wage = price of L ▪ rental rate = price of K How Is National Income Distributed to the Factors of Production? – The Diagram Factor prices are determined by supply and demand in factor markets. Recall that the supply of each factor is fixed, supply curves are vertical The Decisions Facing A Competitive Firm - Demand for Labor Assume there are many identical competitive firms, typical firms are competitive. Basic idea: Just as we did with the aggregate economy for the factors of production we do the same for the firm. we represent the firm’s production technology with the production function: Y = F(K, L) 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 Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit. Each firm takes W × L , R × K, and P × Y as given to maximize Profits. The Decisions Facing A Competitive Firm - Demand for Labor Profit depends on the price at which they can sell their output (the price of a unit of GDP, or P), the rental price of capital in dollars (R), and the dollar wage rate (W): Profit = PY − RK − WL PY = Revenue RK − WL = Costs 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 To see how profit depends on the factors of production, we use the production function. Profit = PF(K, L) − RK − WL The firm’s problem is to choose K and L to maximize its profits. The Firm’s Demand for Products: 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) Most production functions have the property of diminishing marginal product. That is, if the number of machines is fixed (or for example, a bakery’s kitchen is fixed) but the firm employs more and more workers, each additional worker (MPL) will probably contribute less extra output (the kitchen is crowded). Production functions generally exhibit diminishing marginal product. MPL and the production function Diminishing marginal returns As one input is increased (holding other inputs constant), its marginal product falls. Intuition: If L increases while holding K fixed, machines per worker falls, worker productivity falls. Firms compare the extra revenue from one more worker (P × MPL) with the cost of that worker, which is the nominal (dollar) wage (W). The change in profit from hiring an additional unit of labor is Δ Profit=Δ Revenue − Δ Cost=(P×MPL)−W. If P × MPL > W, the firm will want to hire more workers (ie. More profit), and conversely, if P × MPL < W, the firm will want to hire fewer workers. The firm has the optimal number of workers when P × MPL = W, or when the marginal product of labor equals the real wage (W/P) ie. The firm’s demand for labour. W/P – real wage, represents the compensation of workers in terms of goods— units of real GDP—rather than in terms of dollars MPL to The Demand For Labor The equilibrium real wage The real wage adjusts to equate labor demand with supply. The Marginal Product of Capital and Capital Demand - 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 falls as K rises The MPK curve is the firm’s demand curve for renting capital. Firms maximize profits by choosing K such that MPK = R/P. MPK = F(K + 1, L) − F(K, L) = R/P. The increase in profit from renting an additional machine is the extra revenue from selling the output of that machine minus the machine’s rental price: Δ Profit=Δ Revenue − Δ Cost=(P×MPK)−R The equilibrium real rental rate The real rental rate adjusts to equate demand for capital with supply.  The Division of National Income - The Neoclassical Theory of Distribution How the markets for the factors of production distribute the economy’s total income? States that each factor input is paid its marginal product Since each factor of production is paid an amount equal to its marginal contribution to output, total real payments to labor equal (W/P) × L = MPL × L, and total real payments to capital equal (R/P) × K = MPK × K. Total output equals Y. Real economic profit is the difference between real output and total real payments to factors of production Economic Profit=Y−(MPL×L)−(MPK×K) Because we want to examine the distribution of income, we rearrange the terms as follows: Y=(MPL×L)+(MPK×K)+Economic Profit Total income is divided among the return to labor, the return to capital, and economic profit. How large is economic profit? If the production function is constant returns to scale, real economic profit is zero. This follows from the Euler’s Theorem, which states that if the production function has constant returns to scale, then Y = (MPK × K) + (MPL × L) + Economic Profit How Income Is Distributed To L And K 𝑊 Total Labour Income = 𝐿 = 𝑀𝑃𝐿 × 𝐿 𝑃 𝑅 Total Capital Income = 𝑃 𝐾 = 𝑀𝑃𝐾 × 𝐾 If the production function has constant returns to scale, then The Cobb–Douglas production function (1 of 2) Suppose that the economy is competitive so that factors are paid their marginal products. What production function then implies that factor shares are constant? In other words, what production function implies that the ratio of capital payments to income and the ratio of labor payments to income are constant? The answer supplied by mathematician Charles Cobb was that the function has to be of the form Y = AK α L1− α where A represents the level productivity of available technology and is an arbitrary positive constant, so that the factor shares are constant and equal to α and (1 − α): α = capital’s share of total income: capital income = MPK × K = αY labor income = MPL × L = (1 – α )Y The Cobb–Douglas production function (2 of 2) Each factor’s marginal product is proportional to its average product: aY M𝑃𝐾 = aAK a L1−a = or MPK= αY/K K 1−a Y MPL = 1 − a AK a L−a = 𝑜𝑟 MPL=(1−α)Y/L L The ratio of labor income to total income in the United States, 1960–2019  Labor productivity and wages Theory: wages depend on labor productivity U.S. data: Time Period Growth Rate of Growth Rate of Real Labor Productivity Wages 1960-2019 2.0% 1.8% 1960-1973 3.0 2.7 1973-1995 1.5 1.2 1995-2010 2.7 2.2 2010-2019 0.9 1.0