Transcript Chapter 3: National Income Accounting

Chapter 3:
National Income
Production Function
Output of goods and services as a function of
factor inputs
Y = F(K, L)
Y = product output
K = capital input
L = Labor input
Constant Returns to Scale
When an increase in the quantity of the inputs
results in an equal increase in the quantity of the
output
F(zK, zL) = zY
where z > 0
Supply of Products
Because we assume that the supplies of capital
and labor inputs and the production technology
are fixed, the supply of product output is also fixed
Y = F(K, L) = Y
Input Price Determination
Input or factor prices are determined by the supply
and demand for them.
Because we assume the input supply is fixed, its
supply line is vertical. The factor demand curve is
downward sloping.
The intersection of demand and supply determines the
factor price.
Input Price Determination
Price
Supply
Equilibrium price
Demand
Quantity
Profit Determination
Profit = Revenue – Labor Cost – Capital Cost
П = PY – WL – RK
P = price of output
W = price of labor input = wage rate
R = price of capital input = interest rate
Production Function
Output
Labor in the variable input
F(K,L)
MPL
1
MPL
1
MPL
1
Labor
Marginal Product of Inputs
Additional productivity gained from hiring an
extra unit of the labor input. MPL and MPK are:
MPL = F(K, L+1) – F(K, L)
MPK = F(K+1, L) – F(K, L)
Diminishing Marginal Product of Labor
As more labor input is added, holding capital input constant, the
quantity of output will increase at a decreasing rate. Hence, MPL
declines, due to inefficiency, as more labor is added.
Units of output
MPL
Units of labor
The Firm’s Demand for Labor
Demand for labor depends on its price and
marginal product
In a competitive market: MPL = W/P = the real
wage. The labor demand is
W = P  MPL
The Firm’s Demand for Capital
Demand for capital depends on its price and
marginal product
In a competitive market: MPK = R/P = the real
interest. The capital demand is
R = P  MPK
Diminishing Marginal Product of Capital
As more capital input is added, holding labor input constant, the
output will increase at a decreasing rate. Hence, MPK declines,
due to inefficiency, as more capital is added.
Units of output
MPK
Units of capital
Determinants of Demand for Products
The GDP for a closed economy is total spending
by households, firms, and government:
Y=C+I+G
Consumption = C
Investment = I
Government purchases = G
The Circular Flow on Income and Product
Income Payments
Labor Market
Labor Resources
Saving
Investment
Financial Market
Households
Firms
Government
Government Purchases
Taxes
Products
Product Market
Consumption Expenditures
Consumption Function
Consumption is a function of disposable
personal income:
C = C(Y – T)
Y = personal income
T = personal income taxes
Consumption Function
Marginal propensity to consume = additional
consumption from an extra dollar of
disposable personal income
MPC = ΔC / Δ(Y –T)
MPC is slope of consumption function.
Consumption Function
Consumption, C
C = C(Y – T)
MPC
1
Disposable income, Y - T
Investment Function
Investment is a negative function of the real
interest rate
I = I(r)
Low interest rates encourage borrowing for
investment purposes, whereas high interest rates
discourage borrowing
Investment Function
Real interest rate, r
I(r)
Quantity of investment, I
Government Role
We assume government purchases of
goods and services and resources and
personal income taxes are fixed amounts:
G=G
T=T
National Income Identity
Y = C + I + G, where
C = C(Y –T)
I = I(r)
G = G and T = T
Y = C(Y – T) + I(r) + G
Saving Investment Identity
Equilibrium in the product market:
Y = C(Y – T) + I(r) + G
Y - C(Y – T) - G = I(r)
S = I(r)
Where S is national saving
Components of National Saving
Private saving: left over household income:
Sp = Y – T – C
Public saving: left over government revenue:
Sg = T – G
Determination of Real Interest Rate
Real interest rate
S
Equilibrium interest rate
I(r)
Investment, Saving
Increase in Investment Demand
Real interest rate
S
An increase in investment demand
results in a higher interest rate.
r2
r1
I’(r)
I(r)
Investment, Saving
Classical Saving Function
Saving is positively related to the real interest rate
S = S(r)
Real interest rate
S(r)
Quantity of Saving
Increase in Investment Demand
Real interest rate
S(r)
r2
r1
I2
I1
I1
I2
Quantity of Saving