macro session 3
TRANSCRIPT
-
7/27/2019 Macro Session 3
1/23
-
7/27/2019 Macro Session 3
2/23
How does the entire economy work?
Understanding by using
Basic Classical Model
-
7/27/2019 Macro Session 3
3/23
Firms Households
Government
Financial
Markets
Market for goodsand Services
Market for Factors
of ProductionFactor Payment
Income (Y)
Taxes (T)
Private
Savings (S)
Consumption (C)
expenditure
Firms Revenue
Government Purchase (G)
Investment (I)
Simple Circular flow of income model (Closed economy)
Public
Savings (S)
Goods/
Services
Loans
-
7/27/2019 Macro Session 3
4/23
Again: How does an economy work?
Sources and Uses of Nations GDP
What determines the level of production (andthus the level of national income)?
How the markets for factors of production
distribute the income? How much of the income is consumed and
how much is saved?
How are demand for goods and services (C, Iand G) and supply are brought intoequilibrium?
-
7/27/2019 Macro Session 3
5/23
An economys output or Supply of goods and services (GDP)
depends on:
(1) Quantity of inputs : Factors of Production (Capital andLabor)
(2) Ability to turn inputs into output : Production Function
Needs clear understandings on:
Factor Market and
Goods (and Services) Market
-
7/27/2019 Macro Session 3
6/23
Classical theory: Assumption 1
and K K L L
Relating to Factors of Production
Capital: set of tools that workers use
Labor: time people spend on working
The economys supplies of capital and labor are
fixed.
Factors of production are fully utilized i.e. no
resources are wasted.
-
7/27/2019 Macro Session 3
7/23
Classical Theory: Assumption 2
Reflects the economys level of technology.
Denoted by Y= F(K,L)
Shows how much output (Y) the economy canproduce from Kunits of capital and L units of labor.
Three Properties: Increasing, constant and Decreasing(Diminishing) returns to scale.
Classical Assumption: PF exhibits constant returns toscale
(Meaning: If we increase all inputs by 25%, output will alsoincrease by 25%.)
Relating to Production function:
-
7/27/2019 Macro Session 3
8/23
The Supply of Goods and Services
Y = F (K,L)
, ( )Y F K L
Y = F (K, L)
Y = YSince Technology (production function) and K and L
are assumed to be fixed, the output (Y) is also
assumed to be fixed in an economy.
-
7/27/2019 Macro Session 3
9/23
How is National Income distributed to the
Factors of Production?
Depends on: how much economy uses K or L.
How much economy employs K or L depends on their
prices or factor prices.
The prices per unit that economy pays for employing
FOP: factor prices:
wage (w) is the price ofL
Rental/Interest rate (r) is the price ofK.
-
7/27/2019 Macro Session 3
10/23
How factor prices are determined
Factor prices are determined by supply and demand in
factor markets.
The intersection of demand and supply of the factors
determine the factor prices and quantity of factors
utilized. Which one plays major role?
Recall: Supply of each factor is fixed.
Therefore, it is the demand for the factors that
ultimately determine the factor prices
and
K K L L
-
7/27/2019 Macro Session 3
11/23
Factor
price
(Wage or
rental
rate)
Quantity of factor
Factor demand
Factor supply
Equilibriumfactor price
This vertical supply curve
is a result of the
supply being fixed.
Determination of Factor Prices
Factor prices are determined by supply and demand in factor
markets.
Because the factor supply curve is vertical and fixed, it is the
demand curve for the factors of productions which determines the
factor prices.
-
7/27/2019 Macro Session 3
12/23
Factors determining profit
Profit = Revenue Cost
= PY (wL + rK)
= PY wL rK
= PF(K,L) wL rK
So, Profit depends on product price P, factor
prices w and r ,and the factor quantities L and
K.
-
7/27/2019 Macro Session 3
13/23
Big Question:
What determines the
demand for factors of
production?
Answer: Depends upon Marginal Product of
Labor (MPL) and Marginal Product of Capital
(MPK).
-
7/27/2019 Macro Session 3
14/23
slide 14
MPL and the demand for labor
Each firm hires laborup to the point where
P MPL (VMPL) = W
MPL= W/P
Units ofoutput
Units of labor, L
MPL, Labordemand
Real
wage
Quantity of labordemanded
-
7/27/2019 Macro Session 3
15/23
The equilibrium real rental rate
The real rental rate
adjusts to equate
demand for capital with
supply.
Units ofoutput
Units of capital, K
MPK, demandfor capital
equilibriumr/P
Supply ofcapital
K
-
7/27/2019 Macro Session 3
16/23
How Total Income (Y) is distributed?
total labor income =
If production function has constant returns to
scale, then
total capital income =
WLP
MPL L
RK
PMPK K
Y MPL L MPK K
laborincome
capitalincome
nationalincome
-
7/27/2019 Macro Session 3
17/23
The Cobb-Douglas Production Fu
Paul Douglas
Paul Douglas observed that the division of
national income between capital and labor has been
roughly constant over time.
In other words, the total income of workers and the total
income of capital owners grew at almost exactly the
same rate.
He then wondered what conditions might lead to constant
factor shares. Cobb, a mathematician, said that the
production function would need to have the property that:
Capital Income = MPK K = Y
Labor Income = MPL L = (1- ) Y
-
7/27/2019 Macro Session 3
18/23
Capital Income = MPK K = Y
Labor Income = MPL L = (1-
) Y
is a constant and measures capital and
labors share of income.
Cobb showed that the function with this property is:
F (K, L) = A K
L1-
A is a parameter that measures the productivity
of the available technology. (Total Factor Productivity)
Cobb-Douglas
Production
Funct
ion
CobbDouglas Production Function
-
7/27/2019 Macro Session 3
19/23
CobbDouglas Production Function:
Y = F (K, L) = A K
L1-
Differentiating, we get the Marginal product of labor:
MPL = (1- ) A K
L
Multiply and Divide right hand side by L. Then,
MPL = (1- ) [A K
L
] L / L = (1- ) [A K
L1-
] / L
MPL = (1- ) Y / L
Similarly, The Marginal product of capital is:
MPK = A K-1
L1
or, MPK = Y/K
Average Labor
Productivity
Average Capital
Productivity
CobbDouglas Production Function
-
7/27/2019 Macro Session 3
20/23
Properties of the CobbDouglas Production Functio
Equation (i) tells us that marginal product of the labour is
proportional to output per worker (average productivity ofworker).
Similarly, equation (ii) states that marginal product of the capital
is proportional to the output per unit of capital (average
productivity of capital).In conclusion,
Marginal productivity of a factor is proportional to its average
productivity.
(1) Consider the CobbDouglas production function with:
MPL = (1- )Y/L .(i)
MPK= Y/ K (ii)
-
7/27/2019 Macro Session 3
21/23
Properties of the CobbDouglas Production Function
2) The CobbDouglas production function has constant returns to
scale. That is, if capital and labor are increased by the sameproportion, then output increases by the same proportion as
well.
Proof:
Consider the Cobb-Douglas Production function:F (K, L) = A K
L1-
F(zK,zL) =A(zK)
(zL)1-
F(zK,zL) =Az
K
z1-
L1-
F(zK,zL) =Az
z
1-
K
L
1-
F(zK,zL) =Az+1-
K
L1-
F(zK,zL) =AzK
L1-
=zAK
L1-
=zF(K,L) =zY
Therefore, Cobb-Douglas production function has constant
returns to scale.
-
7/27/2019 Macro Session 3
22/23
Empirical Evidence of the CobbDouglas Production
Function
Growth in Labor productivity and Real Wages in US
Period Labor Productivity Real Wages
Growth rate Growth rate
1959-1973 2.9% 2.8%
1973-1995 1.4% 1.2%
1995-2003 3.0% 3.0%
1959-2003 2.1% 2.0%Source: US Economic Report of the President, 2005.
-
7/27/2019 Macro Session 3
23/23
Thank You