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Grogery Mankiw Chapter - 3
Grogery Mankiw Chapter - 3
Grogery Mankiw Chapter - 3
Chapter Three
CHAPTER 3
National Income:
Where It Comes From and Where It Goes
A PowerPoint
Tutorial
To Accompany
MACROECONOMICS, 7th. Edition
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
2
Chapter Three
Copyright 1997 Dead Economists Society
It is a quite simple but powerful analytical model built around
buyers and sellers pursuing their own self-interest (within
rules set by government). Its emphasis is on the consequences
of competition and flexible wages/prices for total employment
and real output. Its roots go back to 1776to Adam Smiths
Wealth of Nations. The Wealth of Nations suggested that the
economy was controlled by the invisible hand whereby the
market system, instead of government would be the best
mechanism for a healthy economy.
3
Chapter Three
The heart of the market system lies in the
market clearing process and the
consequences of individuals pursuing self-
interest. In this module, we will develop a
basic classical model to explain various
economic interactions.
4
Chapter Three
neoclassical theory of distribution
We are going to examine carefully the modern theory of how
national income is distributed among the factors of production.
It is based on the classical (eighteenth-century) idea that prices adjust to
balance supply and demand, applied here to the markets for the
factors of production, together with the more recent (nineteenth-century)
idea that the demand for each factor of production depends on the
marginal productivity of that factor. Proceed to the next slide
to the CLASSICAL FACTORY to learn how to construct the
classical model.
5
Chapter Three
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The place where
Classical-model
mechanics
are made easy!
Welcome to...
6
Chapter Three
We begin with firms and see what determines their
level of production (and thus, the level of national
income).
Then, we examine how the markets for the factors of
production distribute this income to households.
Next, we consider how much of this income
households consume and how much they save. We
will also discuss the demand arising from investment
and government purchases. Finally, we discuss how
the demand and supply for goods and services are
brought into balance.
Lets begin!
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Chapter Three
An economys output of goods and services (GDP) depends on:
(1) quantity of inputs
(2) ability to turn inputs into output
Lets go over both now.
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Chapter Three
The factors of production are the inputs used to produce goods
and services. The two most important factors of production are
capital and labor. In this module, we will take these factors as
given (hence the overbar depicting that these values are fixed).
K (capital) = K
L (labor) = L
In this module, well also assume that all resources are fully
utilized, meaning no resources are wasted.
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Chapter Three
The available production technology determines how much output
is produced from given amounts of capital (K) and labor (L).
The production function represents the transformation of inputs
into outputs. A key assumption is that the production function
has constant returns to scale, meaning that if we increase inputs
by z, output will also increase by z.
We write the production function as:
Y = F ( K , L )
Income is some function of our given inputs
To see an example of a production functionlets visit Mankiws
Bakery
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Chapter Three
Mankiws Bakery production function shows that the number of loaves
produced depends on the amount of the equipment and the number of
workers. If the production function has constant returns to scale, then
doubling the amount of equipment and the number of workers doubles
the amount of bread produced.
The workers hired to
make the bread are its
labor.
The kitchen and its
equipment are Mankiws
Bakery capital.
The loaves of bread
are its output.
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Chapter Three
We can now see that the factors of production and the production
function together determine the quantity of goods and services
supplied, which in turn equals the economys output. So,
Y = F ( K , L )
= Y
In this section, because we assume that capital and labor are fixed,
we can also conclude that Y (output) is fixed as well.
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Chapter Three
The distribution of national income is determined by factor prices.
Factor prices are the amounts paid to the factors of productionthe
wages workers earn and the rent the owners of capital collect.
Because we have assumed a fixed amount of
capital and labor, the factor supply curve
is a vertical line.
The next slide will illustrate this.
Recall that the total output of an economy equals total income.
Because the factors of production and the production function
together determine the total output of goods and services, they also
determine national income.
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Chapter Three
The price paid to any factor of production depends on the supply and
demand for that factors services. Because we have assumed that
the supply is fixed, the supply curve is vertical. The demand curve
is downward sloping. The intersection of supply and demand
determines the equilibrium factor price.
Factor
price
(Wage or
rental
rate)
Quantity of factor
Factor demand
Factor supply
Equilibrium
factor price
This vertical supply curve
is a result of the
supply being fixed.
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Chapter Three
To make a product, the firm needs two factors of
production, capital and labor. Lets represent the firms
technology by the usual production function:
Y = F (K, L)
The firm sells its output at price P, hires workers at a
wage W, and rents capital at a rate R.
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Chapter Three
The goal of the firm is to maximize profit. Profit is revenue minus
cost. Revenue equals P Y. Costs include both labor and capital
costs. Labor costs equal W L, the wage multiplied by the amount
of labor L. Capital costs equal R K, the rental price of capital R times
the amount of capital K.
Profit = Revenue - Labor Costs - Capital Costs
= PY - WL - RK
Then, to see how profit depends on the factors of production, we use
production function Y = F (K, L) to substitute for Y to obtain:
Profit = P F (K, L) - WL - RK
This equation shows that profit depends on P, W, R, L, and K. The
competitive firm takes the product price and factor prices as given
and chooses the amounts of labor and capital that maximize profit.
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Chapter Three
We know that the firm will hire labor
and rent capital in the quantities that
maximize profit. But what are those
maximizing quantities? To answer this,
we must consider the quantity of labor
and then the quantity of capital.
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Chapter Three
The marginal product of labor (MPL) is the extra amount of output the
firm gets from one extra unit of labor, holding the amount of
capital fixed and is expressed using the production function:
MPL = F(K, L + 1) - F(K, L).
Most production functions have the property of
diminishing marginal product: holding the amount of capital
fixed, the marginal product of labor decreases as the amount of labor
increases.
F (K, L)
Y
L
1
MPL
1
MPL
The MPL is the change in output
when the labor input is increased
by 1 unit. As the amount of labor
increases, the production function
becomes flatter, indicating
diminishing marginal product.
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Chapter Three
When the competitive, profit-maximizing firm is
deciding whether to hire an additional unit of labor, it
considers how that decision would affect profits. It
therefore compares the extra revenue from the increased
production that results from the added labor to the extra
cost of higher spending on wages. The increase in revenue
from an additional unit of labor depends on two variables:
the marginal product of labor, and the price of the output.
Because an extra unit of labor produces MPL units of output
and each unit of output sells for P dollars, the extra revenue
is P MPL. The extra cost of hiring one more unit of labor
is the wage W. Thus, the change in profit from hiring
an additional unit of labor is D Profit = D Revenue - D Cost
= (P MPL) - W
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Chapter Three
Thus, the firms demand for labor is determined by P MPL = W,
or another way to express this is MPL = W/P, where W/P is the
real wage the payment to labor measured in units of output rather
than in dollars. To maximize profit, the firm hires up to the point
where the extra revenue equals the real wage.
The MPL depends on the amount of labor.
The MPL curve slopes downward because
the MPL declines as L increases. This
schedule is also the firms labor demand
curve.
Units of
output
Units of labor, L
MPL, labor demand
Quantity of labor demanded
Real
wage
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Chapter Three
The firm decides how much capital to rent in the same way it decides
how much labor to hire. The marginal product of capital, or MPK,
is the amount of extra output the firm gets from an extra unit of
capital, holding the amount of labor constant:
MPK = F (K + 1, L) F (K, L).
Thus, the MPK is the difference between the amount of output produced
with K+1 units of capital and that produced with K units of capital.
Like labor, capital is subject to diminishing marginal product.
The increase in profit from renting an additional machine is the extra
revenue from selling the output of that machine minus the machines
rental price: D Profit = D Revenue - D Cost = (P MPK) R.
To maximize profit, the firm continues to rent more capital until the MPK
falls to equal the real rental price, MPK = R/P.
The real rental price of capital is the rental price measured in units of
goods rather than in dollars. The firm demands each factor of production
until that factors marginal product falls to equal its real factor price.
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Chapter Three
The income that remains after firms have paid the factors of
production is the economic profit of the firms owners.
Real economic profit is: Economic Profit = Y - (MPL L) - (MPK K)
or to rearrange: Y = (MPL L) - (MPK K) + Economic Profit.
Total income is divided among the returns to labor, the returns to capital,
and economic profit.
How large is economic profit? If the production function has the property
of constant returns to scale, then economic profit is zero. This conclusion
follows from Eulers theorem, which states that if the production function
has constant returns to scale, then
F(K,L) = (MPK K) - (MPL L)
If each factor of production is paid its marginal product, then the sum
of these factor payments equals total output. In other words, constant
returns to scale, profit maximization,and competition together imply that
economic profit is zero.
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Chapter Three
The Cobb-Douglas Production Function
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 =
Labor Income = MPL L = (1- ) Y
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Chapter Three
Capital Income = MPK K = Y
Labor Income = MPL L = (1- ) Y
is a constant between zero and one and
measures capital and labors share of income.
Cobb showed that the function with this property is:
F (K, L) = A K
L
1-
A is a parameter greater than zero that
measures the productivity of the
available technology.
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Chapter Three
Next, consider the marginal products for the CobbDouglas
Production function. The marginal product of labor is:
MPL = (1- ) A K