Mankiw Chapter 3: National Income

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CHAPTER 3

National Income

In this chapter you will learn

what determines the economys total
output/income (Production)
how total income is distributed (Distribution)
what determines the demand for goods and
services (Allocation)
how equilibrium in the goods market is
achieved (Equilibrium)
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National Income

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CHAPTER 3

National Income

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Outline of the model

A closed economy, market-clearing model

Supply side

factor markets
determination of output/income

Demand side

determinants of C, I, and G

Equilibrium

goods market
loanable funds market
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National Income

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Assumptions of the model

K = capital,
tools, machines, and structures
used in production
L = labor,
the physical and mental efforts of
workers

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Assumptions of the model

1.Technology is fixed (production function).
2.The economys supplies of capital and

labor are exogenously fixed at

K K

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and

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LL

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Determination of GDP
Output is determined by the fixed factor
supplies and the fixed state
of technology:

Y F (K , L)
We did not talk about demand this far! The
endogenous output is only determined by
exogenous supply factors!
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National Income

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The production function

Factor of production
L = labor, the physical and mental efforts of

workers.
K = physical capital, machines and buildings.

Production function
Y = F (K,L): how much output (Y ) the economy
can produce given an amount of inputs.

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National Income

How does F(K,L) look like?

How are inputs converted into output?
Idea: Lets look at long-run trends.
(w*L)/Y and (r*K)/Y are constant

over time.

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National Income

Labors share of income in the U.S.

Labors share seems to be pretty constant over

time (therefore capitals share of income is also
constant)

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Labors share of income in Spain

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3

National Income

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How are prices determined?

Factor prices are determined by supply and
demand in factor markets.
Recall: Supply of each factor is fixed.
What about demand?

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National Income

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Firms labor demand

Assume markets are competitive:
each firm takes W, R, and P=1 as given
Profit maximization: (the goal of a firm)
Profit=revenue-labor costs-capital cost
=Y-WL-RK=F(K,L)-WL-RK
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

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Firms labor demand

As a result, we have
w = MPL
r = MPK

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National Income

The equilibrium real wage

Units of
output

Labor
supply

equilibriu
m real
wage
L

MPL,
Labor
demand
Units of labor,
L

The
The real
real wage
wage adjusts
adjusts to
to
equate
equate
labor
demand
with
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National
Income
labor
demand
with supply.
supply.

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The equilibrium real rental rate

Units of
output

Supply of
capital

equilibriu
m R/P
K

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National Income

The
The real
real rental
rental
rate
rate adjusts
adjusts to
to
equate
equate
demand
demand for
for
capital
capital with
with
supply.
supply.
MPK,
demand for
capital
Units of capital,
K

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Back to constant factor shares

Constant factor shares imply:
(w*L)/Y = (MPL*L)/Y=(1-a)
(r*K)/Y = (MPK*K)/Y=a
This is true for Cobb-Douglas.

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Cobb-Douglas production function

Cobb-Douglas form:

Y AK L

where A represents total labor

productivity.

The function has important properties:

Constant returns to scale.

Diminishing
marginal returns.
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Further implication of Cobb-Douglas

Cobb-Douglas form:

Y AK L
Wages:

proportional to productivity A
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Productivity and wages in the US

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Productivity and wages in Spain

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Review returns of scale

Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(If z = 1.25, then all inputs are increased by
25%)

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
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Exercise: determine returns to scale

Determine whether each of the following
production functions has constant,
increasing,
or decreasing returns to scale:

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Diminishing marginal returns

Recall, a Cobb-Douglas production
function has diminishing marginal returns.

As a factor input is increased, its

marginal product falls (other things equal).

Intuition:
L while holding K fixed

fewer machines per worker,

lower gains from extra workers.

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Graphical representation

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Check your understanding:

Which of these production functions have
diminishing marginal returns to labor?

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The size of profits

Y=w*L+r*K+profits
With constant returns:
zY=F(zK,zL).
Differentiate with respect to z:

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The size of profits

Evaluate at z=1 and impose

perfect competition:
Y=r*K+w*L.
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How income is distributed

W
L
total labor income =
P
R
K
total capital income
P

MPL L
MPK K

=
If production function has constant
returns to scale, then

Y MPL L MPK K
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income
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labor
income
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capital
income
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Outline of the model

A closed economy, market-clearing model

Supply side

factor markets
determination of output/income

Demand side

determinants of C, I, and G

Equilibrium

goods market
loanable funds market
CHAPTER 3

National Income

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