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

= 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 Firms 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 Firms 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

Investment Saving
Financial Market
Firms Households
Government Taxes
Government Purchases

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 = C / (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

Equilibrium interest rate

I(r)

Investment, Saving
 Increase in Investment Demand
Real interest rate
An increase in investment demand
S 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
Quantity of Saving
I1 I2