ECON7020
The Macroeconomy

LECTURE 2
Determinants of National Income – Long-Run Foundations

Today’s Topics:
 modeling the macroeconomy  what determines the economy’s total output/income  how the prices of the factors of production are determined  how total income is distributed  what determines the demand for goods and services  how equilibrium in the goods market is achieved
 Text treatment: Mankiw 8th (& 7th) edition, Ch. 3
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Modeling the Macroeconomy
Key characteristics A closed economy, market-clearing model  Supply side
 factor markets (supply, demand, price)  determination of output/income

 Demand side
 determinants of C, I, and G

 Equilibrium
 goods market  loanable funds market
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Figure 3.1 The Circular Flow of Dollars Through the Economy Mankiw: Macroeconomics, Seventh Edition
Copyright © 2010 by Worth Publishers

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

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The production function: Y = F(K,L)
 shows how much output (Y ) the economy can produce from K units of capital and L units of labor  reflects the economy’s level of technology  exhibits constant returns to scale

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Returns to scale: a review
Initially Y1 = F (K1 , L1 ) Scale all inputs by the same factor z: K2 = zK1 and L2 = zL1
(e.g., if z = 1.2, then all inputs are increased by 20%)

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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Assumptions in the production function model
1. Technology is fixed. 2. The economy’s supplies of capital and labor

are fixed at

K K

and

LL

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

Y  F (K , L)

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The Distribution of National Income:
Market for Factors of Production  Distribution of NI is determined by factor prices, the prices per unit firms pay for the factors of production
 wage = price of L  rental rate = price of K

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Notation
W R P = nominal wage = nominal rental rate = price of output

W /P = real wage (measured in units of output) R /P = real rental rate

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How factor prices are determined
 Factor prices are determined by supply and demand in factor markets.  Recall: Supply of each factor is fixed.

K, L 

 What about demand?

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Demand for labor
 Assume markets are competitive: each firm takes W, R, and P as given.  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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Marginal product of labor (MPL) definition: The extra output the firm can produce using one additional unit of labor (holding other inputs fixed): MPL = F (K, L +1) – F (K, L)

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MPL and the production function
Y
output
F (K , L )
1

MPL
As more labor is added, MPL 

MPL
1

MPL
1

Slope of the production function equals MPL

labor

L
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Diminishing marginal returns
As a factor input is increased, its marginal product falls (other things equal).

Intuition: Suppose L while holding K fixed
 fewer machines per worker  lower worker productivity

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MPL and the demand for labor
Units of output

Real wage

Each firm hires labor up to the point where MPL = W/P.

MPL, Labor demand Units of labor, L Quantity of labor demanded
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The equilibrium real wage
Units of output Labor supply

The real wage adjusts to equate labor demand with supply.

equilibrium real wage

L

MPL, Labor demand Units of labor, L

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Determining the rental rate
 We have just seen that MPL = W/P.  The same logic shows that MPK = R/P:
 diminishing returns to capital: MPK  as K   The MPK curve is the firm’s demand curve for renting capital.  Firms maximize profits by choosing K such that MPK = R/P.