Review of the previous Lecture

• The overall level of prices can be measured by either

1. the Consumer Price Index (CPI), the price of a fixed basket of
goods purchased by the typical consumer

2. the GDP deflator, the ratio of nominal to real GDP

• The unemployment rate is the fraction of the labor force that is not
employed.

• When unemployment rises, the growth rate of real GDP falls.

 Lecture 4

National Income:
Where it Comes From and Where it Goes - I

Instructor: Prof. Dr.Qaisar Abbas

 Lecture Contents

• 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

 Outline of model

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
 Factors of production

K = capital, tools, machines, and structures used in

production

L = labor, the physical and mental efforts of workers

 The production function

• denoted 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.

 Returns to 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
 Exercise: determine returns to scale

Determine whether each of the following production functions has

constant, increasing, or decreasing returns to scale:

a) F (K , L )  2K  15L

b) F (K , L )  KL

c) F (K , L )  2 K  15 L
 Assumptions of the model

1. Technology is fixed.

2. The economy’s supplies of capital and labor are fixed at

K K and L L
 Determining GDP

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

Y  F (K , L )
 The distribution of national income

• Determined by factor prices, the prices per unit that firms pay for the
factors of production.

• The wage is the price of L

• The rental rate is the price of K.

 Notation

W = nominal wage
W = nominal wage
R = nominal rental rate
R = nominal rental rate
P = price of output
P = price of output
W /P = real wage
W /P = real wage
(measured in units of output)
(measured in units of output)
R /P = real rental rate
R /P = real rental rate
 How factor prices are determined

• Factor prices are determined by supply and demand in factor

markets.

• Recall: Supply of each factor is fixed.

• What about demand?

 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
 Marginal product of labor (MPL)

def:
The extra output the firm can produce using an additional unit of labor
(holding other inputs fixed):

MPL = F (K, L +1) – F (K, L)

 Exercise: compute & graph MPL
L Y
a. Determine MPL at each MPL
value of L 0 0
n.a.
1 10
b. Graph the production ?
function 2 19
?
3 27
c. Graph the MPL curve with MPL on
8
the
4 34
vertical axis and
?
L on the horizontal axis
5 40
?
6 45
?
7 49
?
8 52
?
 Answers

Production function Marginal Product of Labor

12

MPL (units of output)

60
Output (Y)

10
50
8
40
6
30
20 4

10 2

0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor (L) Labor (L)
 The MPL and the production function

Y
output
F (K , L )
MPL
1 As more labor is
MPL added, MPL 
1

MPL Slope of the production

function equals MPL
1
L
labor
 Diminishing marginal returns

• As a factor input is increased, its marginal product falls (other things

equal).

• Intuition:

L while holding K fixed

Þ fewer machines per worker

 lower productivity
 Check your understanding

Which of these production functions have diminishing marginal

returns to labor?

a) F (K , L )  2K  15L

b) F (K , L )  KL

c) F (K , L )  2 K  15 L
 Exercise (part 2)
L Y
MPL
0 0
Suppose W/P = 6.
n.a.
1 10
10
d. If L = 3, should firm hire more or less 2 19 9
labor? Why? 3 27 8
4 34 7
5 40 6
6 45 5
7 49 4
e. If L = 7, should firm hire more or less 8 52 3
labor? Why? 9 54 2
10 55 1
 MPL and the demand for labor

Units of
output Each
Each firm
firm hires
hires labor
labor
up
up to
to the
the point
point where
where
MPL
MPL == W/PW/P
Real
wage

MPL, Labor
demand

Units of labor, L
Quantity of labor
demanded
 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 .

 The
TheNeoclassical
NeoclassicalTheory
Theory
of
ofDistribution
Distribution

• • states
statesthat
thateach
eachfactor
factorinput
inputisispaid
paidits
itsmarginal
marginalproduct
product
• • accepted
acceptedby bymost
mosteconomists
economists
 How income is distributed

W
total labor income = L  MPL  L
P
R
total capital income = K  MPK  K
P

If production function has constant returns to scale, then

Y  MPL  L  MPK  K

national labor capital

income income income
 Summary

1. Total output is determined by

• how much capital and labor the economy has
• the level of technology

2. Competitive firms hire each factor until its marginal product equals its
price.

3. If the production function has constant returns to scale, then labor

income plus capital income equals total income (output).
 Summary

4. The economy’s output is used for

• consumption (which depends on disposable income)
• investment (depends on the real interest rate)
• government spending (exogenous)