Chapter 03 Flashcards
What determines the toal production of goods and services
An economyʼs output of goods and services — its GDP — depends on (1) its quantity of inputs, called the factors of production, and (2) its ability to turn inputs into output, as represented by the production function.
Factors of production
The inputs used to produce goods and services. The 2 most important factors of production are capital (K) and Labor (L)
Factors of production - Capital
the set of tools that workers use: the construction workerʼs crane, the accountantʼs calculator, and this authorʼs personal computer
Factors of production - Labor
the time people spend working.
The production function
The available production technology determines how much output is produced from given amounts of capital and labor. Economists use a production function to express this relationship. Letting Y denote the amount of output, we write the production function as Y = F(K,L)
This equation states that output is a function of the amounts of capital and labor.
Constant returns to scale
Many production functions have a property called constant returns to scale. A production function has constant returns to scale if an increase of an equal percentage in all factors of production causes an increase in output of the same percentage. For example, if the production function has constant returns to scale, then increasing both capital and labor by 10 percent results in 10 percent more output. Mathematically, a production function has constant returns to scale if
How is national income distributed to the factors of production?
Because the factors of production and the production function together determine the total output of goods and services, they also determine national income. ational income flows from firms to households through the markets for the factors of production.
Marginal product of capital or labor
the demand for each factor of production depends on the marginal productivity of that factor. This theory, called the neoclassical theory of distribution, is accepted by most economists today as the best place to begin understanding how the economyʼs income is distributed from firms to households.`
Factor prices
Factor prices are the amounts paid to each unit of the factors of production. In an economy where the two factors of production are capital and labor, the two factor prices are the rent the owners of capital collect and the wage workers earn.
Factor prices example
Rent the owners of capital collect and the wage workers earn.
How a Factor of Production Is Compensated
The price paid to any factor of production depends on the supply and demand for that factor’s services. Because we have assumed that supply is fixed, the supply curve is vertical. As usual, the demand curve slopes downward. The intersection of the supply and demand curves determines the equilibrium factor price.
Production technology is expressed with the production function ____
Y=F(K,L)
where Y is the number of units produced (the firmʼs output), K the number of machines used (the amount of capital), and L the number of hours worked by the firmʼs employees (the amount of labor). Holding constant the technology as expressed in the production function, the firm produces more output only if it uses more machines or if its employees work more hours.
Labor Costs = ____
W * L, the wage W times the amount of Labor L
Capital Costs = _____
R * K, the rental price of capital R times the amount of capital K.
We can write profit as: profit + Revenue (PY)- Labor costs (WL) - capital costs (R*K)
How profit depends on the factors of production
To see how profit depends on the factors of production, we use the production function Y= F(K,L) to substitute for Y to obtain PROFIT = PF(K, L) - WL -RK.
This equation shows that profit depends on the product price P, the factor prices W and R, and the factor quantities L and K. A competitive firm takes the product and factor prices as given and chooses the amounts of labor and capital that maximize profit.
How do firms find their profit maximizing quantities of capital K and labor L.
Finding the marginal product of labor and capital.
The Marginal product of labor
The more labor a firm employs, the more output it produces. 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. We can express this using the production function
MPL = F(K,L +1) - F(K,L)
This equation states that the marginal product of labor is the difference between the amount of output produced with L+1
units of labor and the amount produced with only L units of labor.
Property of diminishing marginal product
Diminishing Marginal Product: Holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases. The MPL is the amount of extra output produced when an extra unit of labor is hired. As more labor is added to a fixed amount of capital, however, the MPL falls. Workers become less productive. In other words, holding capital fixed, each additional workers adds fewer K to the output.
What happens to the amount of output when we hold the amount of capital constant and vary the amount of labor?
The MPL becomes the slope of the production function… as the amount of labor increases, the production function becomes flatter, and that indicates diminishing marginal product.
Change in profit from hiring an additional unit of labor
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. he 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 (P*MPL)-W
How much labor does the firm hire?
where P*MPL = W or we also write this as MPL = W/P
Real wage W/P
Real wage is the payment to labor measured in units of output rather than in dollars. To maximize profits, the firm will hire up to the point at which the MPL = W/P (real wage)
The MPL schedule is also the firm’s labor demand curve because the MPL diminishes as the amount of labor increases.
Marginal Product of Capital and Capital Demand
A firm decides how much capital to rent in the same way it decides how much labor to hire. The marginal product of capital (MPK) is the amount of extra output the firm gets from an extra unit of capital, holding the amount of labor constant.
Marginal product of capital MPK
MPK = F(K+1,L)-F(kK,L)
Thus, the marginal product of capital is the difference between the amount of output produced with units of capital and that produced with only K units of capital.
Diminishing marginal product in capital
The change in profit from renting an additional machine is the extra revenue from selling the output of that machine minus the machineʼs rental price:
Profit = (P*MPK) - R
to maximize profit, the firm continues to rent capital until the MPK falls to equal the real rental price.
Basically it is maximized where MPK = R/P
Real rental price of capital
The rental price measured in units of goods rather than in dollars.
competitive, profit-maximizing firm follows a simple rule about how much labor to hire and how much capital to rent: The firm demands each factor of production until that factor’s marginal product equals its real factor price.
So; maximizes labor when MPL = W/P
maximizes capital when MPK = R/P
income after the firms have paid the factors of production is the economic profit
Economic profit = Y - (MPL * L) - (MPK * K)
so
Y= (MPLL)+(MPKK) + economic profit.
Cobb-douglas production function
Production function that describes how actual economies turn capital and labor into GDP.
Cobb-douglas production function properties
- has constant returns to scale CRS. If capital and labor are increased by the same proportion, then output increases by that proportion as well.
- an increase in the amount of capital raises the MPL and reduces the MPK, and an increase in the amount of labor reduces the MPL and raises MPK.
Consumption
All forms of cosumption together make up about 2/3 of GDP. The level of consumption depends directly on the level of disposable income (Y-T). So, consumption C = C(Y-T)
MPC
The marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income increases by one dollar. The MPC is between zero and one: An extra dollar of income increases consumption but by less than one dollar.
Investment
The most volatile factor of GDP. The quantity of investment goods demanded depends on the interest rate, which measures the cost of the funds used to finance investment. For an investment project to be profitable, its return (the revenue from increased future production of goods and services) must exceed its cost (the payments for borrowed funds). If the interest rate rises, financing is more expensive, fewer investment projects are profitable, and the quantity of investment goods demanded falls.
Nominal Interest Rate
The interest rate as usually reported: it is the rate of interest that investors pay to borrow money
Real interest rate
The nominal interest rate corrected for the effects of inflation. If the nominal interest rate is 8% and inflation is 3% real interest rate is 5.
Investment = __
I = I(r) We can summarize this discussion with an equation relating investment I to the real interest rate r:
how the interest rate affects the supply and demand for loanable funds
If we substitute the consumption function and the investment function into the national income accounts identity, we obtain
Y=C(Y-T)+I(r)+G
This equation states that the supply of output equals its demand, which is the sum of consumption, investment, and government purchases.
Demand for goods and services equations
At the equilibrium interest rate, the demand for goods and services equals the supply.
Supply and demand for loanable funds
Because the interest rate is the cost of borrowing and the return to lending in financial markets, we can better understand the role of the interest rate in the economy by thinking about the financial markets. To do so, we rewrite the national income accounts identity as: Y-C-G= I which equals national savings. It it the output that remains after the demands of consumers and the government has been satisfied. So, this means Savings S = Investment I
Private and public/government saving
Savings S = (Y-T-C)+(T-G) = I
Private saving = Y-T-C = Priv.S
Public saving = T-G = Pub.S.
How interest rate brings financial markets to equilibrium,
Saving and investment is a function of the interest rate S= I(r)
The interest rate adjusts to bring saving and investment into balance. The vertical line represents saving — the supply of loanable funds. The downward-sloping line represents investment — the demand for loanable funds. The intersection of these two curves determines the equilibrium interest rate.
Saving is the supply of loanable funds
Investment is the demand for loanable funds
ecause investment depends on the interest rate, the quantity of loanable funds demanded also depends on the interest rate. The interest rate adjusts until the amount that firms want to invest equals the amount that households want to save.
Equilibrium loanable funds
If the interest rate is too low, investors want more of the economyʼs output than households want to save. Equivalently, the quantity of loanable funds demanded exceeds the quantity supplied. When this happens, the interest rate rises. Conversely, if the interest rate is too high, households want to save more than firms want to invest. Because the quantity of loanable funds supplied exceeds the quantity demanded, the interest rate falls. The equilibrium interest rate is found where the two curves intersect. At the equilibrium interest rate, households’ desire to save balances firms’ desire to invest, and the quantity of loanable funds supplied equals the quantity demanded.
EFFECTS OF FISCAL POLICY: increase in gov’t purchases
An increase in gov’t purchases must be met by an equal decrease in investment. To induce investment to fall, the interest rate must rise. Hence, the increase in government purchases causes the interest rate to increase and investment to decrease. Government purchases are said to crowd out investment.
Crowding out
consider the impact of an increase in government purchases on the market for loanable funds. Because the increase in government purchases is not accompanied by an increase in taxes, the government finances the additional spending by borrowing — that is, by reducing public saving. With private saving unchanged, this government borrowing reduces national saving. a reduction in national saving is represented by a le ward shi in the supply of loanable funds available for investment. At the initial interest rate, the demand for loanable funds exceeds the supply. The equilibrium interest rate rises to the point where the investment schedule crosses the new saving schedule. Thus, an increase in government purchases causes the interest rate to rise from r1 to r2.
Crowding out cont.
A reduction in saving, possibly as a result of a change in fiscal policy, shi s the saving schedule to the le . The new equilibrium is the point at which the new saving schedule intersects the investment schedule. A reduction in saving lowers the amount of investment and raises the interest rate. Fiscal-policy actions that reduce saving are said to crowd out investment.
effects of fiscal policy: a decrease in taxes
The immediate impact of the tax cut is to raise disposable income and thus to raise consumption. Disposable income rises by change in taxes, and consumption rises by an amount equal to the change in taxes * marginal propensity to consume, MPC. The higher the MPC, the greater the impact of the tax cut on consumption. the increase in consumption must be met by a decrease in investment. For investment to fall, the interest rate must rise. Hence, a reduction in taxes, like an increase in government purchases, crowds out investment and raises the interest rate.
Changes in investment demand
- technological innovation leads to an increase in investment demand.
- Investment demand may also change because the government encourages or discourages investment through the tax laws.
- A manager of a perfectly competitive firm observes that the marginal product of labor is 5 units per hour, the marginal product of capital is 40 units per machine, the wage is $20 per hour, the rental price of capital is $120 per machine,
and the price of output is $5 per unit. To maximize profit,
the manager should hire _____ labor and rent _____ capital.
a. more labor, more capital
An economy has the Cobb–Douglas production function y = 10K^1/3L^2/3
. If the economyʼs stock of capital doubles, the share of total income paid to the owners of capital will
stays the same
If immigration increases the labor force in an economy described by a cobb douglas production function, the wage ____ and the rental price of capital _____
c. decreases, increases.
An increase in the ______ interest rate _____ investment
d. real, decreases
- If national income is $1,200, consumption is $600, taxes are
$200, and government purchases are $300, then national saving is
a. $300.
