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ECON 2H03 > Chapter 3 - National Income > Flashcards

Chapter 3 - National Income Flashcards

1
Q

(1) Basic Classical Model, traits and assumptions? (2) Supply side factors, and what they determine? (3) Demand side determines?

A

(1) traits: closed economy (no NX) market-clearing model; assumptions; Y determined by fixed factors (K, L, Tech)

(2) factor markets (supply, demand, price), determine output/income
(3) Demand determines C, I, G

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2
Q

Determinants of G&S production

A

factors of prod (based on technology avail): Capital and Labor

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3
Q

Production Function: (function, returns, assumptions)

A

production function: Y = F(K,L)

Constant returns to scale: cost per unit of output is constant

Assumptions: Tech, L, K fixed and maximized

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4
Q

Returns to scale (definition)

A

Returns to Scale: impact on output (Y), when scale all inputs by same factor (z) (LR property)

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5
Q

Returns to scale (steps and guidelines)

A

Steps:
Initially: Y1 = F(K1,L1)
Scaling: K2 = zK1 & L2 = zL1
Outcome: Y2 = F(K2,L2)

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6
Q

IRS: macro costs trend, micro profitability trends

A

Increasing returns to scale: Y2 > zY1
Macro: average cost decreasing
Micro: profitable at larger scale

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7
Q

DRS: macro costs trend, micro profitability trends

A

Decreasing returns to scale Y2 < zY1
Macro: average costs increase
Micro: profitable at smaller scale

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8
Q

CRS: macro costs trend and micro profitability trend

A

Constant returns to scale: Y2 = zY1
Macro: average cost constant
Micro: neither

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9
Q

Do returns to scale reflect the law of diminishing returns?

A

No, there is no diminishing returns because all inputs are the same (fixed). Diminishing returns apply when one input rises and all other are fixed.`

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10
Q

What determines total output and national income?

A

factors and production function

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11
Q

Circular flow diagram demonstrates?

A

national income flow from firms –> households through factor markets

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12
Q

Neoclassical theory of distribution (define, basis)

A

how national income is divided to factors of prod.
(1) Classical (18th cent.) idea that price adjust to balance markets, for the factors of prod
- Consider: since now know that supply is fixed, we only analyze demand
(2) Recent (19th cent.) idea that demand each factor depends on its marginal productivity

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13
Q

Distribution of national income determined by ____?

A

Factor prices

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14
Q

Factor prices and ex.

A

amounts paid to factors of production

EX. wage = price of L rental rate = price of K

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15
Q

Notation - what represents?
W, R, P, W/P, R/P

A

o W – nominal wage (firm hires workers at W, price of L),
o R – nominal rental rate (firm rents capital at R, price of K)
o P – price of output (firms sells output at P)
o W/P – real wage (measured in units of output)
o R/P – real rental rate

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16
Q

Nominal vs Real

A

nominal: current prices
Real: prices adjusted for inflation

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17
Q

What determines factor prices?

A

the market S and D (where S fixed) in factor markets. Prices reach EQ

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18
Q

Profit as a function of factor costs (K,L)

A

Profit = PF(K,L) = PY - WL - RK = revenue - labor cost - capital cost

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18
Q

PF(K,L) is ???

A

Profit = PF(K,L)
Profit = PY - WL - RK
Profit = revenue - labor cost - capital cost

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19
Q

Competitive firms use what 5 variables to max profit?

A

chooses amount of L and K to max profit using given P, W, R

*Y not a variable

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20
Q

MR = ? (demand for L)

A

MR = MPL*P (benefit of hiring one more)

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21
Q

MC = ? (demand for L)

A

MC = W (cost of hiring one more)

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22
Q

How many units labor competitive firm hire?

A

hire until point where
MC = MR
W = MPL*P
or
MPL = W/P (where W/P is real wage)

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23
Q

MPL = ? (formula)

A

MPL = F(K,L+1) – F(K,L)

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24
Q

MPL definition and graphical implication in G&S market and Labor market

A

Marginal Product of Labor: extra output firm prod. Using additional unit L (other inputs fixed)

represents:
G&S: slope of the production function
Labor market: demand for labor

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25
Q

What law is demonstrated through MPL ?

A

Law of Diminishing Marginal product

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26
Q

Law of diminishing marginal returns? What declines?

A

Law of Diminishing Marginal returns: as input rises (other constant), MPL will eventually fall

Decline in: machines per worker and productivity of workers (if using labor inputs rising)

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27
Q

EXAMPLE: If W/P =6, at what MPL will firm hire more, less, and optimal number of labor units

A

more: if MPL > 6
less: if MPL < 6
optimal: MPL = 6

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28
Q

Labor market EQ real wage = ?

A

when Supply fixed, find where S = MPL

*since MPL is labor demand

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29
Q

Determining rental rate (cost of capital inputs)

A

MPK = R/P

maximize profit by choosing K that makes equation true

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30
Q

MPK definition and represents graphically

A

Marginal Product of Capital: extra output firm prod. Using additional unit K (other inputs fixed)

represents:

Capital market: demand for renting capital

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31
Q

what is income divided/distributed to?

A

return to labor, capital and economic profit

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32
Q

how are factors paid (from income)?

A

in a competitive and profit maximizing firm, paid its marginal contribution to production processes

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33
Q

Economic profit

A

income remain after firm paid factors of production (for owners)

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34
Q

Real Economic Profit

A

Real Economic profit: economic profit includes implicit costs (opportunity cost)

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35
Q

Economic Profit = ? (equation)

A

Economic Profit = Y – (MPLL) – (MRKK)

EP = output - total paid to labor - total paid to capital

OR

Y = (MPLL) + (MRKK) + Economic Profit
MPLL = total paid to labor
MRKK =total paid to capital

36
Q

Each factor earns?

A

according to its marginal product

37
Q

When is economic profit =0

A

Constant returns to scale, profit max, perfect competition: imply LR

each factor paid MP, sum of pmts = total output
aka. F(K,L) = (MPKK) + (MPLL)

38
Q

When firm owners are capital owners, what is lumped together

A

economic profit and return to capital

39
Q

Cobb Douglas Production Function (definition)

A

production function with constant factor shares (sum of powers = 1)

40
Q

Cobb Douglas Production Function Notation = ?

A

Notation: Y = AKalpha * L(1-alpha)

41
Q

What does each represent?
Y = AK^alphaL^(1-alpha)

A

A – level of technology
alpha – capital’s share of total income
1-alpha – labor’s share of total income

42
Q

What does each represent?
Y = A * K^alpha * L^(1-alpha)

A

Y - output
A – level of technology
K - capital
L - labor

alpha – capital’s share of total income
1-alpha – labor’s share of total income aka beta

43
Q

Capital Income =? (formula)

A

Capital income = MPKK = alphaY

44
Q

Cobb Douglas Production Function and returns to scale rules?

A

Sum of powers:
If alpha + beta
= 1 (constant RS),
>1 (increasing RS),
<1 (DRS)

45
Q

In Cobb Douglas Production function, powers represent ___?

A

powers represent the shares of total income for units

46
Q

Labor productivity growth has a +/- relationship with real wage growth?

What are LT and ST observations?

A

Labor productivity growth & real wage growth have POSITIVE relationship

productivity of labor determines wage growth

LT: wages set according to labor productivity (works well)
SR: wage and productivity growth can vary (things take time, does not work in SR)

47
Q

Classical Model:
characteristics?
what consists of each demand, supply, and equilibrium (outlines entire chapter concepts)

A

characteristics: closed economy, market clearing

Supply side:
factor markets (S, D, P)
determination of output/income
Demand side:
determinants of C,G,I
Equilibrium:
goods market
loanable funds market

48
Q

Components of Aggregate demand (G&S market) in basic model

A

C – Consumer demand for g&s
I – demand for investment goods
G – government demand for G&S
Note: closed economy tf: no NX

49
Q

Consumption Function:
Functional form = ?

A

C = C(Y-T)

50
Q

Consumption = ? (equation and represent variables)

A

C = a + b*(Y-T)

a - autonomous consumption (independent of income level), always +
b - Marginal Propensity to consume (MPC)
(Y-T) - Disposable income (income less tax)

51
Q

Marginal Propensity to Consume (MPC)
(1) definition?
(2) graphical representation?
(3) nature of value?

A

definition: MPC is change in C when disposable income rises 1$ (aka how much of each additional dollar spent)

graph: slope of consumption function (aka b)
not linear IRL (poor/higher vs rich/low have different MPC)

value: between 0 and 1 (fraction)

52
Q

Two ways express disposable income (equations)

A

Disposable income = (Y-T)
Disposable income = Spending + savings

53
Q

EX. if b = 0.29, what is the increase in C for each %increase in disposable income?

A

EX. if b=0.6: C increases by 60% for every % increase in (Y-T)

*since b is slope of consumption function

54
Q

Marginal Propensity to Save (MPS)? Definition? Equation? Nature of value?

A

MPS is change in Investment when disposable income rises 1$ (Fraction of $1 increase in disposable income that is saved)

MPS = 1 - MPC

value is always positive (unless debt?)

55
Q

EXAMPLE:
if C = 50 + 0.8(Y-T)
Find MPC, MPS

If Y-T rises by 100, find:
change in S
Change in C

When income is 100, total consumption is __

 ^^what is induced consumption value?
A

MPC = 0.8 (b value)
MPS = 0.2 (1-b)

C increase by 80 (100.8)
S increase by 20 (100.2)

Total consumption is 130
aka C(100) = 130

Induced consumption: 80

56
Q

Induced consumption definition

A

change in consumption due to the change in income (C*MPC)

57
Q

Investment Function
Functional form - ?

describe variable(s)

A

I = I(r)

r - real interest rate aka cost borrowing

58
Q

real interest rate

Alternate name?
Definition?
Opportunity cost?
Relationship with I?
Relationship with demand for I?

A

Alt name: cost of borrowing

Definition: nominal interest rate adjusted for inflation

OC of using own funds to finance investment spending

r negative relationship with I

r negatively determines demand for investment

59
Q

Will an increase in r impact a

A

Yes!

r increases will reduce household consumption. cost of borrowing will fall

60
Q

Government Spending functional form ?

Tax functional form(s)?

A

G = Gbar

T = Tbar (not proportional to income, lump sum)

T = t*Y (tax is proportional)
t - tax rate

61
Q

Aggregate Demand Equation =?

A

Aggregate demand = C(Ybar-Tbar) + I(r) + Gbar

*I(r) is only endogenous variable (all other fixed/exogenous)
Gov changes taxes
household change C`

62
Q

Aggregate Supply equation = ?

A

Ybar = F(Kbar,Lbar)

63
Q

Aggregate Equilibrium
Formula?
Definition?

A

Definition: where aggregate supply meets aggregate demand, and r changes to equate them both

Equilibrium: Ybar = F(Kbar,Lbar) = C(Ybar-Tbar) + I(r) + Gbar

64
Q

what are loanable funds?
Who are the players in the market?

A

Demand for funds: investment (mainly firms, some households)
Supply for funds: saving (mainly households, also gov if surplus)
Price of funds: real interest rate (determined by S and D)
*In turn determines the EQ in the market G&S

65
Q

what determines the demand for Loanable funds

A

investment curve represents the demand curve for loanable funds
(depends negatively on r)

66
Q

What can cause investment curve/loanable funds demand to rise

A

business more optimistic economy
expect high profit
less business tax
tech change

67
Q

what players determine supply of loanable funds

A

households (deposits) and government (if surplus tax revenue) in the form of savings

68
Q

3 Types of saving and equations

A

Private saving = (Y-T)-C
Public Saving = T-G
National saving = private + public saving = Y-C-G

*remember:
y(supply) must =demand in EQ
as G changes, C and I change to keep EQ
change in demand are related to change in C or I (maintain eq since y fixed)

69
Q

What are the conditions of budget surplus, deficit, and balanced budget

A

T > G -> budget surplus
T < G -> budget deficit (public saving negative)
T = G -> balanced budget (public saving =0)

70
Q

Supply Curve for loanable funds (equation)?

A

national saving independent r, supply vertical (fixed)

Sbar = Ybar - C(Ybar-Tbar) - Gbar (all fixed)

71
Q

what is the special role of r (real interest rate)

A

adjusts to equilibrate goods market and loanable funds market simultaneously
 Loanable Funds market in eq: Y-C-G=I
* Transfer to goods market by add (C+G) each side
* Goods market in eq: Y = C+I+G
 Thus: EQ in LF market = EQ in goods market

72
Q

what is fiscal policy and what does it impact?

A

Fiscal policy is government changes in spending and level of tax
Impacts: 1. D for output G&S 2. Alter national saving/investment/and EQ interest rate

73
Q

increases in government purchases are met by…

A

equal decreases in investment (since T and C remain unchanged)
Y = C + I + G (I falls and G rises)

74
Q

how does government finance additional spending? what changes and remains constant?

A

finance spending by borrowing (reducing public saving)
private saving unchanged, gov borrowing reduces national saving
S = Y – C – G (S falls and G rises)

Reduce saving -> supply LF shift left -> increase EQ r -> crowd out (I)

75
Q

how does reduction in taxes (fiscal policy) effect saving and investment?

A

Tax cut -> raise (Y-T) by changeT -> C rises by MPC*changeT
*New Disposable income (after tax cut) = (Y-T) + changeT
New Consumption (after tax cut) = C + MPCchangeT

National Saving (S = Y-C-G) falls by MPC*changeT
New National Savings: S = Y-C-G – MPCchangeT

where MPC*changeT: portion of change in taxes that consumers will spend (rather than save)

76
Q

why might investment demand increase (2 reasons)

A

technological innovation, tax laws

77
Q

When investment demand increases, what impact on EQ of I and EQ r?

A

o EQ of I remain unchanged (amount invested depends on a fixed level of saving aka. supply of LF)
o EQ rate increases: since supply fixed, investment shift up only changes r (not I)

78
Q

when saving depends on r (supply not fixed), what impact on EQ I and r?

A

increase in r -> household consume less -> save more -> more resources for investment (supply rises)

Graphically: increase in demand for investment -> causes raise interest rates -> cause raise in EQ investment and saving

79
Q

How do you find the Equilibrium values for Y, C, I, r, and S(national saving)?

A

Equilibrium is when total output for G&S market = total

80
Q

When is the loanable funds market in EQ?

A

when Y-C-G=I

81
Q

When is G&S market in equilibrium?

A

when Y = C+I+G

82
Q

How are the G&S and LF markets related?

A

r changes to adjust to ensure EQ is reached in both markets simultaneously.

Thus;
 Loanable Funds market in eq: Y-C-G=I
* Transfer to goods market by add (C+G) each side
* Goods market in eq: Y = C+I+G
 Thus: EQ in LF market = EQ in goods market

83
Q

what is closed economy output used for (3 things)

A

consumption, government spending, investment

84
Q

total output (Y) determined by what factors?

A

economy quantity of K, L and technology

85
Q

Competitive firms hire each factor until ___ (condition)

A

MP = MC or MP=P

86
Q

if the production function has CRS, how caan we express total income (formula)?

A

Labor income + capital income = total income

87
Q

what causes r to rise and I to fall?

A

decrease in national saving (S) caused by government spending (fiscal policy)

88
Q

what causes r to rise but does not impact EQ level of I (since supply fixed)?

A

increase in investment demand

ECON 2H03 (8 decks)

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