ECON 282: Chapter 3 Flashcards
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 Labour
-Reflects the economy’s level of technology
-Exhibits constant returns to scale
Returns to SCALE:
-Initally, Y1=F(K1, L1)
Scale all inputs by the same factor z:
If constant returns to scale, Y2 = zY1
If increasing returns to scale, Y2 >zY1
If decreasing returns to scale, Y2 < zY1
Assumptions
- Technology is fixed
- The economy’s supplies of capital and labour are fixed at:
K bar and L bar
The distribution of national income
-determined by factor prices, the prices per unit firms pay for the factors of production
wage = price of L
rental price = price of K
Notation: W, R, P, (W/P), (R/P)
W= nominal wage
R = nominal rental rate
P = price of output
W/P = real wage
R/P = real rental rate
Demand for labour
-Assumes that markets are competitive, each firm takes W, R, and P as given
-A firm hires each unit of labour if the cost does not exceed the benefit
cost = real wage
benefit = marginal product of labour
Marginal Product of Labour
The extra output the firm can produce using an additional unit of labour (holding other inputs fixed)
MPL = F(K,L +1) - F(K,L)
Diminishing Marginal Returns
-As one input is increased (holding other inputs constant) its marginal product falls
- If L increases while holding k fixed, machines per worker falls, worker productivity falls
Determining the rental rate
-MPL = W/P
- The same logic shows that MPK = R/P
Diminishing returns to capital: MPK falls as K rises
-The MPK cure is the firms demand curve for renting capital
Firms maximise profits by choosing K such that MPK = R/P
Neoclassical theory of distribution
-States that each factor input is paid its marginal product
How Income is distributed to L and K
Total capital income: W/PxL=MPLxL
Total capital income=R/PxK=MPKxK
Cobb-Douglas Production Function
a = capitals share of total income
capital income = MPK x K = aY
Explanation for rising inequality
-Technological progress has increased the demand for skilled relative to unskilled workers
-Rise in self-employment rates and a fall in the number of hours worked for low-skill
Disposable income
Total income minus total taxes: Y-T
Consumption function
C=C(Y-T)
Marginal propensity to consume (MPC)
the change in C when disposable income increases by one dollar
Investment function
I = I (r)
r = real interest rate (nominal interest rate corrected for inflation)
I depends negatively on r
Real Interest Rate
-the cost of borrowing
-the opportunity cost of using one’s funds to finance investment spending
Government Spending
-Government spending on goods and services
-G excludes transfer payments (For example, Canada pension plan payments, employment insurance benefits)
-Assume that government spending and total taxes are exogenous
G bar and T bar
The market for goods and services equations
Aggregate demand: C(Ybar-Tbar) + I(r) + Gbar
Aggregate Supply: Ybar=F(Kbar, Lbar)
Equilibrium: Ybar= C(Ybar-Tbar) + I(r) + Gbar
The loanable funds market
-A simple supply-demand model of the financial system
-demand for funds: investment
-supply of funds: saving
-price of funds: real interest rate
The demand for loanable funds
-Comes from investment(firms borrow to finance, consumers to buy house, etc)
-depends negatively on r (r is the “price” of loanable funds (cost of borrowing)
Supply of funds: Saving
-The supply of loanable funds comes from saving
-Households use their saving to make bank deposits and purchase bonds. These funds become available to firms to borrow and finance investment spending.
-the government may also contribute to saving if it does not spend all the tax revenue it receives
Types of Saving
Private Saving= (Y-T)-C
Public Saving=(T-G)
National Saving=S
National Saving
private saving + public saving
(Y-T)-C + T-G
=Y-C-G
Budget Surplus
-If T > G
-(T-G)
public saving
Budget Deficit
-If T < G, budget deficit
(G-T) and public saving is negative
Balanced budget
T=G
public saving=0
R
-adjusts to equilibrate the goods market and the loanable funds market simultaneously
-If the loanable funds market is in equilibrium, them Y-C-G=I
Add (C+G) to both sides to get Y=C+I+G
Things that shift the loanable funds model
-public saving
-fiscal policy
-private saving
Things that shift the investment curve
-some technological innovations
-tax laws that affect investment
Saving and the interest rate
-An increase in desired investment
-raises the interest rate
-and raises equilibrium investment and saving
