L3 - The classical model of production Flashcards
Sketch a diagram showing circular flow in the economy.
Check photo.
What is the long-run model of production?
Maximally simplified economy: single, closed, one good consumed/produced, markets clear, prices flexible.
Explain a general production function, defining Y, L, K and A.
PF shows how much output (Y) can be produced given a set of inputs (K, L, etc) for productivity parameter A.
Define Marginal Product of Labour (MPL).
The amount of extra output produced when labour input increases by one unit.
Define Marginal Product of Capital (MPK).
The amount of extra output produced when capital input increases by one unit.
State the assumptions of the neoclassical production function. Give an example of such a function.
Constant returns under scaling. Diminishing marginal returns (as one factor is increased its marginal product decreases). Cobb- Douglas production function.
What does it mean for firms to be perfectly competitive?
Firms small and price takers (at P), hire workers at wage W, rent capital at rate R.
How would a competitive firm demand capital and labour to maximise profit?
Max profit = max{PF(K, L) - RK - WL}
Give MPL and MPK in terms of W, P, R.
MPL = W/P, MPK = R/P
State the 5 endogenous variables and the parameters of the classical production model.
Output (Y), amount of capital (K), amount of labour (L), real wage (W/P), real rental rate of capital (R/P). Productivity parameter A, exogenous supplies of capital and labour, the production parameter function a.
What is the economic profit of the CPM? Why is this?
Zero - perfect competition drives economic profits to zero.
What is the accounting profit of the CPM?
Y - (MPL x L) = Economic profit + (MPK x K).
According to the CPM, output per person in equilibrium is the product of which forces?
Productivity A (known as Total Factor Productivity (TFP)), capital per person k.
Why does the CPM under-predict income differences compared to what is observed?
Capital per person varies enormously between countries, and the model has a strong diminishing return to capital per person which smooths out the differences.
How can you explain the output differences between rich and poor countries?
Differences in capital per person (~1/4) and different TFP (~3/4). They have more capital per person and they use labour and capital more effectively.
