Lecture II Flashcards
The contents of the cards within this deck all assume the context of the classical model.
On what tenets did Classical Economists disagree with Mercantilists on?
Classical economists completely opposed the two key tenets of mercantilism
(bullionism and government activism). The title of Smith’s book, An Inquiry Into the Nature and Causes of the Wealth of Nations alludes to the fact that his central argument was that PRODUCTION, not money, was the key to the wealth of the nation.
What do Classical Economists believe money is used for? What is its impact on equilibrium?
They argued that money was significant only as a means of facilitating
transactions (e.g. a medium of exchange). Money had no real effect on the equilibrium in an economy, meaning that money only affects nominal values (e.g. prices) in equilibrium.
What factors have real effects on output? How did Classical Economists feel about government activism in markets?
Only real (i.e. non-monetary) factors could have real effects on output and the wealth of a nation—technology, productivity, labour, capital stock, work ethic, legal issues such as private property rights, etc.
Furthermore, the classical economists argued that government activism to direct market outcomes is completely unnecessary and at best has no impact and
at worst impedes market mechanisms and leads to sub-optimal equilibria
Did Classical Economists believe in a self-correcting tendency within the economy?
Classical economists stressed the self-
correcting tendency of the economy, and argued that, assuming people were self-interested and behaved optimally individually–but constrained by moral and legal requirements–
competition would ensure a socially optimal result.
Did Classical Economists believe that the economy would be perfect at any given time?
It is important to note that classical economists believed that an economy operated under the idea of laissez-faire was the perfect system, not that the economy itself would always be perfect at any given point in time.
What is Say’s Law?
Say’s Law, which states that supply creates its own demand. Essentially, the very act of production would provide incomes, and thus encourage consumption with no need for any governmental stimulus. This emphasizes a key point in the classical model: aggregate supply determines output; price levels will adjust to ensure
that aggregate demand will meet this level of aggregate supply.
Did Classical Economists believe that the government could correct an economic slump?
Government intervention could not correct the slump, and if the intervention impeded the self-correcting mechanisms the economy could even be made
worse.
What was Smith’s primary argument?
Smith’s major argument can be expressed as follows: production is the key to wealth, and the issue then is how to utilize scarce resources to most efficiently maximize production. The center of Smith’s
economic theory was that the wealth of a nation is not how much gold it has, but is rather the well-being of the people.
What is the production function?
y = f(Kbar, N)
Real output (y) is a function of the capital stock (K) (fixed in the short run) and the quantity of labour (N).
Describe the production function over time.
The production function (when plotted against labour, the only variable that is not
fixed in the short-run) gives output for different levels of labour input. It is a straight line for low levels of labour input, indicating constant returns. As the quantity of labour applied to the fixed capital stock increases, the output per additional unit of labour gradually declines
until the production function becomes flat (i.e. diminishing marginal returns).
What is the marginal product of labor (MPN)?
Taking the partial derivative of the production function with respect to labour (N) gives us the marginal product of labour (MPN) curve, which, like any derivative, gives the slope of the production function.
The MPN curve is downward sloping because as more and more labour is applied to a fixed quantity of capital, the marginal product of the additional workers gets lower and lower.
Describe labor demand and its formulas.
Firms hire workers as an input to produce output; labour demand is thus derived from the firm’s production decision. Marginal cost of a unit of output can be defined as the nominal (or money) wage (W) of a worker divided by his marginal product (MP), i.e. how much he
produces.
MC = W/MPN
In a perfectly competitive equilibrium, the optimising firm sets P = MR = MC, so we have:
P = W/MPN
Rearranging yields:
W/P = MPN
What is the real wage (W/P)?
Therefore, in equilibrium the real wage W/P must be equal to the marginal product of labour.
(When something is divided by the price level, P, it gives the real value of that variable—in
this case the wage adjusted for the price level.) In other words, the condition for optimality for producing output (marginal benefit equals marginal cost) is the same as for deciding the optimal level of inputs to use
Is the marginal product of labor curve the labour curve?
Yes, the marginal product of labour curve is the labour demand curve.
We can conclude that the quantity of labour demanded for any real wage W/P is given by the MPN curve.
Describe Labor Supply and its formula.
Labour supply is essentially determined by workers’ preferences. Individuals face a trade off between consumption and leisure, and must pick the optimum amount of work for them.
Labour supply can be expressed as a positive function of the real wage:
N^S = g(W/P)
