Topic 1 - National Income Flashcards
What are the factors of Production
land, labour, capital and technology
How does technology help the the three factors of production?
technology helps to
combine all the other 3 factors – this is how you supply goods/services
How you supply goods/services and from that supply your total income will be
determined. why?
as whatever firms produce; they sell and from that revenue they pay
the factors of production – and that is spent – that is consumption and the
consumption is the revenue of firms
What price should each factor of production be priced at
Its marginal product
What is the additional output generated by labour known as ?
the Marginal product of Labour (MPL)
for example if you work for 1 extra hour and make 3 pizzas – then the
value of your wage should be equal to the price of 3 pizzas
MPL
CRS
Constant Returns to scale. if you increase
each factor of production by 1% then output will increase by 1%
What side does the Classical model focus on
on supply not the demand side
What prices do Classical models believe in
In flexible prices – the supply creates the demand – when there is a surplus price is lowered to sell everything – if there is a shortage prices will rise – and everything will be sold
Classical Model - How is supply determined
output/income
Classical Model – demand side is made
up of?
Consumption (C) + Investment (I) + Government Spending (G)
Classical Model - What demand side determines
only determines the price level
Classical Model - How much output is produced is answered by?
The supply side
How is equilibrium reached
Equilibrium is reached in goods market and loanable funds market
What does the keynesian model focus on?
Keynesian model focuses on demand – says that demand creates supply – what
people demand is what should be produced
The Classical cannot explain the Great Depression because?
whatever the economy demands we produce it – whenever there are excess demand people will work to produce that good/service – on the other hand if there is excess supply there will be depression and people will be made redundant.
In that sense if you don’t want people to be laid off the government should intervene to increase demand
What is the production function formula
Y = F (K, L) – the K and L are in the bracket as you combine
labour to capital – how you arrange them is F
How is the distribution of income determined by
by factor prices – the price firms pay for the factors of production
Wages = Price of L – we don’t just use wage we use real wage which is equal to
W/P (price level)
- Rental Price = Price of K – we use real rental price which is equal to R/P
How are factor prices determined?
by supply and demand of factor markets
Firms demand and hire each unit of labour at a price until?
each unit of labour at a price
which does not exceed the benefit – cost = real wage
Diminishing Returns of Marginal Labour
this is because when all other inputs are kept the same there is more workers sharing the same input and so they are unable to maximise it since they don’t have the opportunity – labour productivity falls because capital per labour is falling
What is the slope of the Production Function
Slope is equal to ∆Y/∆L – the slope is equal to the MP
A
Average Product
Y/ L
What is elasticity
Elasticity is when you increase an input by 1% how many percent will output
increase by
Ø Elasticity = %∆Y/%∆L
Ø %∆ is equal to ∆/Initial x 100
Ø (∆Y/Y) x 100 / (∆L/L) x 100 = the x100 will cancel each other out = and we multiply
the top and bottom by Y which will equal ∆Y/ ∆L x (Y/L) – then you divide both the
bottom and top by ∆L – this will equal (∆Y/∆L) / (Y/L)
Ø Elasticity = MP/AP
What does A represent in Y=AKL
A represents total factor productivity – as if it increases total output will increase
What happens if you only increase one input
MP declines as you increase one input – since the other inputs remain the same –
diminishing marginal return to input
If there is a perfect competitive economy – how can you guarantee that total income will be equal to the income of Labour?
Given the real market wage – firms will hire until the real wage rate is equal to the marginal product of the last worker
Ø W/P = MPL will be when total product has been exhausted –
if you MPL > W/P then you can make more profit by hiring
more worke
The equilibrium of real will automatically come due to the
invisible hand because
– if real wages are too high there will be excess
supply and people will be willing to work for less
Ø While if real wages are too low there will be excess demand
and so will be willing to pay more – until it reaches the
equilibrium
In order to maximise profit was MPK equal.
The real rental Price R/P
Y will only be equal to the the factor prices When?
the production function exhibits constant
returns to scale
Total Labour income equals?
(w/p) x L = MPL x L
Total Capital income equals?
(r/p) x K = MPK x K
The Neo Classical Theory of Distribution
Tells us How Labour and income are distributed in an economy
States that each factor input is paid its marginal product
National Income
Y = MPL x L + MPK x K
If the GDP growth is more than the increase in real wage growth
then it means that the economy is not competitive as they do not have a constant return to scale – this can be because of income disparity (inequality) – so real wage is not equal to MPL
Components of Demand
Consumption – which is consumer demand for goods/services
- Investment – demand for investment goods
- Government spending – government demand for goods/services
Disposable income equals
Y – T = in which Y is income and T is tax
What is consumption equal to
Y - T
MPC
Marginal Propensity to consume – is the change in C when
disposable income rises by $1
Investment is equal to ?
the real rate of interest – the real
interest rate is the cost of investment – so if real interest
increases investment will fall and vice versa
Government spending is just a fixed number and excludes?
transfer payments such as unemployment benefits
Consumption Function
The investment function relates the quantity of investment to the real interest rate. Investment depends on the real interest rate because the interest rate is the cost of borrowing. The investment function slopes downward: when the interest rate rises, fewer investment projects are profitable
Aggregate Demand equals
C (Y – T) + I (r) + G
Aggregate Supply equals
Y = F (K, L)
What Brings the Supply and Demand For Goods and Services Into Equilibrium?
In the Classical Model the interest rate is the price that has the crucial role of equilibrating supply and demand.
(1) We can consider how the interest rate affects the supply and demand for goods or services.
(2) Or we can consider how the interest rate affects the supply and demand for loanable funds.
Market for goods and services - if interest rate is too high?
The greater the interest rate, the lower the level of investment, and thus the lower the
demand for goods and services, C + I + G.
If the interest rate is too high, then investment is too low and the demand for output falls
short of the supply.
Market For Goods and Services - If Interest Rate is too low?
If the interest rate is too low, then investment is too high and the demand exceeds the
supply.
Private Savings equals?
Y – T – C
Public Savings equals
T - G
Y > C + I + G
Since private savings is equal to disposable income minus consumption
- And government spending is equal taxes minus government spending
- So, Y – C – G > I
- S > I
- This means you have excess supply of loanable funds
- Excess supply of goods means excess supply of loanable fund
Tax Does not affect total savings because?
as increase will lower private saving but increase
public savings, so it cancels out
The AD line in perfectly inelastic and vertical straight line – as
the demand equation
does not have price in it
Explain the The Loanable Funds Market (components)
A simple supply/demand model of financial system One asset: “loanable funds”: Demand for funds: investment Supply of funds: savings Price of funds: real interest rate
Demand for Funds
The demand for loanable funds comes from investment
Firms borrow to finance spending on plant and
equipment, new office buildings, etc.
Consumers borrow to buy new houses
The demand for loanable funds depends negatively on r
The ‘price’ of loanable funds (cost of borrowing
Budget Surplus occurs when?
Taxes are more than government spending so positive
public savings
Budget Deficit is when
when taxes are lower than government spending so
negative public savings
When there is a deficit the government has to?
to borrow – so they can borrow from the
tax-payers or they can borrow from abroad for interest rate – and if
governments don’t pay them back public debt keeps increasing
National savings does not depend on interest rate
as Keynes
assumed that consumption cannot be affected by interest rate
When savings equal investment
loanable market is at equilibrium
Increased government spending will reduce savings – and tax cut will increase consumption which will again reduce savings. What happens to investment and national income?
he reduction in savings crowds out investment and interest rate
rise – and no change in national income
Ø Since Y is equal to the production function – it cannot be
changed by consumption or government spending
in the classical model you cannot increase raise supply by increasing demand. Why?
this will just lead to the interest rate rising – so in
order to increase investment you need to
increase savings
Explain Increased government spending
In the short run we see that due to increased government spending and lower taxes
– savings fall – but interest rate hasn’t adjusted yet
Ø This will result in higher AD – which will mean higher output – this will increase the
demand for labour leading to higher wages – but this shift is temporary
Ø In the long-run interest rate is able to adjust pushing output back to the original
output
Higher government will not increase output because we assume government
spending is not a part of the production function – but if government spending is
able to increase the level of technology – by improving infrastructure, research and
development – but still this will take a very long time
Tax cut will not also increase production unless?
unless we assume that a tax cut will make
workers work overtime
How does TFP affect Inequality
So, when Y = A LS LU – which is the distribution of skilled and
unskilled labour
The MPLU = ß(Y/Lu)
Ø Some people from the unskilled labour will have access to
education – and their wage is much higher because they are
more productive
