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Ace Institute of Management
Session 2: National incomewhere it comes
and where it goes?
Instructor
Sandeep Basnyat
Sandeep_basnyat@yahoo.com
9841 892281
How does the economy work?
– What determines the total income in an economy?
– What determines the level of production in an
economy?
– Who gets the income from production?
– How the income is distributed among the factors of
production?
Simple demonstration:
Circular Flow of Income Model
Firms Households
Government
Financial
Services
Market for goods
and Services
Market for Factors
of Production
Wages, Interest, Rent
and Profit
National
Income (Y)
Foreign Sector
Imports (M)
Taxes (T)
Savings (S)
Consumption
Expenditure
(C)
National
Products
Government Purchase (G)
Investment (I)
Loans or
Investment Funds
Exports (X)
International Capital Flows
Loans
Repay
Transfer Payments
S + T + M = I + G + X
Total Leakages = Total Injections
Equilibrium Level of National Income
Aggregate Demand (AD) = Aggregate Supply (AS)
How does the economy work?
Our first theory:
the Neo classical theory
(based on classical theory)
• Its roots go back to 1776—to Adam Smith’s Wealth
of Nations.
• Economy was controlled by the “invisible hand”
• Market system, instead of government mechanism
• Buyers and sellers pursuing their own selfinterest
• Emphasis on competition and flexible wages/prices
• Prices adjust to balance supply and demand in an
economy
• Economy usually maintains Full employment of
resources and general equilibrium in economy
(1)Factor Market (Capital and Labour)
(2)Goods Market
An economy’s output of goods and services (GDP) depends
on:
(1) Quantity of inputs : Factors of Production (Capital and
Labour)
(2) Ability to turn inputs into output : Production Function
slide 8
Factors of production
K = capital,
tools, machines, and structures used
in production
L = labor,
the physical and mental efforts of
workers
and = = K K L L
Assumption: The economy’s supplies of capital and
labor are fixed.
The production function
• Usually denoted Y = F (K, L)
• Shows how much output (Y ) the economy can
produce from K units of capital and L units of labor.
• Reflects the economy’s level of technology.
• Three Properties: Increasing, constant and Decreasing
(Diminishing) returns to scale.
• NeoClassical Assumption: PF exhibits constant
returns to scale
(Meaning: If we increase all inputs by 25%, output will also
increase by 25%.)
Overall Assumption of Neo
Classical Theory
Y = F (K,L)
, = ( ) Y F K L
Y = F (K, L)
Y = Y
Since Technology (production function) and K and L
are assumed to be fixed, the output (Y) is also
assumed to be fixed in an economy.
Factor Prices
• How much economy employees FOP depends on
factor prices.
• The prices per unit that economy pays for employing
FOP: factor prices:
• wage (w) is the price of L
• rental rate (r) is the price of K.
How factor prices are determined
• Factor prices are determined by supply and demand in
factor markets.
• Recall: Supply of each factor is fixed.
• What about demand?
and = = K K L L
Factor
price
(Wage or
rental
rate)
Quantity of factor
Factor demand
Factor supply
Equilibrium
factor price
This vertical supply curve
is a result of the
supply being fixed.
Determination of Factor Prices
Factor prices are determined by supply and demand in factor
markets.
Because the factor supply curve is vertical and fixed, it is the
demand curve for the factors of productions which determines the
factor prices.
• Big Question:
What determines the
demand for factors of
production?
Answer: Depends upon Marginal Product of
Labour (MPL) and Marginal Product of Capital
(MPK).
slide 15
MPL and the demand for labor
Each firm hires labor
up to the point where
P × MPL (VMPL) = W
MPL = W/P
Units of
output
Units of labor, L
MPL, Labor
demand
Real
wage
Quantity of labor
demanded
The equilibrium real rental rate
The real rental rate
adjusts to equate
demand for capital with
supply.
Units of
output
Units of capital, K
MPK, demand
for capital
equilibrium
R/P
Supply of
capital
K
How Total Income (Y) is distributed?
total labor income =
If production function has constant returns to
scale, then
total capital income =
W
L
P
MPL L = ×
R
K
P
MPK K = ×
Y MPL L MPK K = × + ×
labor
income
capital
income
national
income
Y
output
The MPL and the production function
L
labor
F K L ( , )
1
MPL
1
MPL
1
MPL
As more labor is
added, MPL +
Slope of the production
function equals MPL
The CobbDouglas Production Function
Paul Douglas
Paul Douglas observed that the division of
national income between capital and labor has been
roughly constant over time.
In other words, the total income of workers and the total
income of capital owners grew at almost exactly the
same rate.
He then wondered what conditions might lead to constant
factor shares. Cobb, a mathematician, said that the
production function would need to have the property that:
Capital Income = MPK × K = αY
Labor Income = MPL × L = (1 α) Y
Capital Income = MPK × K = α Y
Labor Income = MPL × L = (1 α) Y
α is a constant and measures capital and
labors’ share of income.
Cobb showed that the function with this property is:
F (K, L) = A K
α
L
1 α
A is a parameter that measures the productivity
of the available technology. (Total Factor Productivity)
C
o
b
b

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o
u
g
l
a
s
P
r
o
d
u
c
t
i
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F
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t
i
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n
Cobb–Douglas Production Function
Cobb–Douglas Production Function:
Y = F (K, L) = A K
α
L
1 α
Differentiating, we get the Marginal product of labor:
MPL = (1 α) A K
α
L
–α
Multiply and Divide right hand side by L. Then,
MPL = (1 α) [A K
α
L
–α
] L / L = (1 α) [A K
α
L
1α
] / L
MPL = (1 α) Y / L
Similarly, The Marginal product of capital is:
MPK = α A K
α1
L
1–α
or, MPK = α Y/K
Average Labour
Productivity
Average Capital
Productivity
Cobb–Douglas Production Function
Properties of the Cobb–Douglas Production Function
Equation (i) tells us that total income of workers and the total
income of capital owners grow at almost exactly the
same rate when MPL and MPK are equal to their average
productivities.
(1) Consider the Cobb–Douglas production function:
MPL = (1 α)Y/L ………….(i)
MPK= α Y/ K ………………(ii)
Properties of the Cobb–Douglas Production Function
2) The Cobb–Douglas production function has constant returns to
scale. That is, if capital and labor are increased by the same
proportion, then output increases by the same proportion as
well.
Proof:
Consider the CobbDouglas Production function:
F (K, L) = A K
α
L
1 α
F(zK,zL) = A(zK)
α
(zL)
1 α
F(zK,zL) = Az
α
K
α
z
1 α
L
1 α
F(zK,zL) = Az
α
z
1 α
K
α
L
1 α
F(zK,zL) = Az
α+1 α
K
α
L
1 α
F(zK,zL) = Az
K
α
L
1 α
= zA
K
α
L
1 α
= zF(K,L) = zY
Therefore, CobbDouglas production function has constant
returns to scale.
Empirical Evidence of the Cobb–Douglas Production Function
Growth in Labour productivity and Real Wages in US
Period Labour Productivity Real Wages
Growth rate Growth rate
19591973 2.9% 2.8%
19731995 1.4% 1.2%
19952003 3.0% 3.0%
19592003 2.1% 2.0%
Source: US Economic Report of the President, 2005.
FYI: Prepare list of some of countries that support CobbDouglas
production function with their growth rates.
• According to C.D. Prod. Func. : MPL α Y/L
• According to Neo Classical Theory, MPL = W /P
• So, MPL α W/P
Demand for goods & services
Components of aggregate demand:
C = consumer demand for g & s
I = demand for investment goods
G = government demand for g & s
(closed economy: no NX )
Consumption, C
• def: disposable income is total income minus total
taxes: Y – T
• Consumption function: C = C (Y – T )
Shows that (Y – T ) ¬ C
• def: The marginal propensity to consume is the
increase in C caused by a oneunit increase in
disposable income.
• Meaning: If MPC is 99%, then
• 1 unit A(Y ÷ T ) will cause 0.99 unit AC
• MPC = AC / A(Y ÷ T )
• Or, AC = MPC (AY ÷ AT )
The consumption function
C
Y – T
C (Y –T )
1
MPC
The slope of the
consumption function
is the MPC.
Investment, I
• The investment function is I = I (r ),
where r denotes the real interest rate, the
nominal interest rate corrected for inflation.
• The real interest rate is the cost of borrowing
funds to finance investment spending.
So, r ¬ +I
The investment function
r
I
I (r )
Spending on
investment goods
is a downward
sloping function of
the real interest rate
Government spending, G
• G includes government spending on goods
and services raised by Tax revenue
• Neoclassical theory assumes that
government spending and total taxes are
exogenous:
= = and G G T T
Budget surpluses and deficits
• When T > G ,
budget surplus = (T – G ) = public saving
• When T < G ,
budget deficit = (G –T )
and public saving is negative.
• When T = G ,
budget is balanced and public saving = 0.
Equilibrium in The market for goods & services
The real interest rate adjusts
to equate demand with supply in the goods
market.
Agg. demand: ( ) ( ) C Y T I r G  ÷ + +
Agg. supply: ( , ) Y F K L  =
Equilibrium: = ( ) ( ) Y C Y T I r G  ÷ + +
Equilibrium in the Financial Market:
The loanable funds market
A simple supplydemand model of
the financial system.
One asset: “loanable funds”
demand for funds: investment demands
supply of funds: savings (Public + Private)
Supply of the fund: Saving
• private saving = (Y –T ) – C
• public saving = T – G
• national saving or Saving, S
= private saving + public saving
= (Y –T ) – C + T – G
= Y – C – G
Loanable funds market equilibrium
r
S, I
I (r )
( ) S Y C Y T G = ÷ ÷ ÷
Equilibrium real
interest rate, r
Equilibrium level
of investment
National saving
does not
depend on r,
so the supply
curve is
vertical.
The special role of r
r adjusts to equilibrate the goods market and the
loanable funds market simultaneously:
Thus,
Eq’m in
L.F. market
Eq’m in goods
market
·
An Increase in Government Purchases (G) by AG :
• Total demand for goods and services
• General price level and demand for money
(Since Total Output ( Supply) is fixed)
• Govt. spends more money from its savings.
• Savings
• Interest rate (Banks have less money for public)
• Investment level
Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
Thus, government purchases are said to crowd out
investment
The Crowdout effect
r
S, I
1
S
I (r )
r
1
I
1
r
2
2. …which causes the real
interest rate to rise…
I
2
3. …which reduces the
level of investment.
1. The increase in the
deficit reduces saving… 2
S
Macroeconomic Assumption on
Consumption and Saving
• Disposable income (YT) has two functions:
Consumption and Savings
•(Y ÷ T ) = C + S
•A(Y ÷ T ) = AC + AS
• For any given amount of (Y ÷ T),
Increase in ‘C’ leads to decrease in ‘S’.
Also, Since Y is fixed and if C increased S decreased as:
S =YCG)
A Decrease in Taxes:
• Disposable (YT) income
• Consumption (C)
• Saving decreases
• Interest rate (r)
• Investment (I)
Like an increase in government purchases, tax cuts
crowd out investment and raise the interest rate.
Fiscal Policy Operations: Increase/Decrease in “G” or ‘T”
An increase in the demand for
investment goods shifts the investment
schedule to the right. At any given
interest rate, the amount of investment
is greater. The equilibrium moves
from A to B. Because the amount
of saving is fixed, the increase in
investment demand raises
the interest rate while leaving
the equilibrium
amount of investment
unchanged.
But, what if interest rates are even higher?
Investment, Saving, I, S
I
1
Real
interest
rate, r
Saving, S
S
I
2
A
B
Two reasons: Technological changes and Tax Policy
When saving is positively related to the interest rate, it results in the
upwardsloping S(r) curve.
A rightward shift in the investment schedule I(r)
increases the interest rate (r) and the amount of investment (I).
Investment, Saving, I, S
I
1
Real
interest
rate, r
S(r)
I
2
A
B
Upward sloping savings
The higher
interest rate
induces people
to decrease
consumption
and increase
saving, which
in turn allows
investment to
increase.
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