Macroeconomics & the Global Economy

Session 3: National Income-where it comes

and where it goes?
(Classical/Neo-classical Model)
How does the entire economy work?

Understanding by using
Basic Classical Model
Simple Circular flow of income model (Closed economy)

Firm’s Revenue Market for goods Consumption (C)

and Services expenditure
Government Purchase (G) Goods/

Investment (I) Taxes (T) Services

Government

Firms Public Households

Savings (S)
Private
Loans Financial Savings (S) Income (Y)
Markets

Market for Factors

of Production
Factor Payment
Again: How does an economy work? Sources
and Uses of Nation’s GDP
• What determines the level of production (and
thus the level of national income)?
• How the markets for factors of production
distribute the income?
• How much of the income is consumed and how
much is saved?
• How are demand for goods and services (C, I
and G) and supply are brought into equilibrium?
An economy’s output or Supply of goods and services (GDP)
depends on:

(1) Quantity of inputs : Factors of Production (Capital and

Labor)
(2) Ability to turn inputs into output : Production Function

Needs clear understanding on:

Factor Market and

Goods (and Services) Market
 Classical theory: Assumption 1
Relating to Factors of Production

• Capital: set of tools that workers use

• Labor: time people spend on working
• The economy’s supplies of capital and labor are
fixed.
K K and L L
• Factors of production are fully utilized i.e. no
resources are wasted.
 Classical Theory: Assumption 2
Relating to Production function:
• Reflects the economy’s level of technology.
• Denoted by Y = F (K, L)
• Shows how much output (Y ) the economy can
produce from K units of capital and L units of labor.
• Three Properties: Increasing, constant and Decreasing
(Diminishing) returns to scale.
• Classical Assumption: PF exhibits constant returns to
scale
(Meaning: If we increase all inputs by 25%, output will also
increase by 25%.)
The Supply of Goods and Services

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.
How is National Income distributed to the
Factors of Production?
• Depends on: how much economy uses K or L.
• How much economy employs K or L depends on their prices
or factor prices.
• The prices per unit that economy pays for employing FOP:
factor prices:
• wage (w) is the price of L
• Rental/Interest rate (r) is the price of K.
 How factor prices are determined
• Factor prices are determined by supply and demand in
factor markets.
• The intersection of demand and supply of the factors
determine the factor prices and quantity of factors
utilized. Which one plays major role?
• Recall: Supply of each factor is fixed.
K K and L L
• Therefore, it is the demand for the factors that
ultimately determine the factor prices
 Determination of Factor Prices
Factor prices are determined by supply and demand in factor
markets.

Factor Factor supply

price
(Wage or
rental This vertical supply curve
rate) is a result of the
supply being fixed.

Equilibrium
factor price Factor demand

Quantity of factor
Because the factor supply curve is vertical and fixed, it is the
demand curve for the factors of productions which determines the
factor prices.
 Factors determining profit
Profit = Revenue – Cost
= PY – (wL + rK)
= PY – wL – rK
= PF(K,L) – wL – rK

So, Profit depends on product price P, factor

prices w and r ,and the factor quantities L and
K.
• Big Question:

What determines the

demand for factors of
production?

Answer: Depends upon Marginal Product of Labor

(MPL) and Marginal Product of Capital (MPK).
 MPL and the demand for labor
Units of
Each
Each firm
firm hires
hires labor
labor
output
up
up to
to the
the point
point where
where
PP××MPL
MPL ==W
W
Real MPL
MPL==W/P
W/P
wage

MPL, Labor
demand

Units of labor, L
Quantity of labor
demanded

slide 14
 The equilibrium real rental rate
Units of
output Supply of
The
Thereal
realrental
rentalrate
rate
capital
adjusts
adjuststo
toequate
equate
demand
demandforforcapital
capitalwith
with
supply.
supply.

equilibrium
r/P MPK, demand
for capital

K Units of capital, K
How Total Income (Y) is distributed?
W
total labor income = L  MPL  L
P
R
total capital income = K  MPK  K
P

If production function has constant returns to

scale, then
Y  MPL  L  MPK  K
national labor capital
income income income
Thank You