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The Circular Flow of Income 3 National Income: Where It Comes From and Where It Goes 1 Chapter Three The circular flow of income 2 Chapter Three 1 The circular flow of income - examples • Examples of factor payments, consumption, government purchases? • What is government deficit and where should it be placed in the chart? 3 Chapter Three Assumptions: • Buyers and sellers pursue their own self-interest • Market competition and market balance with flexible wages/prices (and total employment) • Origin of classical theory: Adam Smith (1776) •Wealth of Nations •The economy is controlled by the “invisible hand ” – market forces instead of government Copyright 1997 Dead Economists Society 4 Chapter Three 2 Key questions: 1. Firms: what determines their level of production (and thus, the level of national income). 2. The markets for the factors of production : how do they distribute this income to households ? 3. Households: how much of this income do households consume and how much do they save ? 4. Demand arising from investment and government purchases. 5. Finally: how are the demand and supply for goods and services brought into balance ? 5 Chapter Three An economy’s output of goods and services (GDP) depends on: (1) quantity of inputs (2) ability to turn inputs into output • Inputs used to produce goods and services. • The two most important factors of production are capital (K) and labor (L). • Assumption: these factors are given fixed values: K and L 6 Chapter Three 3 1. The available production technology determines how much output is produced from given amounts of capital (K) and labor (L). 2. The production function represents the transformation of inputs into outputs . 3. A key assumption: the production function has constant returns to scale (i.e. if we increase inputs by z, output will also increase by z ) Assume that capital and labor 4. The production function is: are fixed, Y = F ( K , L ) Then Y (output) is fixed, too. is Income some function of our given inputs 7 Chapter Three • Total output of an economy equals total income . • The factors of production and the production function together determine the total output of goods and services, • They also determine national income . • The distribution of national income is determined by factor prices. • Factor prices are the amounts paid to the factors of production • the wages workers earn and • the rent the owners of capital collect. • Because we have assumed a fixed amount of capital and labor , the factor supply curve is a vertical line. 8 Chapter Three 4 Market for factors of production The price paid to any factor of production depends on the supply and demand for that factor’s services. Assumed: supply is fixed, the supply curve is vertical . The demand curve is downward sloping. The intersection of supply and demand determines the equilibrium factor price. Factor Factor supply Price (Wage or Rental Rate) Equilibrium Factor demand factor price Quantity of Factor 9 Chapter Three Profit maximising behaviour of the firms The firm needs two factors of production, capital and labor. The firm’s technology: the production function Y = F (K, L) The firm sells its output at price P, hires workers at a wage W , and rents capital at a rate R . • The goal of the firm is to maximize profit: • Profit is revenue minus cost. • Revenue equals P • Y. • Costs include both labor and capital costs. • Labor costs = W • L ( wage • amount of labor) • Capital costs = R • K (rental price of capital • amount of capital) • Profit = Revenue - Labor Costs - Capital Costs = P • Y - W • L- R • K • How does profit depend on the factors of production? Y = F (K,L) Profit = P • F (K,L) - W • L - R • K Profit depends on P, W, R, L, and K. The competitive firm • takes the product price and factor prices as given • and chooses the amounts of labor and capital that maximize profit. 10 Chapter Three 5 The firm will hire labor and rent capital in the quantities that maximize profit. What are those maximizing quantities? The marginal product of labor (MPL) is the extra amount of output the firm gets from one extra unit of labor , holding the amount of capital fixed and is expressed using the production function: MPL = F(K,L + 1) - F(K,L). Most production functions have the property of diminishing marginal product: holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases. Y The MPL is: F (K, L) • the change in output when the labor MPL input is increased by 1 unit. 1 • As the amount of labor increases, the production function becomes flatter MPL indicating diminishing marginal 1 product. 11 Chapter Three L • A profit maximizing firm, when deciding whether to hire an additional unit of labor compares the extra revenue from the increased production that results from the added labor to the extra cost of higher spending on wages: ∆∆∆ Profit = ∆∆∆ Revenue - ∆∆∆ Cost • The increase in revenue: = P • MPL ; The increase in cost: = W • Thus, the firm’s demand for labor is determined by P × MPL = W, or MPL = W/P , where W/P is the real wage • The firm hires up to the point where the extra revenue = the real wage . Units of output • The MPL depends on the amount of labor. • The MPL curve slopes downward because the MPL declines as L increases. Real • This schedule is also the firm’s labor demand curve. wage Quantity of labor demanded MPL, labor demand 12 Chapter Three Units of labor, L 6 • The firm decides how much capital to rent in the same way it decides how much labor to hire. • The MPK is the amount of extra output the firm gets from an extra unit of capital, holding the amount of labor constant: MPK = F(K + 1,L) - F(K,L). • Thus, the marginal product of capital is the difference between the amount of output produced with K+1 units of capital and that produced with K units of capital. • Like labor, capital is subject to diminishing marginal product . • The increase in profit from renting an additional machine is the extra revenue from selling the output of that machine minus the machine’s rental price: ∆∆∆ Profit = ∆∆∆ Revenue - ∆∆∆ Cost = (P • MPK) - R • To maximize profit, the firm continues to rent more capital until the MPK falls to equal the real rental price, MPK = R/P. • The real rental price of capital is the rental price measured in units of goods rather than in dollars. The firm demands each factor of production until that factor’s marginal product falls to equal its real factor price . 13 Chapter Three • The income that remains after the firms have paid the factors of production is the economic profit of the owners of the firms. • Real economic profit is: Economic Profit = Y - (MPL • L) - (MPK • K) • or to rearrange: Y = (MPL • L) + (MPK • K) + Economic Profit . • Total income is divided among the returns to labor, the returns to capital, and economic profit. • HOW LARGE IS ECONOMIC PROFIT? • If the production function has the property of constant returns to scale , then economic profit is zero . • This conclusion follows from Euler’s Theorem, which states that if the production function has constant returns to scale, then • F(K,L) = (MPK • K) + (MPL • L) • If each factor of production is paid its marginal product, then the sum of these factor payments equals total output. • Constant returns to scale, profit maximization,and competition together imply that economic profit is zero. 14 Chapter Three 7 Recall from Chapter 2, the four components of GDP: Y = C + I + G + NX Investment Total demand spending by Net exports for domestic is composed businesses and or net foreign output (GDP) of households demand Consumption Government spending by purchases of goods households and services Assumption: closed economy , eliminating the last term net exports NX . So, the three components of GDP are: Consumption (C), Investment (I) and Government purchases (G). 15 Chapter Three C C = C(Y - T) ) -T ( Y C = C depends disposable on income consumption Y-T spending by households The slope of the consumption function is the MPC. The marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income (Y-T) increases by one dollar. Example : a large value MPC= 0.99 means that for every extra dollar we earn after tax deductions, we spend $0.99 of it . MPC measures the sensitivity of the change in C with respect to a change in (Y-T). 16 Chapter Three 8 I = I(r) Investment depends real interest rate spending on • The quantity of investment depends on the real interest rate (r) , which measures the cost of the funds used to finance investment . • The nominal interest rate (i) is the interest rate as usually reported; it is the rate of interest that investors pay to borrow money. • The real interest rate is the nominal interest rate corrected for the effects of inflation ( r = i - πππ, real interest rate = nominal interest rate – rate of inflation ). • The role of interest rates in the economy: real interest rate is especially relevant when the overall level of prices is changing. 17 Chapter Three • The investment function relates the quantity of investment I to the real interest rate r . • Investment depends on the real interest rate (the Real cost of borrowing). interest • The investment function slopes downward: rate, r when the interest rate rises, fewer investment projects are profitable. Investment function, I(r) Quantity of investment, I 18 Chapter Three 9 • We take the level of government spending and taxes as given. •(here: T = taxes minus transfers, also called: net taxes) • If government purchases equal taxes minus transfers, then G = T , and the government has a balanced budget.
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