Mankiw Chapter 3: National Income

Mankiw Chapter 3: National Income
Worth Publishers, all rights reserved

CHAPTER 3
National Income
In this chapter you will learn

what determines the economys total
output/income (Production)
how total income is distributed (Distribution)
what determines the demand for goods and
services (Allocation)
how equilibrium in the goods market is
achieved (Equilibrium)
CHAPTER 3
National Income
slide 2
CHAPTER 3
National Income
slide 3
Outline of the model

A closed economy, market-clearing model
Supply side
factor markets
determination of output/income
Demand side
determinants of C, I, and G
Equilibrium
goods market
loanable funds market
CHAPTER 3
National Income
slide 4
Assumptions of the model

K = capital,
tools, machines, and structures
used in production
L = labor,
the physical and mental efforts of
workers
CHAPTER 3
National Income
slide 5
Assumptions of the model

1.Technology is fixed (production function).
2.The economys supplies of capital and
labor are exogenously fixed at
K K
CHAPTER 3
and
National Income
LL
slide 6
Determination of GDP
Output is determined by the fixed factor
supplies and the fixed state
of technology:
Y F (K , L)
We did not talk about demand this far! The
endogenous output is only determined by
exogenous supply factors!
CHAPTER 3
National Income
slide 7
The production function

Factor of production
L = labor, the physical and mental efforts of
workers.
K = physical capital, machines and buildings.
Production function
Y = F (K,L): how much output (Y ) the economy
can produce given an amount of inputs.
CHAPTER 3
National Income
How does F(K,L) look like?

How are inputs converted into output?
Idea: Lets look at long-run trends.
(w*L)/Y and (r*K)/Y are constant
over time.
CHAPTER 3
National Income
Labors share of income in the U.S.
Labors share seems to be pretty constant over

time (therefore capitals share of income is also
constant)
CHAPTER 3
National Income
Labors share of income in Spain
CHAPTER 11
3
National Income
01/03/17
How are prices determined?

Factor prices are determined by supply and
demand in factor markets.
Recall: Supply of each factor is fixed.
What about demand?
CHAPTER 3
National Income
slide 12
Firms labor demand

Assume markets are competitive:
each firm takes W, R, and P=1 as given
Profit maximization: (the goal of a firm)
Profit=revenue-labor costs-capital cost
=Y-WL-RK=F(K,L)-WL-RK
Basic idea:
A firm hires each unit of labor
if the cost does not exceed the benefit.
cost = real wage
benefit
= marginal product of labor
CHAPTER 3
National Income
slide 13
Firms labor demand

As a result, we have
w = MPL
r = MPK
CHAPTER 3
National Income
The equilibrium real wage

Units of
output
Labor
supply
equilibriu
m real
wage
L
MPL,
Labor
demand
Units of labor,
L
The
The real
real wage
wage adjusts
adjusts to
to
equate
equate
labor
demand
with
CHAPTER 3
National
Income
labor
demand
with supply.
supply.
slide 15
The equilibrium real rental rate

Units of
output
Supply of
capital
equilibriu
m R/P
K
CHAPTER 3
National Income
The
The real
real rental
rental
rate
rate adjusts
adjusts to
to
equate
equate
demand
demand for
for
capital
capital with
with
supply.
supply.
MPK,
demand for
capital
Units of capital,
K
slide 16
Back to constant factor shares

Constant factor shares imply:
(w*L)/Y = (MPL*L)/Y=(1-a)
(r*K)/Y = (MPK*K)/Y=a
This is true for Cobb-Douglas.
CHAPTER 3
National Income
Cobb-Douglas production function

Cobb-Douglas form:
Y AK L
where A represents total labor

productivity.
The function has important properties:

Constant returns to scale.
Diminishing
marginal returns.
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CHAPTER 3
Further implication of Cobb-Douglas
Cobb-Douglas form:
Y AK L
Wages:
proportional to productivity A
CHAPTER 3
National Income
Productivity and wages in the US
CHAPTER 3
National Income
Productivity and wages in Spain
CHAPTER 3
National Income
01/03/17
Review returns of scale

Initially Y1 = F (K1 , L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(If z = 1.25, then all inputs are increased by
25%)
What happens to output, Y2 = F (K2 , L2 ) ?
If constant returns to scale, Y2 = zY1

If increasing returns to scale, Y2 > zY1
If decreasing returns to scale, Y2 < zY1
CHAPTER 3
National Income
Exercise: determine returns to scale

Determine whether each of the following
production functions has constant,
increasing,
or decreasing returns to scale:
CHAPTER 3
National Income
Diminishing marginal returns

Recall, a Cobb-Douglas production
function has diminishing marginal returns.
As a factor input is increased, its

marginal product falls (other things equal).
Intuition:
L while holding K fixed
fewer machines per worker,

lower gains from extra workers.
CHAPTER 3
National Income
Graphical representation
CHAPTER 3
National Income
Check your understanding:

Which of these production functions have
diminishing marginal returns to labor?
CHAPTER 3
National Income
The size of profits

Y=w*L+r*K+profits
With constant returns:
zY=F(zK,zL).
Differentiate with respect to z:
CHAPTER 3
National Income
The size of profits
Evaluate at z=1 and impose

perfect competition:
Y=r*K+w*L.
CHAPTER 3
National Income
How income is distributed

W
L
total labor income =
P
R
K
total capital income
P
MPL L
MPK K
=
If production function has constant
returns to scale, then
Y MPL L MPK K
national
income
CHAPTER 3
labor
income
National Income
capital
income
slide 29
Outline of the model

A closed economy, market-clearing model
Supply side
factor markets
determination of output/income
Demand side
determinants of C, I, and G
Equilibrium
goods market
loanable funds market
CHAPTER 3
National Income
slide 30

Mankiw Chapter 3: National Income

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Mankiw Chapter 3: National Income

Worth Publishers, all rights reserved

In this chapter you will learn

Outline of the model

Assumptions of the model

Assumptions of the model

labor are exogenously fixed at

The production function

How does F(K,L) look like?

Labors share of income in the U.S.

Labors share seems to be pretty constant over

Labors share of income in Spain

How are prices determined?

Firms labor demand

= marginal product of labor

Firms labor demand

The equilibrium real wage

The equilibrium real rental rate

Back to constant factor shares

Cobb-Douglas production function

where A represents total labor

The function has important properties:

Further implication of Cobb-Douglas

Productivity and wages in the US

Productivity and wages in Spain

Review returns of scale

What happens to output, Y2 = F (K2 , L2 ) ?

If constant returns to scale, Y2 = zY1

Exercise: determine returns to scale

Diminishing marginal returns

As a factor input is increased, its

fewer machines per worker,

Check your understanding:

The size of profits

The size of profits

Evaluate at z=1 and impose

How income is distributed

Outline of the model

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