Topic 1 – National Income
Ø Factors of production are land, labour, capital and technology – technology helps to
combine all the other 3 factors – this is how you supply goods/services
Ø With the same amount of land, labour and capital you may be able to produce more
due to the higher level of technology
Ø How you supply goods/services and from that supply your total income will be
determined – 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
Ø Each factor of production should be priced at its marginal product
Ø Additional output generated by additional labour is known as the marginal product
of labour – 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
Ø This will be satisfied if the factors give a constant return to scale – if you increase
each factor of production by 1% then output will increase by 1%
Ø Classical model focuses only on supply not the demand side
Ø Classical models believe 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
Ø Classical model – the supply is determined by output/income – demand side is made
up of consumption (C) + Investment (I) + Government Spending (G) – demand side
only determines the price level – as far is how much output is produced is answered
by the supply side
Ø Equilibrium is reached in goods market and loanable funds market
Ø Keynes made fun of this model in the 1930s – he said firms should focus on
producing what is demanded – as prices were falling and workers had to kept being
laid off
Ø Keynesian model focuses on demand – says that demand creates supply – what
people demand is what should be produced
Ø The classical model cannot explain the Great Depression – 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
Ø In that sense if you don’t want people to be laid off the government should
intervene to increase demand
Ø K stands for capital goods – such as tools, machines and structures used in
production – it is a durable good and is input
Ø L stands for labour – physical or mental efforts of workers – time spent by one
person
Ø The production function = Y = F (K, L) – the K and L are in the bracket as you combine
labour to capital – how you arrange them is F
Ø The difference with F is how you combine your factors will determine how much
output you can get with the same level of capital and labour
Ø So, output doesn’t only depend on how much inputs the firm puts in but also how
they combine them – the F is known as the production function – also known as
technology
Ø Classical model assumes technology is fixed and labour and capital is also fixed
,Ø Distribution of income is determined 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
Ø Factor prices are determined by supply and demand of factor markets
Ø Demand for labour comes from firms – so firms hire each unit of labour at a price
which does not exceed the benefit – cost = real wage
Ø Benefit is how many additional unit that person can produce – this is limited to
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
M PL and the production function
to maximise it since they don’t have the opportunity – labour productivity falls
Skip for Tutorial
because capital per labour is falling Y
As more labor is
output
Ø Slope is equal to ∆Y/∆L – the slope is equal to the MP added, MPL ↓
F (K , L )
Ø If something is tangent to the line – this will mean that tangent has 1
MPL
the same slope as the line 1
MPL
Ø The output falls as you increase one input as the other inputs stay the Slope of the production
MPL
same which will mean that worker has less opportunity to use it function equals MPL
1
Ø Average Product (AP) = Y/L labor
L
Ø Elasticity is when you increase an input by 1% how many percent will output National Income
CHAPTER 3
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
Ø For example, if your production function is equal to Y = 10K1/2 – the power is the
elasticity – and so, in this case elasticity is equal to ½
Ø Y = AK1/2L1/2 – in this case A represents technology – for example, if there is a place
that doesn’t have dishwashers and you introduce it to them – with the capital and
labour remaining constant there will be an increase in output
Ø The question maybe that if population remains the same why they would buy more
– but this will mean that prices will fall and so they will be able to buy more
Ø A represents total factor productivity – as if it increases total output will increase
Ø MP declines as you increase one input – since the other inputs remain the same –
diminishing marginal return to input
Ø If there is a perfect competitive economy – how can you guarantee that total income
will be equal to the income of Labour
Ø Given the real market wage – firms will hire until the real wage M PLrate
and is theequal
demand to thefor labor
marginal product of the last worker Units
output
of
Each firm hires labor
Ø W/P = MPL will be when total product has been exhausted – up to the point where
MPL = W/P.
if you MPL > W/P then you can make more profit by hiring Real
wage
more workers MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded
CHAPTER 3 National Income 18
, The equilibrium real wage
Ø The equilibrium of real will automatically come due to the Units of
output
Labor The real wage
invisible hand – if real wages are too high there will be excess
supply
adjusts to equate
labor demand
supply and people will be willing to work for less with supply.
Ø While if real wages are too low there will be excess demand equilibrium
MPL,
real wage
and so will be willing to pay more – until it reaches the Labor
demand
equilibrium L Units of labor, L
Ø To find real wage of a country – you need an idea of the production function – you
National Income
need to know the labour force – and you need the MP of labour when everyone is
CHAPTER 3 20
employed – and you will get the real wage
Ø The situation is the same for capital – this will determine the rental of capital
Ø So, MPK = R/P to maximise profit
Ø Y will only be equal to factor prices when the production function exhibits constant
returns to scale
Ø Total Labour Income = (w/p) x L = MPL x L
Ø Total Capital Income = (r/p) x K = MPK x K
Ø Y = MPL x L + MPK x K – only if the production function has constant returns to scale
Ø CRS means if you increase a factor by some amount then output will also increase by
the same amount:
- Y = F (K, L)
- If you increase K by 1% it will become 1.01K and if you increase L by 1% it will
become 1.01L
- This will mean that output will be equal to 1.01Y
- 1.01Y = F (1.01K, 1.01L)
- If the result was less than 1.01 there is diminishing returns to scale – if the result
was more than 1.01 then there is increasing returns to scale
- Y = AKBLA
- Y = A [1.01K]B x [1.01L]A
- If you have (X x Y)a = Xa x Ya
- Y = A (1.01)B KB (1.01)A LA
- If you have Xa x Xb = Xa+b
- Y = A (1.01)a+b Kb La
- (1.01)a+b [AKb La = Y]
- Y = 1.01a+bY
- Constant returns require that Y increase by 1% so be 1.01Y
- So, we need A+B to be equal to 1
Ø Since there are constant returns to scale you can make the equation Y = A KB L1-B
Ø B is equal to MPK/APK = MPK / (Y/K) so we can have MPK = B(Y/K)
Ø In the end you will get MPL x L + MPK x K = Y
Ø MPL = ∆Y/∆L
Ø Y = MPL x L + MPK x K if production function has constant returns to scale – this is
known as the Production Exhaustion Theorem
Ø [W/P]/[Y/L] = e
Ø 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
Ø Components of demand are:
- Consumption – which is consumer demand for goods/services
Ø Factors of production are land, labour, capital and technology – technology helps to
combine all the other 3 factors – this is how you supply goods/services
Ø With the same amount of land, labour and capital you may be able to produce more
due to the higher level of technology
Ø How you supply goods/services and from that supply your total income will be
determined – 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
Ø Each factor of production should be priced at its marginal product
Ø Additional output generated by additional labour is known as the marginal product
of labour – 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
Ø This will be satisfied if the factors give a constant return to scale – if you increase
each factor of production by 1% then output will increase by 1%
Ø Classical model focuses only on supply not the demand side
Ø Classical models believe 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
Ø Classical model – the supply is determined by output/income – demand side is made
up of consumption (C) + Investment (I) + Government Spending (G) – demand side
only determines the price level – as far is how much output is produced is answered
by the supply side
Ø Equilibrium is reached in goods market and loanable funds market
Ø Keynes made fun of this model in the 1930s – he said firms should focus on
producing what is demanded – as prices were falling and workers had to kept being
laid off
Ø Keynesian model focuses on demand – says that demand creates supply – what
people demand is what should be produced
Ø The classical model cannot explain the Great Depression – 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
Ø In that sense if you don’t want people to be laid off the government should
intervene to increase demand
Ø K stands for capital goods – such as tools, machines and structures used in
production – it is a durable good and is input
Ø L stands for labour – physical or mental efforts of workers – time spent by one
person
Ø The production function = Y = F (K, L) – the K and L are in the bracket as you combine
labour to capital – how you arrange them is F
Ø The difference with F is how you combine your factors will determine how much
output you can get with the same level of capital and labour
Ø So, output doesn’t only depend on how much inputs the firm puts in but also how
they combine them – the F is known as the production function – also known as
technology
Ø Classical model assumes technology is fixed and labour and capital is also fixed
,Ø Distribution of income is determined 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
Ø Factor prices are determined by supply and demand of factor markets
Ø Demand for labour comes from firms – so firms hire each unit of labour at a price
which does not exceed the benefit – cost = real wage
Ø Benefit is how many additional unit that person can produce – this is limited to
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
M PL and the production function
to maximise it since they don’t have the opportunity – labour productivity falls
Skip for Tutorial
because capital per labour is falling Y
As more labor is
output
Ø Slope is equal to ∆Y/∆L – the slope is equal to the MP added, MPL ↓
F (K , L )
Ø If something is tangent to the line – this will mean that tangent has 1
MPL
the same slope as the line 1
MPL
Ø The output falls as you increase one input as the other inputs stay the Slope of the production
MPL
same which will mean that worker has less opportunity to use it function equals MPL
1
Ø Average Product (AP) = Y/L labor
L
Ø Elasticity is when you increase an input by 1% how many percent will output National Income
CHAPTER 3
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
Ø For example, if your production function is equal to Y = 10K1/2 – the power is the
elasticity – and so, in this case elasticity is equal to ½
Ø Y = AK1/2L1/2 – in this case A represents technology – for example, if there is a place
that doesn’t have dishwashers and you introduce it to them – with the capital and
labour remaining constant there will be an increase in output
Ø The question maybe that if population remains the same why they would buy more
– but this will mean that prices will fall and so they will be able to buy more
Ø A represents total factor productivity – as if it increases total output will increase
Ø MP declines as you increase one input – since the other inputs remain the same –
diminishing marginal return to input
Ø If there is a perfect competitive economy – how can you guarantee that total income
will be equal to the income of Labour
Ø Given the real market wage – firms will hire until the real wage M PLrate
and is theequal
demand to thefor labor
marginal product of the last worker Units
output
of
Each firm hires labor
Ø W/P = MPL will be when total product has been exhausted – up to the point where
MPL = W/P.
if you MPL > W/P then you can make more profit by hiring Real
wage
more workers MPL,
Labor
demand
Units of labor, L
Quantity of labor
demanded
CHAPTER 3 National Income 18
, The equilibrium real wage
Ø The equilibrium of real will automatically come due to the Units of
output
Labor The real wage
invisible hand – if real wages are too high there will be excess
supply
adjusts to equate
labor demand
supply and people will be willing to work for less with supply.
Ø While if real wages are too low there will be excess demand equilibrium
MPL,
real wage
and so will be willing to pay more – until it reaches the Labor
demand
equilibrium L Units of labor, L
Ø To find real wage of a country – you need an idea of the production function – you
National Income
need to know the labour force – and you need the MP of labour when everyone is
CHAPTER 3 20
employed – and you will get the real wage
Ø The situation is the same for capital – this will determine the rental of capital
Ø So, MPK = R/P to maximise profit
Ø Y will only be equal to factor prices when the production function exhibits constant
returns to scale
Ø Total Labour Income = (w/p) x L = MPL x L
Ø Total Capital Income = (r/p) x K = MPK x K
Ø Y = MPL x L + MPK x K – only if the production function has constant returns to scale
Ø CRS means if you increase a factor by some amount then output will also increase by
the same amount:
- Y = F (K, L)
- If you increase K by 1% it will become 1.01K and if you increase L by 1% it will
become 1.01L
- This will mean that output will be equal to 1.01Y
- 1.01Y = F (1.01K, 1.01L)
- If the result was less than 1.01 there is diminishing returns to scale – if the result
was more than 1.01 then there is increasing returns to scale
- Y = AKBLA
- Y = A [1.01K]B x [1.01L]A
- If you have (X x Y)a = Xa x Ya
- Y = A (1.01)B KB (1.01)A LA
- If you have Xa x Xb = Xa+b
- Y = A (1.01)a+b Kb La
- (1.01)a+b [AKb La = Y]
- Y = 1.01a+bY
- Constant returns require that Y increase by 1% so be 1.01Y
- So, we need A+B to be equal to 1
Ø Since there are constant returns to scale you can make the equation Y = A KB L1-B
Ø B is equal to MPK/APK = MPK / (Y/K) so we can have MPK = B(Y/K)
Ø In the end you will get MPL x L + MPK x K = Y
Ø MPL = ∆Y/∆L
Ø Y = MPL x L + MPK x K if production function has constant returns to scale – this is
known as the Production Exhaustion Theorem
Ø [W/P]/[Y/L] = e
Ø 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
Ø Components of demand are:
- Consumption – which is consumer demand for goods/services
