Chapter 3

Front 1

GDP measures what?

Back 1

Both total income and total output

income = total output

Front 2

What determines the GDP

Back 2

1. Quantity of factors of production

2. Ability to turn inputs (factors of production) into output (production function)

Front 3

Factors of Production

Back 3

2 most important factors of production

1. Capital (K)
2. Labor (L)

_
K = Fixed amount of Capital
_
L = Fixed amount of Labor

Front 4

The Production Function

Back 4

Y = F(K,L)

Output depends upon (is a function of) the amount of capital (K) and Labor (L) available to the economy

Front 5

Constant returns to scale

Back 5

when an increase of an equal percentage in all factors of production causes an increase in output of the same percentage.

zY = F(zK,zL)

where z is any positive number

Front 6

Factors of production & the production function determine what?

Back 6

quantity of goods and services supplied = Y

or

_
Y = F( Kbar, Lbar )

Front 7

neo-classical theory of distribution

Back 7

the best place to start understanding how the economy's income is distributed from firms to households

Front 8

Factor Prices

Back 8

determines distribution of national income

the amounts paid to the factors of production.

Wages to workers (L)
Rent to the owners of capital (K)

Front 9

Profit =

Back 9

P=Price
Y=output/units produced
W=Wages
L=Labor Hours
R=Rate (interest)
K=Capital

Profit = Revenue - Labor Costs - Capital Costs

or

PxY - WxL - RxK

Front 10

to see HOW profit depends on the factors of production we can substitute the production function in to the profit equation for Y

Back 10

PxF(K,L) - WxL -RxK

Front 11

A competitive firm will take the product price and the factor prices as given and then chooses what?

Back 11

the amount of labor and capital that will maximize profit

Front 12

The Marginal Product of Labor (MPL) i

Back 12

the extra amount of output the firm gets from one extra unit of labor, holding the amount of capital fixed.

we can see this using the production function

MPL = F(K, L +1) - F(K,L)


The MPL is a firms labor demand curve

Front 13

Most production functions exhibit the property of Diminishing Marginal Product:

Back 13

holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases

Front 14

The Marginal Product of Labor (MPL) is the slope of what?

Back 14

the production function

see pg 52 fig 3.3

Front 15

the competitive firm will hire when what = what?

Back 15

MRPL = W

or

PxMPL = W

The firms manager knows that if the extra revenue Px MPL exceeds teh wage W and extra unit of labor increases profit.

(P x MPL) - W = Profit

Front 16

MPL = W/P

what doe sthis mean?

Back 16

W/P is the REAL WAGE--the payment to labor measured in units of output rather than in dollars.

To maximize profit, the firm hires up to the point at which the marginal product of labor equals the real wage.

just another way of saying

(MRPL = W) = (MPL = W/P)

Front 17

Marginal Product of Capital (MPK)

Back 17

the amount of extra output the firm gets from an extra unit of capital, holding labor constant.

MPK = F(K+1, L) - F(K,L)

The difference between the amount of output produced with K+1 units of capital and that Produced with only K units of capital

Front 18

Capital is subject to diminshing marginal product?

Back 18

true

Front 19

the increase in profit from renting an additional machine is the extra revenue from selling the output of that machine minus the machines rental price

Back 19

true

Change in Profit = (P x MPK) - R

Front 20

To maximize profit a firm will continue to rent new capital until the MPK....

Back 20

falls to equal the rental price

or

rent capital until MPK = R/P (the real rental price of capital)

Front 21

The competitive profit maximizing firm hires labor or rents capital

Back 21

until the factor's marginal product EQUALS its REAL factor price

Front 22

Total real wages paid to labor =

Total real return paid to capital owners is

Back 22

MPL x L

MPK x K

Front 23

The income that remains after the firms have paid the factors of production is the ECONOMIC PROFIT

Back 23

Real Economic Profit is

Econ. Profit = Y - (MPL x L) - (MPK x K)

OR

Y = (MPL x L) + (MPK x K) + Econ. Profit

Front 24

Total income is divided among:

Back 24

Return to labor (wages)

Return to capital (Rent)

Economic Profit (whats left goes to FIRM)

Front 25

Euler's Theorem

Back 25

F(K, L) = (MPK x K) + (MPL x L)

constant returns to scale, profit maximization, and competition together imply that economic profit = 0

If each factor of production is paid its marginal product, then the sum of these factor payments equals total output

Front 26

Accounting Profit =

Back 26

Economic Profit + (MPK x K)

Because firm owners and capital owners re the same people, economic profit and the return to capital are often lumped together.

"profit" must mostly be the return to capital (MPK x K)

Front 27

Total output is divided between the payments to capital and the payments to labor, depending on their marginal productivities

Back 27

true

economic profit = 0 becase each factor of production is paid its marginal product and as a result these factor payments exhaust total output

Front 28

Cobb-Douglas Production Function
pg. 57--Walk through proof

Back 28

alpha = a constant between 0 and 1. alpha determines what share of the income goes to capital and what share goes to labor

A = Parameter greater than 0 that measures the productivity of the available technology


F(K,L) = A x K^alpha x L ^(1-alpha)

Front 29

Properties of the Cobb-Douglas Function

Review pg. 58 now!

Back 29

has constant returns to scale (if capital and labor are increased by the same proportion then output increases by the same proportion)

MPL = (1-alpha) x A x K^alpha x L^-alpha

MPK = alpha x A x K^alpha-1 x L^1-alpha

OR

MPL = (1-alpha)Y/L

MPK = alphaY/K

MPK =

Front 30

Y/L = Average labor productivity

Y/K = Average capital productivity

Back 30

true

if the production function is Cobb-Douglas then the marginal productivity of a factor is proprotinal to its average productivity

Front 31

1-alpha is labors share of output

alpha is capital's share of outupt

Back 31

true

the ratio of labor income to capital income is the constant

(1-alpha)/alpha

Front 32

labor productivity and what are closely related?

Back 32

real wages (W/P)

Front 33

National Income for a CLOSED economy

Back 33

Y = C + I + G

Front 34

Disposable income

Back 34

Y-T

households divide their disposable income between consumption and savings

Front 35

Consumption is a function of what?
pg. 62

Back 35

Disposable income:

C = C(Y-T)

The consumption function

The slope of the consumption function is the Marginal Propensity to Consume (MPC)

the MPC is between 0 and 1

Front 36

the quantity of investment goods demanded depends on

Back 36

the REAL interest rate

nominal interest rate = real interest rate + inflation

I = I(r)

Front 37

If government purchases equal taxes minus transfers then G=T, if G > T then the government runs a budget deficit, which it funds by issuing govt. bonds, if G<T the government runs a budget surplus, which it can use to repay some of its outstanding debt

Back 37

true

Front 38

Endogenous variables

Back 38

Consumption
Investment
Interest Rates

Front 39

rvw pg. 66

_
Y = C(Ybar - Tbar) + I(r) +Gbar

Back 39

this equation sates that the supply of output equals its demand, which is the sum of consumption, investment, and government purchases

notice that the real interest rate is the only variable not already determined or fixed (bar). it adjusts to ensure that the demand for goods aequals the supply.

the greater the interest rate, the lovwer the level of investment, and thus the lower the demand for goods and services (C + I + G)

<b>At the equilibrium interest rate the demand for goods and services equals supply</b>

Front 40

Y - C - G = I = S

or

Y - C(Y-T) - G = I(r)

or
_
Y = C(Ybar-Tbar) - Gbar = I(r)
Sbar=I(r)


pg. 67

Back 40

National saving (S) is the sum of private + public savings

In closed economy:

Savings = Investments

S=(Y-T-C) + (T-G) = I

Y-T-C = Private Savings

T-G = Public Savings


The flows into the ifinancial markets (private and public savings) must balance the flows out of the financial markets (Investment)

Front 41

At the equilibrium interest rate in the market for loanable funds, households' desire to sae balances firms' desire to invest, and the quantity of loanable funds supplied equals the quantity demanded

Back 41

true