A PowerPoint Tutorial

to Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

CHAPTER THREE
National Income:
Where It Comes From and Where It Goes

Mannig J. Simidian
1
Chapter Three
 A quite simple but powerful analytical model built around
buyers and sellers pursuing their own self-interest (within
rules set by government). Its emphasis is on the consequences
of competition and flexible wages/prices for total employment
and real output. Its roots go back to 1776 in Adam Smiths
Wealth of Nations. The Wealth of Nations suggested that the
economy was controlled by the invisible hand whereby the
market system, instead of government would be the best
mechanism for a healthy economy.

Copyright 1997 Dead Economists Society

2
Chapter Three
 The heart of the market system lies in the market
clearing process and the consequences of
individuals pursuing self-interest. In this module,
we will develop a basic classical model to explain
various economic interactions. Proceed to the next
slide to the CLASSICAL FACTORY to learn
how to construct the classical model.

3
Chapter Three
Welcome to...

The place where

classical model
mechanics
are made easy!
P
S
P*
Chapter Three
4 D
Q* Q
 We begin with firms and see what determines their level
of production (and thus, the level of national income).

Then, we examine how the markets for the factors of

production distribute this income to households.

Next, we consider how much of this income households

consume and how much they save.

We will also discuss the demand arising from investment

and government purchases.

Finally, we discuss how the demand and supply for

goods and services are brought into balance.
5
Chapter Three
An economys output of goods and services (GDP) depends on:

(1) quantity of inputs

(2) ability to turn inputs into output

Lets go over both now.

6
Chapter Three
KL
The factors of production are the inputs used to produce goods
and services. The two most important factors of production are
capital and labor. In this module, we will take these factors as
given (hence the overbar depicting that these values are fixed).
K (capital) = K
L (labor) = L
In this module, well also assume that all resources are fully
utilized, meaning no resources are wasted.

7
Chapter Three
The available production technology determines how much output is
produced from given amounts of capital (K) and labor (L). The
production function represents the transformation of inputs into
outputs. A key assumption is that the production function has
constant returns to scale, meaning that if we increase inputs by z,
output will also increase by z.
We write the production function as: Y = F (K,L)

Income is some function of our given inputs

8
Chapter Three
We can now see that the factors of production and the production
function together determine the quantity of goods and services
supplied, which in turn equals the economys output. So,

Y = F ( K , L)
=Y

In this section, because we assume that capital and labor are fixed,
we can also conclude that Y (output) is fixed as well.

9
Chapter Three
Recall that the total output of an economy equals total income.
Because 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.

The next slide will illustrate.

10
Chapter Three
The price paid to any factor of production depends on the supply and
demand for that factors services. Because we have assumed that
the 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
11
Chapter Three
To make a product, the firm needs two factors of
production, capital and labor. Lets represent the firms
technology by the usual 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.

12
Chapter Three
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 equal W L, the wage multiplied by the amount
of labor L. Capital costs equal R K, the rental price of capital R times
the amount of capital K.

Profit = Revenue - Labor Costs - Capital Costs

= PY - WL - RK

Then, to see how profit depends on the factors of production, we use

production function Y = F (K,L) to substitute for Y to obtain:

Profit = P F (K,L) - WL - RK

This equation shows that 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.13
Chapter Three
 We know that the firm will hire labor
and rent capital in the quantities that
maximize profit. But, what are those
maximizing quantities? To answer this,
we must consider the quantity of labor
and then the quantity of capital.

14
Chapter Three
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.
The MPL is the change in output Y
when the labor input is increased
F (K, L)
by 1 unit. As the amount of labor MPL
increases, the production function 1
becomes flatter indicating MPL
diminishing marginal product.
1 15
Chapter Three
L
 When the competitive, profit-maximizing firm is
deciding whether to hire an additional unit of labor, it
considers how that decision would affect profits. It
therefore compares the extra revenue from the increased
production that results from the added labor to the extra
cost of higher spending on wages. The increase in revenue
from an additional unit of labor depends on two variables:
the marginal product of labor, and the price of the output.
Because an extra unit of labor produces MPL units of output
and each unit of output sells for P dollars, the extra revenue
is P MPL. The extra cost of hiring one more unit of labor
is the wage W. Thus, the change in profit from hiring
an additional unit of labor is Profit = Revenue - Cost
Chapter Three = (P MPL) - W16
 Thus, the firms demand for labor is determined by P MPL = W,
or another way to express this is MPL = W/P, where 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
where the extra revenue equals 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. This
Real schedule is also the firms labor demand
wage curve.

Quantity of labor demanded

MPL, labor demand

Units of labor, L 17
Chapter Three
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 machines
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 factors marginal product falls to equal its real factor price.
18
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 Eulers 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. In other words, constant
returns to scale, profit maximization,and competition together imply that
economic profit is zero. 19
Chapter Three
 Recall from Chapter 2, we
identified the four components
of GDP:

Y = C + I + G + NX
Investment
Total demand Net exports
is composed spending by
for domestic or net foreign
of businesses and
output (GDP) demand
households
Consumption Government
spending by purchases of goods
households and services
We are going to assume a closed economy, therefore eliminating the
last term net exports, NX. So, the three components of GDP are
Consumption (C), Investment (I) and Government purchases (G). 20
LetsChapter Three
see how GDP is allocated among these three uses.
 C
C = C(Y- T)
T) )
-
Y-T
C((Y
==C
disposable CC
depends income
on
consumption Y-T
spending by
households The slope of the consumption function is
the MPC. 21
Chapter Three
 The
Themarginal
marginalpropensity
propensityto toconsume
consume(MPC)
(MPC)isisthe
theamount
amountby by
which
whichconsumption
consumptionchanges
changeswhen
whendisposable
disposableincome
income(Y-T)
(Y-T)
increases
increasesbybyone
onedollar.
dollar.To
Tounderstand
understandthe
theMPC
MPCconsider
consideraa
shopping
shoppingscenario.
scenario.AAperson
personwho
wholoves
lovestotoshop
shopprobably
probablyhashasaa
large
largeMPC,
MPC,lets
letssay
say(.99).
(.99).This
Thismeans
meansthat
thatfor
forevery
everyextra
extradollar
dollar
he
heororshe
sheearns
earnsafter
aftertax
taxdeductions,
deductions,he heor
orshe
shespends
spends$.99
$.99of
ofit.
it.
The
TheMPCMPCmeasures
measuresthethesensitivity
sensitivityof
ofthe
thechange
changein inone
onevariable
variable
(C)
(C)with
withrespect
respectto toaachange
changeininthe
theother
othervariable
variable(Y-T).
(Y-T).

22
Chapter Three
 II == I(r)
I(r)
Investment depends
spending real interest rate
on
The
Thequantity
quantityof ofinvestment
investmentdepends
dependson onthe
thereal
realinterest
interestrate,
rate,which
which
measures
measuresthe thecost
costofofthe
thefunds
fundsused
usedto tofinance
financeinvestment.
investment. When
When
studying
studyingthetherole
roleofofinterest
interestrates
ratesininthe
theeconomy,
economy,economists
economists
distinguish
distinguishbetween
betweenthe thenominal
nominalinterest
interestrate
rateand
andthe
thereal
realinterest
interestrate,
rate,
which
whichisisespecially
especiallyrelevant
relevantwhen
whenthe theoverall
overalllevel
levelof
ofprices
pricesisis
changing.
changing.The Thenominal
nominalinterest
interestrate
rateisisthe
theinterest
interestrate
rateas
asusually
usually
reported;
reported;ititisisthe
therate
rateofofinterest
interestthat
thatinvestors
investorspay
paytotoborrow
borrowmoney.
money.
The
Thereal
realinterest
interestraterateisisthe
thenominal
nominalinterest
interestrate
ratecorrected
correctedforforthe
the
effects
effectsof
of inflation.
inflation. 23
Chapter Three
The investment function relates the quantity of investment I to the real
interest rate r. Investment depends on the real interest rate because the
interest rate is the cost of borrowing. The investment function slopes
downward; when the interest rate rises, fewer investment projects are
profitable.
Real
interest
rate, r

Investment function, I(r)

Quantity of investment, I
24
Chapter Three
G == G
G G We take the level of government spending and
taxes as given. If government purchases equal taxes
minus transfers, then G = T, and the government has a
TT == TT balanced budget. If G > T, then the government is
running a budget deficit. If G < T,
then the government is running a
budget surplus.

25
Chapter Three
The following equations summarize the discussion of the demand
for goods and services:
1)
1)YY==CC++II++GG Demand
DemandforforEconomys
EconomysOutput
Output
2)
2)CC==C(Y-T)
C(Y-T) Consumption
ConsumptionFunction
Function
3)
3)II==I(r)
I(r) Real
RealInvestment
InvestmentFunction
Function
4)
4)GG==GG Government
GovernmentPurchases
Purchases
5)
5)TT==TT Taxes
Taxes
The demand for the economys output comes from consumption,
investment, and government purchases. Consumption depends on
disposable income, investment depends on the real interest rate;
government purchases and taxes are the exogenous variables set by
fiscal policy makers.
26
Chapter Three
To this analysis, lets add what weve learned about the supply
of goods and services earlier in the module. There we saw that the
factors of production and the production function determine the
quantity of output supplied to the economy:
Y = F (K,L)
=Y
Now, lets combine these equations describing supply and demand
for output Y. Substituting all of our equations into the national
income accounts identity, we obtain:
Y = C(Y-T) + I(r) + G
and then, setting supply equal to demand, we obtain an equilibrium
condition:
Y = C(Y-T) + I(r) + G
This equation states that the supply of output equals its demand,
which is the sum of consumption, investment,
and government purchases.
27
Chapter Three
 Y = C(Y-T) + I(r) + G

Notice that the interest rate r is the only variable not already determined
in the last equation. This is because the interest rate still has a key role
to play: it must adjust to ensure that the demand for goods equals the
supply. The greater the interest rate, the lower the level of investment.
and thus the lower the demand for goods and services, C + I + G.

If the interest rate is too high, investment is too low, and the demand
for output falls short of supply. If the interest rate is too low,
investment is too high, and the demand exceeds supply. At the
equilibrium interest rate, the demand for goods and services equals
the supply.

Lets now examine how financial markets fit into the story.
28
Chapter Three
First, rewrite the national income accounts identity as Y - C - G = I.
The term Y-C-G is the output that remains after the demands of
consumers and the government have been satisfied; it is called national
saving or simply, saving (S). In this form, the national income accounts
identity shows that saving equals investment.
To understand this better, lets split national saving into two parts-- one
examining the saving of the private sector and the other representing
the saving of the government.
(Y-T-C) + (T-G) = I
The term (Y-T-C) is disposable income minus consumption, which is
private saving. The term (T-G) is government revenue minus
government spending, which is public saving. National saving is the
sum of private and public saving.

29
Chapter Three
 To see how the interest rate brings financial markets into equilibrium,
substitute the consumption function and the investment function into
the national income accounts identity:
Y - C (Y-T) - G = I(r)
Next, note that G and T are fixed by policy and Y is fixed by the factors
of production and the production function: Y - C (Y-T) - G = I(r)
S = I(r)
Real
interest Saving, S The
Thevertical
verticalline
linerepresents
represents
rate, r saving--
saving--the
thesupply
supplyof ofloanable
loanable
funds.
funds. The
Thedownward-sloping
downward-sloping
Equilibrium line
linerepresents
representsinvestment--
investment--the the
interest demand
demandfor forloanable
loanablefunds.
funds.
rate The
Theintersection
intersectiondetermines
determinesthe the
equilibrium
equilibriuminterest
interestrate.
rate.
Desired Investment, I(r)
Chapter Three S Investment, Saving, I, S 30
An Increase in Government Purchases: If we increase government
purchases by an amount G, the immediate impact is to increase the
demand for goods and services by G. But since total output is fixed
by the factors of production, the increase in government purchases must
be met by a decrease in some other category of demand. Because
disposable Y-T is unchanged, consumption is unchanged. The increase
in government purchases must be met by an equal decrease in investment.
To induce investment to fall, the interest rate must rise. Hence, the rise
in government purchases causes the interest rate to increase and investment
to decrease. Thus, government purchases are said to crowd out investment.
A Decrease in Taxes: The immediate impact of a tax cut is to raise
disposable income and thus to raise consumption. Disposable income
rises by T, and consumption rises by an amount equal to T times the
MPC. The higher the MPC, the greater the impact of the tax cut on
consumption. Like an increase in government purchases, tax cuts crowd
31
Chapter Three out investment and raises the interest rate.
 Real AAreduction
reductionin insaving,
saving,possibly
possiblythe
the
S' Saving, S result
interest resultof
ofaachange
changein infiscal
fiscalpolicy,
policy,
rate, r shifts
shiftsthe
thesaving
savingschedule
scheduleto tothe
theleft.
left.
The
Thenew
newequilibrium
equilibriumisisthe
thepoint
pointatat
which
whichthethenew
newsaving
savingschedule
schedulecrosses
crosses
the
theinvestment
investmentschedule.
schedule. AAreduction
reduction
in
insaving
savinglowers
lowersthe
theamount
amountof of
investment
investmentandandraises
raisesthe
theinterest
interestrate.
rate.
Desired Investment, I(r)
S Investment, Saving, I, S
Fiscal
Fiscalpolicy
policyactions
actionsare
aresaid
saidto
tocrowd
crowdout
outinvestment.
investment.
32
Chapter Three
 Real An increase in the demand for
interest Saving, S investment goods shifts the investment
rate, r schedule to the right. At any given
interest rate, the amount of investment
is greater. The equilibrium moves
B from A to B. Because the amount
of saving is fixed, the increase in
A I2 investment demand raises
I1 the interest rate while leaving
the equilibrium
S Investment, Saving, I, S amount of investment
Now lets see what happens to the interest unchanged.
rate and saving when saving depends on the
interest rate (upward-sloping saving (S) curve).
33
Chapter Three
 S(r)
Real
interest
rate, r

B
A I2
I1
Investment, Saving, I, S
When saving is positively related to the interest rate, as shown by
the upward-sloping S(r) curve, a rightward shift in the investment
schedule I(r), increases the interest rate and the amount of
investment. The higher interest rate induces people to increase
saving, which in turn allows investment to increase.
34
Chapter Three
Factors of production Nominal interest rate
Production function Real interest rate
Constant returns to scale National saving
Factor prices (saving)
Competition Private saving
Marginal product of labor (MPL) Public saving
Diminishing marginal product Loanable funds
Real wage Crowding out
Marginal product of capital (MPK)
Real rental price of capital
Economic profit vs. accounting profit
Disposable income
Consumption function
Marginal propensity to consume
35
Chapter Three