NATIONAL INCOME: WHERE IT COMES

FROM AND WHERE IT GOES

 Income Markets for Factors Factor Payments
of Production

Private Saving
Financial Markets

Public Saving

Taxes
Households Government Firms

Government Investment
Purchases

Markets for Goods

Consumption and Services Firm Revenue
The government receives revenue from taxes and uses it to pay
for government purchases

Public saving – any excess of tax revenue over government

spending

Positive public saving BUDGET SURPLUS

Negative public saving BUDGET DEFICIT
 WHAT DETERMINES THE TOTAL
PRODUCTION OF GOODS AND SERVICES?

The Supply Side of the Economy

SUPPLY SIDE OF THE ECONOMY

An economy’s output of goods and services (technically,

GDP) depends on:

– Its quantity of inputs (factors of production)

– Its ability to turn inputs to outputs (production function)
FACTORS OF PRODUCTION
• Are inputs used to produce goods and services

CAPITAL (K)
Is the set of tools that
workers use

LABOR (L)
Is the time people spend
working
ASSUMPTIONS
Assumption 1: the economy has a fixed amount of capital and a
fixed amount of labor
The overbar means
K=K that each variable is
fixed at some level
L=L

Assumption 2: factors of production are fully utilized – no

resources are wasted
THE PRODUCTION FUNCTION
The available production technology determines how much output
is produced from given amount of capital and labor

Y = F(K, L)

States that output is a function of the amount of capital andthe

amount of labor
THE PRODUCTION FUNCTION
Many production functions have a property called constant
returns to scale

–An increase of an equal percentage in all factors of production

causes an increase in output of the same percentage

zY = F(zK, zL)
SUPPLY OF GOODS AND SERVICES

Y = F(K, L)
=Y
HOW IS NATIONAL INCOME DISTRIBUTED
TO THE FACTORS OF PRODUCTION

Neoclassical Theory of Distribution

FACTOR PRICES

Are the amounts paid to the factors of production

In an economy where the factors were labor and capital,

what are the factor prices?
– The wage the workers earn
– The rent owners of capital collect
 Factor Price Factor
Supply

Equilibrium
Factor Price

Factor
demand

Quantity of factor
DECISIONS FACING THE COMPETITIVE FIRM

We assume that a typical firm is COMPETITIVE

The competitive firm takes the prices of its output and its inputs as
given by the market condition
In order to produce a product, a firm needs two
factors of production, capital and labor
The firm sells its
output at a price P,
Y = F(K, L) hires workers at a
wage W and rents
capital at a rate R

Y – number of units produced

K – number of machines used
L – number of hours worked by the firm’s employees

15
The goal of the firm is to maximize profit

Profit = Revenue – Costs

It is what the owners of the firm keep after paying for the costsof
production

Profit = Revenue – Labor Costs – Capital Costs

= PY – WL – RK
16
To see how profit depends on the factors of production,
we use the production function

Profit = PF(K, L) – WL – RK
THE FIRM’S DEMAND FACTOR

Firms will surely hire labor and rent capital in the

quantities that maximize profit

What are those profit maximizing quantities?

MARGINAL PRODUCT OF LABOR
Refers to the extra amount of output the firm gets from
one extra unit of labor, holding the amount of capital fixed

MPL = F(K, L+1) – F(K, L)

 Y
Output
F (K , L)
MPL
1 As more labor is
added, MPL 
MPL
1

Slope of the production Most production functions have

MPL
function equals MPL
the property of diminishing
1 marginal product
L - Holding the amount of capital
Labor fixed, the MPL decreases as the
amount of labor increases
MPL TO LABOR DEMAND

When the competitive, profit-maximizing firm is deciding

whether to hire an additional unit of labor, it considers
how that decision would affect profits
The increase in revenue from an additional unit of labor
depends on:
–Marginal product of labor
–Price of the output

Extra Revenue = P x MPL

The extra cost of hiring one more unit of labor in the wage
W

∆Profit = ∆Revenue - ∆Cost

= (P x MPL) – W
If the extra revenue P x MPL exceeds the wage W, an extra
unit of labor increases profit

Therefore, the competitive firm’s demand for labor is

determined by

P x MPL = W or
MPL = W/P
W/P is the real wage

Real wage is the payment to labor measured in units of

output rather than in dollars

Maximized Profit:
Firm hires up to the point at which the MPL equals
the real wage
Units of
output
Each firm hires labor
up to the point where
MPL = W/P.
Real
wage

MPL, Labor
demand

Units of labor, L
Quantity of labor
demanded
MARGINAL PRODUCT OF CAPITAL AND
CAPITAL DEMAND

Marginal Product of Capital

–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)

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 x MPK) – R
To maximize profit, the firm continues to rent more capital until
the MPK falls equal the rental price

MPK = R/P

Real Rental Price of Capital

– Rental price measured in units of goods rather than in dollars
In a competitive, profit-maximizing firm…

– The firm demands each factor of production until that factor’s

marginal product falls to equal its real factor price