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# 302-03 - CHAPTER NationalIncome WhereitComesFrom...

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C H A P T E R National Income: Where it Comes From  and Where it Goes University of Wisconsin Charles Engel 3

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Ch 3.02 slide 2 In this chapter, you will learn… what determines the economy’s total output/income how the prices of the factors of production are determined how total income is distributed what determines the demand for goods and services how equilibrium in the goods market is achieved
Ch 3.02 slide 3 Outline of model A closed economy, market-clearing model Supply side factor markets (supply, demand, price) determination of output/income Demand side determinants of C , I , and G Equilibrium goods market loanable funds market

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Ch 3.02 slide 4 Factors of production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers
Ch 3.02 slide 5 The production function denoted Y = F ( K , L ) shows how much output ( Y ) the economy can produce from K units of capital and L units of labor reflects the economy’s level of technology exhibits constant returns to scale

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Ch 3.02 slide 6 Returns to scale:  A review Initially Y 1 = F ( K 1 , L 1 ) Scale all inputs by the same factor z : K 2 = zK 1 and L 2 = zL 1 ( e.g. , if z = 1.25, then all inputs are increased by 25%) What happens to output, Y 2 = F ( K 2 , L 2 )? If constant returns to scale , Y 2 = zY 1 If increasing returns to scale , Y 2 > zY 1 If decreasing returns to scale , Y 2 < zY 1
Ch 3.02 slide 7 Example 1 ( , ) F K L KL = ( , ) ( )( ) F zK zL zK zL = z KL = 2 z KL = 2 z KL = ( , ) z F K L = constant returns to scale for any z > 0

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Ch 3.02 slide 8 Example 2 ( , ) F K L K L = + ( , ) F zK zL zK zL = + z K z L = + ( , ) z F K L = decreasing returns to scale for any z > 1 ( 29 z K L = +
Ch 3.02 slide 9 Example 3 ( , ) F K L K L = + 2 2 ( , ) ( ) ( ) F zK zL zK zL = + 2 2 ( , ) z F K L = 2 increasing returns to scale for any z > 1 ( 29 z K L = + 2 2 2

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Ch 3.02 slide 10 Assumptions of the model 1. Technology is exogenous. 2. The economy’s supplies of capital and labor are exogenous at and K K L L = =
Ch 3.02 slide 11 Determining GDP Output is determined by the exogenous factor supplies and the exogenous state of technology: , = ( ) Y F K L

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Ch 3.02 slide 12 The distribution of national income determined by factor prices , the prices per unit that firms pay for the factors of production wage = price of L ren tal rate = price of K
Ch 3.02 slide 13 Notation W = nominal wage R = nominal rental rate P = price of output W / P = real wage (measured in units of output) R / P = real rental rate

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Ch 3.02 slide 14 How factor prices are determined Factor prices are determined by supply and demand in factor markets. Recall: Supply of each factor is fixed. What about demand?
Ch 3.02 slide 15 Demand for labor Assume markets are competitive: each firm takes W , R , and P as given. Basic idea: A firm hires each unit of labor if the cost does not exceed the benefit.

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302-03 - CHAPTER NationalIncome WhereitComesFrom...

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