Economics 3307

Main Points of Chapter 3

1. A production process converts *inputs* into *outputs*. This chapter
introduces the aggregate production function Y = F(K,L), which says that total
output in the economy, or Real GDP (Y) is a function of the total amount of
capital (K) and labor (L) used by firms in the production process.

2. K and L have positive but decreasing marginal
products. That is, Y increases with
increases in K or L (positive marginal product), but as K or L gets larger and
larger the marginal increase in Y caused by using still more K or L gets
smaller and smaller.

3. Firms maximize profits, which means they will
hire additional capital and/or labor as long as the marginal revenue of doing
so exceeds the marginal cost. Firms are
maximizing profits when the marginal revenue of each input equals the marginal
cost. These conditions are (i) P·MPL =
W for labor, and (ii) P·MPK = R for capital, where P is the price of output,
MPL is the marginal product of labor, W is the wage rate, MPK is the marginal
product of capital, and R is the rental price of capital.

4. We can rearrange these conditions to imply MPL
= (W/P) and MPK = (R/P). These
conditions give us the demand curve for labor and the demand curve for capital.

5. We assume in Chapter 3 that the supplies of
capital and labor are exogenous. This
means that the labor supply curve and capital supply curve are vertical lines.

6. In equilibrium, (W/P) has adjusted so that the
aggregate demand for labor equals the supply of labor, and (R/P) has adjusted
so that the aggregate demand for capital equals the supply of capital.

7. The total real income earned by labor is
(W/P)·L, which in equilibrium is equal to MPL·L. The total real income earned by owners of capital is (R/P)·K,
which in equilibrium is equal to MPK·K.

8. The total income earned in the economy is
equal to (MPL·L + MPK·K), which under certain conditions -- that seem to be
satisfied in practice -- is equal to real output Y. (The "certain conditions" are that the aggregate
production function exhibits *constant
returns to scale*.)

9. Thus the relative income earned by labor and
capital is = . This is the neoclassical theory of income distribution, which
says that factors of production each earn their marginal products.

10. If L rises, the equilibrium W/P falls. If L falls, the equilibrium W/P rises. If K rises, the equilibrium (R/P)
falls. If K falls, the equilibrium
(R/P) rises.

11. If something happens (such as a
technological innovation) to increase MPL at any given L, the labor demand
curve shifts right and the equilibrium (W/P) rises. If something happens to decrease MPL at any given L, the labor
demand curve shifts left and the equilibrium (W/P) falls.

12. If something happens to increase MPK at any
given K, the capital demand curve shifts right and the equilibrium (R/P)
rises. If something happens to decrease
MPK at any given K, the capital demand curve shifts left and the equilibrium
(R/P) falls.

13. In practice, it is possible that a change
in the supply of one factor will change the marginal product of the other
factor. For example, an increase in K
might increase MPL, or an increase in L might also increase MPK.

14. In general, the total demand for GDP goods
and services is C + I + G + NX, where C = personal consumption expenditures, I
= gross private domestic investment, G = government purchases, and NX = net
exports. In Chapters 3-6 we assume the
economy is *closed* -- that is, the
economy has no international trade -- so that NX = 0. This implies that total demand
= C + I + G.

15. The supply of goods and services is given
by Y = F(K,L). Y is completely
determined by the exogenous values of K and L.

16. C depends positively on after-tax income (=
*disposable* income) Y-T, so we write C
= C(Y-T). The *marginal propensity to consume* (MPC) is the fraction of any change
in disposable income that is spent on consumption. If Y-T increases by $100 and the MPC is 0.8, then C will rise by
$80 and consumer saving will therefore rise by $20.

17. The *real
interest rate* (r) is the cost of borrowing (and the return to lending)
after adjustment for inflation. If the
nominal interest rate on a loan is 10% and the inflation rate is 7%, the real
interest rate is 3%.

18. I depends negatively on the real interest rate, so we write I =
I(r).

19. We assume in Chapter 3 that G and T are exogenous.

20. Thus supply = demand in the goods market
implies that Y = C(Y-T) + I(r) +
G. Y is completely determined by the
exogenous values of K and L. T is
exogenous, so Y-T completely determines C.
G is exogenous. Thus the only
variable that can adjust to maintain the above equality is I, which depends on
r. This means that *the real interest rate adjusts so that the aggregate market for goods and services moves to equilibrium*.

21. If Y > C+I+G, then r needs to
decrease. This increases I, and should
occur until C+I+G has risen enough to equal Y.

22. If Y < C+I+G, then r needs to
increase. This decreases I, and should
occur until C+I+G has fallen enough to
equal Y.

23. For an intuitive understanding of why the
real interest rate (r) adjusts, note that Y
= C + I + G implies (Y - C - T)
+ (T - G) = I. (Y - C - T) is private
saving, and (T - G) is government saving.
The sum of private and government saving is *total saving*, which we denote S.
Thus the goods market is in equilibrium with Y = C+I+G if and only if S
= I. In the market for loans, we can
think of S as the *supply* of loans and
I as the *demand* for loans. If Y > C+I+G, then S > I and the
excess supply of loans makes the real interest rate decrease as in #21
above. If Y < C+I+G, then S < I
and the excess demand for loans makes the real interest rate increase as in #22
above.

24. If C depends only on Y-T, then private saving
is determined entirely by K and L (which determine Y) and T. Government saving equals T-G, both of which
are exogenous. Thus total saving S
depends only on Y (which depends only on K and L), T, and G. This means that the "supply curve"
in the loan market graph is vertical.
The demand curve, which depends on investment spending I, is downward
sloping.

25. If we allow C to depend negatively on the
real interest rate (r), then S will depend positively on the real interest rate
and the supply curve in the loan market will be upward-sloping.