Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-761 2. Distribution of National Income Factors...

Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76 1

2. Distribution of National Income

• Factors of production and production function determine output and therefore national income

• Circular flow: national income flows from firms to households through the markets for the factors of production

• The neoclassical theory of distribution: theory of how national income is divided among the factors of production


Factor Prices

• Factor prices – determine the distribution of national income– The amounts paid to the factors of production

= wages, rent – Price of each factor depends on the supply

and demand for that factor– Vertical factor supply curve– Downward sloping factor demand curve– Intersection = determines equilibrium factor

price


Demand for the factors of production

• Examine a typical firm to look at decisions taken by firms on how much of these factors to demand

• Assume: firm is competitive– Little influence on market prices– Firm produces and sells at market prices

• Firm’s production function:Y = F(K, L)



• Y = firm’s output• K = machines used (amount of capital)• L = number of hours worked by employees

(amount of labour)• P = price the firm sells its output for• W = wages firm hires workers at• R = rent of capital paid by the firmAssume: that households own the economy’s

stock of capital. Firms produce output and households own capital



• Goal of firm: to maximise profits• Profit = revenue – costs• Revenue = P x Y

– P = price of goods– Y = amount of good produced

• Costs: labour costs and capital costs– Labour costs = W x L (wage times amount of labour)– Capital costs = R x K (rental times amount of capital)


Demand for the factors of Production

Profit = revenue – labour costs – capital costs

Profit = PY – WL – RK

Y = F(K,L)

Therefore:

Profit = PF(K,L) – WL – RK



• Profit depends on the product price, P, the factor prices, W and R, and the factor quantities, L and K

• Competitive firm: takes the product price and the factor prices as given and chooses amounts of labour and capital that will maximise profits.

• P, W and R are given• Firm chooses L and K



• Firm will hire labour and capital that will maximise profits

• But what are those profit-maximising quantities?



• Quantity of labour

• More labour employed, more output firm produces

• Marginal Product of Labour (MPL) = the extra output the firm gets from one extra unit of labour, holding amount of capital fixed



MPL = F(K, L+1) – F(K,L)

Equation: MPL is the difference between the amount of output produced with L+1 units of labour and the amount produced with only L units of labour



• Diminishing marginal product: – Most production functions have this property– Holding the amount of capital fixed, MPL

decreases as the amount of labour increases– “too many cooks spoil the broth”

• Graph of a production function when we hold capital fixed and allow labour to vary



• Deciding to hire an additional unit of labour depends on how it will affect profits

• Firm compares:– the extra revenue from the increased

production as a result of that extra labour– to the cost of that extra labour, i.e. the wages

given to that extra labour

• Extra revenue depends on the MPL and the price of the output



• Extra revenue = P x MPL• Cost of the extra labour = WΔProfit = ΔRevenue – ΔCost

= (P x MPL) – W• How much labour does the firm hire?• Answer: if the extra revenue (P x MPL) is

greater than the cost of (W), then the profits increase and the firm will hire the extra unit of labour



• The firm will continue to hire labour until the next unit of labour would no longer be profitable

• That is until:

P x MPL = W

Revenue of extra labour = cost of that labour

• That can be written as: MPL = W/P



• MPL = W/P

• W/P = real wage

• Graph: the Marginal Product of Labour Schedule



• The firm decides how much capital to rent in the same way it decides how much labour to hire

• Marginal product of capital (MPK) = amount of extra output the firm gets from one extra unit of capital, holding the amount of labour fixed

MPK = F(K + 1, L) – F(K, L)



• Diminishing marginal product of capital

• Firm compares:– the extra revenue from the increased

production as a result of that extra capital– to the cost of that extra capital, i.e. the rent

• Extra revenue = P x MPK

• Cost of the capital = R



ΔProfit = ΔRevenue – ΔCost

= (P x MPK) – R

• To maximise profits the firm continues to rent more capital until the MPK falls to equal the real rental price

MPK = R/P



• Summary: How a firm decides how much of each factor to employ– The firm will hire additional labour up to the

point when MPL = W/P– The firm will rent additional capital up to the

point when MPK = R/P


The Division of National Income

• We can now see how the markets for the factors of production distribute the economy’s total income

• Assuming all firms are competitive and profit-maximising then: – Each factor of production is paid its marginal

contribution to the production process



• The real wage paid to each worker = MPL• The real rental price paid to each capital-owners

= MPK• For the whole economy then:

– Total real wages paid to labour is MPL x L– Total rental paid to all capital-owners is MPK x K

• Income that remains after firms pay the factors of production = economic profit of the owners of firms



Economic profit = Y – (MPL x L) – (MPK x K)• Rearrange to see how total income is

divided:

Y = (MPL x L) + (MPK x K) + economic profit• How large is economic profit?• Answer: if production function has constant

returns to scale then economic profit is zero



• Reason: if – each factor is paid its marginal product i.e.

labour is paid the additional output it produces and capital-owners are paid the additional output it produces AND

– if there is constant returns to scale, i.e. output increases by the same amount that the factors have increased by

– THEN– Economic profit left over is zero



• Constant returns to scale, profit maximisation and competition implies economic profit is zero

• Why is there ‘profit’ in the economy?• Assumed

– three agents in economy: workers, owners of capital and owners of firms

– Total output or income is divided among wages, return to capital and economic profit



• But most firms own rather than rent the capital they use, so firm owners and capital owners are the same people

• Accounting profit = economic profit + (MPK x K)

• So the ‘profit’ is the return to capital


Summary

1. What determines the level of production?Answer: the factors of production and the

production function determine total output in the economy

2. How the income is distributed:Answer: wages paid to labour, rent paid to

capital-owners and economic profit3. What determines the demand for goods

and services?

Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-761 2. Distribution of National Income Factors...

Documents

Transcript of Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-761 2. Distribution of National Income Factors...