What is the Classical Model? It is a quite simple but powerful analytical model built around buyers and sellers pursuing their own self-interest (within rules set by government). It’s emphasis is on the consequences of competition and flexible wages/prices for total employment and real output. Its roots go back to 1776—to Adam Smith’s 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. Bzhar N. Majeed

What determines the total production of goods and services? An economy’s output of goods and services (GDP) depends on: Quantities of inputs… (the factors of production). Ability to turn inputs into outputs… (the production function). Output (GDP) Factors of production The production function Bzhar N. Majeed

The factors of production Factors of production are the inputs used to produce goods and services. The two most important factors of production are capital and labor. Capital is the set of tools that workers use. We use letter K to denote the amount of capital. Labor is the people that working. We use letter L to denote the amount of labor. In this model, we will assume that all resources are fully utilized, meaning no resources are wasted. Bzhar N. Majeed

The production function The production function is a mathematical expression relating the amount of output produced to quantities of capital and labor utilized. A key assumption is that the production function has constant return to scale (CRTS), meaning that if we increase inputs by z, output will also increase by z. Production function: Y = ƒ (K,L), while Y is real output produced, K and L are the given inputs, ƒ is function relating output to inputs Bzhar N. Majeed

Constant Return to Scale CRTS If we have this production function (Q = 2K + 3L), also (K=1) and (L=2) Q = 2*1 + 3*2 = 8 We will increase the inputs (K & L) by (2) So, Q = If we increase the input by (3) the new production function would be: Q = Bzhar N. Majeed

Mankiw’s Bakery The kitchen and its equipment are Mankiw’s Bakery capital The worker hired to make the bread are its labor The Loaves of bread are its output Mankiw’s Bakery production function shows that the number of loaves produced depends on the amount of the equipment and the number of workers. If the production function has constant returns to scale, then doubling the amount of equipment and the number of workers doubles the amount of bread produced. Bzhar N. Majeed

Return to Scale RTS Increased RTS If (Q = 0.5 KL)… we will create new production function. We increase the inputs by amount (M) Q = Since M>1, then M2>M… So, our new production has increased by more than M, it means we have IRTC Decreased RTS (Q = K0.3 L0.2), Since M>1, then M0.5<M, our new production has increased by less than M, so we have DRTS Bzhar N. Majeed