Lecture 9: Markets, Prices, Supply and Demand II L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.6 11 February 2010

Introduction Last time: – Introduced fluctuations topic and foundations of macroeconomic model. – Households as producers, consumers, labour suppliers, capital owners Today – Build on budget constraint by developing production decision

Last time: Budget Constraint Derived budget constraint in real terms nominal consumption + nominal saving = nominal income (price per unit of consumption x number of units consumed) + change in value of bonds + new spending on capital = profit from the household business + wages earned supplying labour to the household business or others + rent earned leasing capital to the household business or others

Decisions Each period the household has to decide: – How much to produce – From income earned: how much to consume / save / invest Households do not have to decide: – how many hours to work: assume fixed – How much capital to use: assume all capital is either used in family firm or leased to others Today: how much to produce

Profit Maximisation Households use capital and labour to make output, which earns profit: Households choose K and L to maximise profit. – (w/P) and (R/P) are fixed for the firm (perfectly competitive price takers) real profit = output – real wage payments – real rental payments

Labour Market We know (from micro) that firms hire labour up to the point where MPL = real wage – MPL falls as more labour it added to production. – Wage rate is constant – So firm continues to hire workers until MPL = real wage: at this point marginal profit = 0 – So at w/P firm will hire L d workers.

Labour Market Labour supply is fixed – Each household (one-person business) supplies a fixed quantity of labour per week e.g hrs – So supply is perfectly inelastic – The market clears at (w/P)* – Any change in labour demand (due to changes in labour productivity) simply raises or lowers the market-clearing wage

Capital Market Households have to decide how much capital to utilise – As with labour, they can hire their own capital or hire other households’ capital – Hired capital is paid a rent (R/P) per unit – MPK is falling as more capital hired – So decision to utilise capital identical to the decision to utilise labour

Capital Supply Again, analogous to labour supply – Households have an accumulated value of capital, depending on their past investment decisions. – All capital is leased to the market in every period: supply is perfectly inelastic – So position of demand curve determines price (rental cost) charged on the market

Market Interest Rate Equilibrium price of capital (R/P*) also determines equilibrium interest rate i* – Households can choose to invest in capital or bonds – Capital gives a net returen of R/P - δ – If i*>R/P*, investment in capital would fall, capital holding would reduce so MPK would rise – vice versa, until i*=MPK* - δ

Profit in Equilibrium We now know how much labour and capital households will hire. In equilibrium So profit: Now:

Profit is Zero Profit in equilibrium – A cost of a unit of labour or capital is its MP – The return to a unit of labour or capital is its MP So profit is zero: all of the value of inputs is transferred to owners in rent payments

Explaining Profit This is a perfectly competitive market – So no abnormal profit is made Households do earn income! – They hire out their own labour to either their own firm or another – so they earn the wage – They similarly hire out their own capital, to themselves or another – so they earn rent – So household income isn’t zero, but ‘profit’ is.

Summary Explained the production decision – Households maximise profit by equating the MP of labour and capital with the MC – This determines equilibrium wages, rents and incomes to the household Next time: consume / save / invest decision – Plus whether to save in bonds or invest in capital