1. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-761 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

2. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-762 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

3. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-763 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)

4. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-764 Demand for the factors of production 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 firm Assume: that households own the economy’s stock of capital. Firms produce output and households own capital

5. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-765 Demand for the factors of production 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)

6. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-766 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

7. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-767 Demand for the factors of production 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

8. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-768 Demand for the factors of production Firm will hire labour and capital that will maximise profits But what are those profit-maximising quantities?

9. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-769 Demand for the factors of production 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

10. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7610 Demand for the factors of production 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

11. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7611 Demand for the factors of production 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

12. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7612 Demand for the factors of production 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

13. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7613 Demand for the factors of production Extra revenue = P x MPL Cost of the extra labour = W ΔProfit = 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

14. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7614 Demand for the factors of production 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

15. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7615 Demand for the factors of production MPL = W/P W/P = real wage Graph: the Marginal Product of Labour Schedule

16. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7616 Demand for the factors of production 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)

17. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7617 Demand for the factors of production 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

18. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7618 Demand for the factors of production 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

19. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7619 Demand for the factors of production 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

20. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7620 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

21. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7621 The Division of National Income 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

22. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7622 The Division of National Income 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

23. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7623 The Division of National Income 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

24. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7624 The Division of National Income 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

25. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7625 The Division of National Income 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

26. Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-7626 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 profit 3. What determines the demand for goods and services?