Lecture 3National Income

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1. Supply side factor markets (supply, demand, price) determination of output/income

2. Demand side determinants of C, I, and G

3. Equilibrium goods market loanable funds market

Lecture 3. National Income

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A basic classical model

• the determinants of the level of output (income)

• how income is distributed

• how output is allocated among alternative uses

• what ensures that the supply of and demand for goods are

equal

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Lecture 3. National Income

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What Determines the Total Production of Goods and Services?

• The Factors of Production K = capital: tools, machines, and structures used in production L = labor: the physical and mental efforts of workers

• The Production Function: Y = F(K,L)o shows how much output (Y ) the economy can produce from K units of capital and L units of labor o reflects the economy’s level of technology o exhibits constant returns to scale

• The Supply of Goods and Services

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Returns to scale: A review

Initially Y1 = F (K1 , L1 )

Scale all inputs by the same factor z:

K2 = zK1 and L2 = zL1

(e.g., if z = 1.2, then all inputs are increased by 20%)

What happens to output, Y2 = F (K2, L2 )?

• If constant returns to scale, Y2 = zY1

• If increasing returns to scale, Y2 > zY1

• If decreasing returns to scale, Y2 < zY1

Lecture 3. National Income

6Capital (K)

Out

put (

Y)

0

Y=F K,L( )

Production function

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k

y

Slope. Marginal product of capital (>0)

Output-labourratio

(y=Y/L)

0

y=f k( )

Capital-labour ratio(k=K/L)

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1y

2} y

Curve. Diminishing marginal productivity

Output-labourratio

(y=Y/L)

0

y=f k( )

k

k

Capital-labour ratio(k=K/L)

1 2y y

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Shift. Changes in productivity

Output-labourratio

(y=Y/L)

0

( )1

y=f k

Capital-labour ratio(k=K/L)

( )2

y=f k

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The Distribution of National Income to the Factors of Production

• Factor Prices

• The Decisions Facing the Competitive Firm

• The Firm’s Demand for Factors

• The Division of National Income

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Lecture 3. National Income

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Production Function: Y=f(K,L)

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The Cobb–Douglas Production Function

• The Cobb-Douglas production function has constant factor shares: = capital’s share of total income:capital income = MPK x K = Ylabor income = MPL x L = (1 – )Y

• The Cobb-Douglas production function is:

where A represents the level of technology.

1Y AK L

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Demand for Goods and Services

• Consumption

• Investment

• Government Purchases

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The Consumption Function

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The Investment Function

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What Brings the Supply and Demand for Goods and Services Into Equilibrium?

• Equilibrium in the Market for Goods and Serviceso Demand for g&s

o Supply of g&s

• Equilibrium in the Financial Markets

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Saving, Investment, and the Interest Rate

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A Reduction in Saving

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Wars and Interest Rates in the UK

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An Increase in the Demand for Investment

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An Increase in Investment Demand When Saving Depends on the Interest Rate

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Student Presentations

Due: February 24th at the end of the lecture

1st topic: GDP in Azerbaijan

2nd topic: Inflation and Unemployment in Azerbaijan