Lecture 3 National Income 1 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 2 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

Lecture 3. National Income 3

4 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

Lecture 3. National Income 5 Returns to scale: A review Initially Y 1 = F (K 1, L 1 ) Scale all inputs by the same factor z: K 2 = zK 1 and L 2 = zL 1 (e.g., if z = 1.2, then all inputs are increased by 20%) What happens to output, Y 2 = F (K 2, L 2 )? If constant returns to scale, Y 2 = zY 1 If increasing returns to scale, Y 2 > zY 1 If decreasing returns to scale, Y 2 < zY 1

Lecture 3. National Income 6 Capital (K) Output (Y) 0 Production function

Lecture 3. National Income 7 Slope. Marginal product of capital (>0) Output-labour ratio (y=Y/L) 0 Capital-labour ratio (k=K/L)

Lecture 3. National Income 8 Curve. Diminishing marginal productivity Output-labour ratio (y=Y/L) 0 Capital-labour ratio (k=K/L)

Lecture 3. National Income 9 Shift. Changes in productivity Output-labour ratio (y=Y/L) 0 Capital-labour ratio (k=K/L)

Lecture 3. National Income 10 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 14 Production Function: Y=f(K,L)

Lecture 3. National Income 15 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 =  Y labor income = MPL x L = (1 –  )Y The Cobb-Douglas production function is: where A represents the level of technology.

Lecture 3. National Income 16 Demand for Goods and Services Consumption Investment Government Purchases

Lecture 3. National Income 17 The Consumption Function

Lecture 3. National Income 18 The Investment Function

Lecture 3. National Income 19 What Brings the Supply and Demand for Goods and Services Into Equilibrium? Equilibrium in the Market for Goods and Services o Demand for g&s o Supply of g&s Equilibrium in the Financial Markets

Lecture 3. National Income 20 Saving, Investment, and the Interest Rate

Lecture 3. National Income 21 A Reduction in Saving

Lecture 3. National Income 22 Wars and Interest Rates in the UK

Lecture 3. National Income 23 An Increase in the Demand for Investment

Lecture 3. National Income 24 An Increase in Investment Demand When Saving Depends on the Interest Rate

Lecture 3. National Income 25 Student Presentations Due: February 24 th at the end of the lecture 1 st topic: GDP in Azerbaijan 2 nd topic: Inflation and Unemployment in Azerbaijan