ECON 102 Macroeconomic Theory

Discussion Sessions F and G, Musa Orak1

WEEK # 2

SUPPLY SIDE Production Function: The function that shows the amount of output that is produced for all combinations of inputs (labor and capital) for a given technology. Y=Af(K,L) where, A is available technology and K and L are capital and labor respectively. We usually use a production function in the following form (ignoring A): Y=KaLb If output is doubled/tripled/quadrupled (and so), when all the factors of production are doubled/tripled/quadrupled (and so), then the technology available is said to be Constant Returns to Scale (CRS). In other words, if a+b=1, then we have CRS. If a+b>1, then production technology is Increasing Returns to Scale (IRS). If a+b<1, then production technology is Decreasing Returns to Scale (IRS). Cobb-Douglas production function is a special case for which b=1-a, and we will be using it throughout this course. Hence, it is very important to know its properties. Cobb-Douglas: Y=KL1- Remember that Cobb-Douglas production function is CRS. Lets double all the inputs: f(2K,2L)=(2K)(2L)1- = 2K 21-L1- =2+1- KL1- =21 KL1-=2 KL1-=2Y=2 f(K,L) Hence, f(2K,2L)= 2 f(K,L) Thus, Cobb-Douglas is CRS. This result does not change if you use 3, 4, instead of 2.

Marginal Product of Labor (Capital): The change in amount of output produced when labor (capital) is increased by 1 unit, while capital (labor) is kept fixed.
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In discrete notation:

This is a preliminary version. Please let me know for any mistakes you figure out.

MPL=f(K,L+1)-f(K,L) MPK=f(K+1,L)-f(K,L) Why do we care about MP? Because, profit maximization requires that real return on inputs (real wages, real rent of capital) should equal to the MP. Therefore, MPL is the demand for labor, while, MPK is the demand for capital. As usual, these demand functions are negatively sloped. In continuous notation, MPL (MPK) is the first derivative of the production function with respect to labor (capital): MPL= MPK=
, ,

= , = ,

Going back to Cobb-Douglas Specification: MPL=(1-) KL-=(1-) MPK= K-1L1-=

How does a firm decide how many labor/capital to hire? There comes the concept of Value of Marginal Product. A firm hires inputs up to the point where cost of hiring an additional unit of factor (wage, rent) equals to the value of the contribution of that additional factor (value of marginal product): VMPL=P*MPL=W VMPK=P*MPL=R

If VMPL>W, hire more. If VMPL<W, fire some of labor. Stop when VMPL=W. Rearranging this, we obtain: MPL=W/P=Real wage MPK=R/P=Real rental price of capital We can obtain same relationship from profit maximization as well. Thus, in an economy, real wage and real rental rate of capital are determined by only the demand for the factor (MP). and L= are fixed, the supply curves are Note that since we are assuming that K= vertical at some level and the quantity is determined by supply only. On the other hand, price of inputs are determined by demand only. (See figure 3.2). Note: Total product increases as you hire more factors (as long as MP is positive). However, MP decreases as you hire more of a factor, while keeping the other one fixed. We call this as diminishing marginal product. (See Figures 3-3 and 3-4 for this

relationship). Dont get confused. Total product is still increasing, however, at a decreasing rate (say when you hire third labor, TP increases by 5 units, but when you hire 4th labor, it increases by 3 units, and 2 units for the fifth etc) MP is the slope of the TP. Factor Income Shares
=MPL* Labor receives: Real Wage*Labor= =MPK* Capital receives: Real rental rate*Capital=

+ MPK* =Y for CRS production technology. Claim: MPL*

Proof: Remember that (for CRS): F(zK,zL)=zF(K,L) Take derivative with respect to z, using Chain Rule on left hand side: KFK(zK,zL)+L FL(zK,zL)=F(K,L)=Y Because this is true for every z, set z=1: KFK(K,L)+L FL(K,L)=F(K,L)=Y Since FK(K,L)=MPK and FL(K,L)=MPL and also capital and labor are fixed: K*MPK+L*MPL=Y Thus, all income is divided between labor and capital. There is no other economic profit.

When we have Cobb Douglas, total income shares are constant. o = Share of capital. Thus capital gets Y. o 1-= Share of labor. Thus labor gets (1-)Y.

Proof: Remember that marginal products for Cobb-Douglas are:

MPL=(1-) KL- MPK= K-1L1- Multiplying by L and K respectively gives us factor income shares: MPL*L=(1-) KL-L=(1-) KL1-=(1-) Y MPK*K= K-1L1-K= KL1-= Y

DEMAND SIDE Remember our assumptions: o Closed economy (NX=0): Y=C+I+G o Perfect competition (zero economic profit) o Fixed technology (A is fixed) o Capital and labor are fixed (Thus supply is fixed) o Markets clear (long run) Consumption is a function of disposable income (DI=Y-T). o Consumption function C=C(Y-T) o Thus, households either consume or save their disposable incomes. o Marginal Propensity to Consume (MPC): The increase in consumption when income increases by $1. o 0<MPC<1. o Marginal Propensity to Save (MPS)=1-MPC. o MPC is the slope of the consumption function (first derivative of consumption function). o Since in our model Y is fixed and we assume that T is fixed (exogenous) as well, consumption is fixed (exogenous) too. Investment is NOT fixed and it is a function of real interest rate: I=I(r).2 o Negatively correlated with real interest rate. Why? When interest rates increase, the opportunity cost of investment rises and agents will save more instead of investing. Hence, there will be less investment. Firms finance their investment through borrowing. When interest rates increases, cost of borrowing will be higher, and thus investment will be more expensive. Again, there will be less investment. o Thus, investment function is negatively sloped. Government can implement two actions: o Expenditures: government purchases (G) o Revenues: collecting taxes (T) o Government budget=T-G If T-G>0: budget surplus If T-G<0: budget deficit If G=T: balanced budget o In our model, we assume both G and T are fixed (exogenous).

Real interest rate is nominal interest rate adjusted by inflation. For instance, when nominal interest rate (the interest rate we hear every day in our daily lives, TV, news etc) is 10% and inflation rate is 6%, then the real interest rate is 10%-6%=4%. This means that, even though you seem to earn 10% for your investment, 6% of it is eroded by inflation and hence your real gain is only 4%.

Equilibrium: = + + Here, r (and consequently I) is the only variable that is NOT fixed. We know that supply side (left hand side is fixed). Then r adjusts to ensure that right hand side (demand) equals to left hand side. Thus, through the adjustment of r, we reach at equilibrium, at which demand equals supply. This adjustment basically takes in the market for loanable funds: o I(r) represents demand in this market. o Supply in this market is fixed since savings are fixed: Private Saving=Y-T-C Public Saving=T-G (National) Saving=Private Saving+Public Saving=Y-T-C+T-G=Y-C-G.

o o o o

Because Y, C and G are fixed, savings are fixed (vertical supply of loanable funds). At the same time, from Y=C+I+G, we have I=Y-C-G, which equals savings. Thus, S=I(r) at the equilibrium. Therefore, r adjusts to equate savings and investment!!!

Exercise: Consider the following cases and describe the dynamics of our model economy. In each case, state which curves shift (if any) and what happens to real interest rate and aggregate output. I. Government decides spending more on public education.
Answer: Initially G increases, then S shifts to the left since public saving (and hence total savings) is lower (Remember that public saving: T-G). This increases the real interest rate up, which in turn, reduces investment. The decline in investment equals to the initial increase in G. This is called as crowding out. In other words, G crowds investment out.

II.

To reduce public debt burden, government decided raising the taxes.

Answer: I was wrong about this in class. Sorry for the confusion! When T increases, disposable income DI=T-G) declines. Since consumption is a function of DI, C decreases as well. This increase private saving, and thus S shifts right. Then, real interest declines and investment increases.

III.

MPC has increased for some reason.

Answer: This means, for every dollar of DI, households will consume more. So, C increases, which means a decline in S (if MPC increased, this means MPS declined). So S shifts left, real interest rate goes up and finally investment declines.

IV.

There is a higher demand for investment (demand for investment increased at every level of interest rates).
Answer: Higher demand for investment means a rightward shift of I(r). S does not shift. Real interest rate goes up, while level of investment remains the same (since S did not change).

Note: In a more realistic set up, consumption will also be a function of r. When r increases opportunity cost of consuming increases, since people can alternatively save and get high returns. 5

Thus, r and C would be negatively correlated in that case. Then, S will not be constant anymore and will be upward sloping rather than being vertical. In such a case, the analysis would be like the same above, but you should keep in your mind that S is not fixed anymore. For instance, in case (iv) above, if S was upward sloping, r would still increase while level of investment increases as well. Unless you are told otherwise, have C independent from r and keep S vertical!

END OF CHAPTER 3 QUESTIONS: Tips Question 1: Amount of factors of production and technology (production function) determines the amount of output. Question 2: A competitive profit-maximizing firm hires labor until the marginal product of labor equals the real wage. Or in other words, firm hires where VMPL=P*MPL=W. Similar is true for capital. Question 3: When we have CRS, total income is divided between return to labor and return to capital: K*MPK+L*MPL=Y (as proven above). Question 4: Y=K0.25L0.75. Question 5: Consumption is a function of disposable income: C=C(Y-T). It depends positively on disposable income. Investment is a function of real interest rate: I=I(r) and it has negative correlation with investment. Question 6: Government purchases are the dollar value of the goods and services directly purchased by the government. Two examples: government builds a bridge and government provides traffic services. Transfer payments are governments payments to individuals that are not in return for goods and services. Examples: retirement payments and unemployment insurance.

Problem 1: a) Due to diminishing marginal returns, MPL declines. Since real wage equals MPL, real wage declines as well. Graphically, this is a rightward shift of labor supply curve. b) Capital supply curve shifts left and real rental rate of capital and MPK declines. c) Same amount of labor and capital produces more output, and hence both MPK and MPL are likely to increase. Thus, real wage and real rental rate of capital are likely to increase. d) This doubles all the nominal variables and prices at the same time. Thus, real variables do not change. Problem 3: DRS may happen if there is a fixed factor such as land in the production function, and this fixed factor becomes scarce as the economy grows larger.
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IRS may happen if specialization of labor becomes greater as the population grows. For example, if only one worker builds a car, then it takes him a long time because he has to learn many different skills, and he must constantly change tasks and tools. But if many workers build a car, then each one can specialize in a particular task and become very fast at it. Problem 6: a) Real wage should increase. b) Real wage is measured in terms of units of output per worker. c) Real wage should remain the same. d) Same as b. e) If workers can freely move between jobs, they will do so until the real wages are equal at both jobs. f) We know that real wage rises in food market and remains the same in haircut market. Assuming that the nominal wages W is the same in both markets, PF should grow less than PH so that real wage will be relatively higher in food market. Thus, growth of price will be larger in the market for haircuts. g) Both groups benefit.

Problem 12: a) Demand curve for business investment shifts to the right (increases) while it remains the same for residential investment. b) Supply does not change. The total demand for loanable funds shifts to the right. Real interest rate increases. c) Total quantity of investment remains the same (since it is determined by supply). The quantity of business investment rises while that of residential investment falls by an equal amount (crowds out).