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Economics 154a Fall 2008 Agenda for this week: 1. The Classical macro model 2. Measuring output

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### Economics 154aFall 2008Agenda for this week:1. The Classical macro model2. Measuring output

Some announcements

- First problem set will be posted this week and due next Wednesday (Sept 17).
- I will post readings on logarithms on the course web page. There will probably be an optional section on logs in the next couple of weeks.
- Sections will begin next week. You should sign up on the Registrar’s section list.

Wednesday 4:50-4:50 and 5:00-5:50

Thursday 1:30-2:20 and 2:30-3:20 (REVISED)

Thursday 4:50-4:50 and 5:00-5:50

Basics of Static Classical Model: Production Theory

Classical production model.

Aggregate production function (for real GDP, Y)

(1) Y = F( K, L)

Standard assumptions: positive marginal product (PMP), diminishing returns (DR), constant returns to scale (CRTS):

CRTS: mY = F( mK, mL)

PMP: ∂Y/∂K>0; ∂Y/∂L>0

DR: ∂2Y/∂K2<0; ∂2Y/∂L2<0

Example: Cobb-Douglas production function

Very popular production function: Cobb-Douglas (log linear)

F( K, L) = AKαL1-α

Properties:

MPL = ∂[AKαL1-α]/∂L=(1-α)AKαL1-α /L = (1-α)Y/L = (1-α) x APL

(and similarly for MPK)

Factor Markets

Factor markets: capital and labor inputs (K and L):

- Capital inherited from past investments
- Labor inputs exogenous (from biology, health, customs)

Real wage rate: = W/P = MPL = ∂Y/∂L = ∂[F( K, L)]/∂L (see Fig. 1)

Real rental rate on capital (like apartment rental as $ per month):

= R/P = MPK = ∂Y/∂K = ∂[F( K, L)]/∂K

National income = labor income + capital income = WL + RK

Exhaustion of product theorem: With CRTS and competitive pricing, paying factors their marginal product leads income = output.

Example: Cobb-Douglas production nction

Very popular production function: Cobb-Douglas (log linear)

F( K, L) = AKαL1-α

Properties:

MPK = ∂[AKαL1-α]/∂K=αAKαL1-α /K = αY/K = α x APK

(and similarly for MPL)

National income

Y = MPL x L + MPK x K = L[(1-α)Y/L] +K[αY/K ] = Y

(exhaustion of product theorem)

Shares of capital and labor:

share of K = RK/Y = (αY/K ) x (K/Y) = constant = α

Why do economists like Cobb-Douglas? See next slide.

Neoclassical distribution of output/income

W/P

Capital

income*

*More generally, all non-labor income

Can reverse axes and get analogous results for capital.

(W/P)*

Total wages

MPL

L

L*

Effect of immigration

W/P

Assume immigrants are perfect substitutes for L

- Results:
- Wage rate falls.
- Output and national income rise.
- Capital income rises.
- More generally, income of substitutes fall and complements rise.
- Empirical studies suggest that low-skilled and Hispanic workers are hurt by Mexican immigration.

E1

(W/P)1

E2

(W/P)2

MPL

L

L*

National Academy of Sciences study (The New Americans)

“Immigration over the 1980s increased the labor supply of all workers by about 4 percent. On the basis of evidence from the literature on labor demand, this increase could have reduced the wages of all competing native-born workers by about 1 or 2 percent. Meanwhile, noncompeting native-born workers would have seen their wages increase…”

“Based on previous estimates of responses of wages to changes in supply, the supply increase due to immigration lowered the wages of high school dropouts by about 5 percent…”

Other applications of static neoclassical model

Impact of foreign investment :

- Assume that foreign firms build a factory in US. What is effect in simple neoclassical model?
- Answer: Same as immigration, but reverse the factors.

Impact of outsourcing:

- What is effect of hiring foreign workers for call centers, radiology, computer programming?
- I will post an interesting discussion by Mankiw on the politics and economics of outsourcing.

Impact of government debt:

- What is the effect of a growing government debt?
- Slightly more complicated, but might crowd out capital stock. This then reduces output. Note effects on wages and rentals.

Let’s go back and ask:“Just what is this ‘Y’?”“Just how do we measure GDP and real GDP?”

How to measure output growth?

- Now take the following numerical example.
- Suppose good 1 is computers and good 2 is Yale BAs.
- How would we measure total output and prices?

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