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2. Distribution of National Income

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

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2. Distribution of National Income

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  1. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  2. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  3. 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) Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  4. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  5. 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) Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  6. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  7. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  8. Demand for the factors of production • Firm will hire labour and capital that will maximise profits • But what are those profit-maximising quantities? Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  9. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  10. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  11. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  12. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  13. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  14. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  15. Demand for the factors of production • MPL = W/P • W/P = real wage • Graph: the Marginal Product of Labour Schedule Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  16. 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) Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  17. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  18. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  19. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  20. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  21. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  22. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  23. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  24. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  25. 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 Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

  26. 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? Source: Mankiw (2000) Macroeconomics, Chapter 3 p. 42-76

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