Macroeconomics Lecture2 Notes

Macroeconomics Lecture 2 1 Introduction The ‘long run’: • Wages and prices have had time to adjust so that production and employment are at their equilibrium values, but the capital stock is fixed • Time perspective: ‘a few years’ The ‘very long’ run: • Even the capital stock has had time to adjust 2 Introduction Why is it important to study the economy in the long run? • Long run growth affects the population’s standard of living much more than short-term fluctuations • Decisions about consumption and investments depend on expectations of what will happen in the long run • You can’t analyse what stabilisation policy should do – or should not do – without knowing more about the long-run equilibrium level 3 Introduction Questions: • What factors determine the income level and the distribution of income in the long run? • What determines demand (investments and consumption) and the real interest in the long run? • Why are some countries richer than others? • Why is there always unemployment in a market economy? • What determines inflation in the long run? (Later on) 4 Introduction Presentation Outline: • Production, prices and distribution of income • Investments, consumption and the real interest rate • Capital accumulation and growth (Later on) • Wage determination and unemployment • Money and inflation in the long run (Later on) 5 Production, prices and the distribution of income (Chapter 2) Questions: • How much can a country produce? • How does the product market work and how are prices determined? • What factors determine the distribution of income between labour and capital income? 6 Production: Production factors Production factors: • Labour • Capital (buildings, machines etc.) • Fixed factors (land, natural resources etc.) • Intermediate goods (raw materials, energy, components etc.) • Technology (knowledge) 7 Production: Production technology In the model the typical firm produces a commodity that can be used for consumption or investment Production function: Y  F (K , N ) Y K N production capital stock number of workers We disregard fixed factors and intermediate goods The production function describes the technology 8 Production: Characteristics of production function • The marginal product of capital: how much production increases when we add a unit of capital • The marginal products are positive: production is an increasing function of K and N • The marginal product of capital is lower if we have more capital already • The marginal product of capital is higher if we have more labour that can use the machines 9 Production: Characteristics of production function 10 Production: Characteristics of production function 11 Production: Characteristics of production function Constant returns to scale (CRS) If we double K and N, then Y is doubled F(zK, zN)  zY where z is an arbitrary positive number. F(K, N)  Y F(2K, 2N)  2Y F(3K,3N)  3Y 12 Production: Example K Y  10 KN 10 20 30 10 100 141 173 20 141 200 245 30 173 245 300 N 13 Production: Technical development Technical development: • Production function: Y=F(K, EN) • E is a measure of the efficiency of labour • An increase in E by 10% has the same effect on production as a 10% increase in the number of workers • We can think of EN as the ‘efficient number of workers’ 14 Production: Example We often use the Cobb-Douglas production function: 0 £ a £1 Y = K (EN ) Rewrite: Y = K a E 1- a N 1- a and take derivative with respect to N: a a 1- a a MPL = K E 1-a (1- a ) N -a = (1- a ) E • The more N, the lower is MPL • The more K, the higher is MPL • The higher the E, the higher is MPL 1-a æK ö ç ÷ èN ø 15 Production: Example 16 Price-setting: Introduction Questions: • How does the product market work? • How are prices set? 17 Price-setting: Introduction Perfect competition: Firms produce identical goods and they can sell everything they produce, but they have to set the price equal to the market price Monopolistic competition: Firms produce goods that are similar but not identical to the goods of other firms. A firm can set its own price and the price affects sales In both cases: many firms – no ‘strategic’ interaction 18 Price-setting: Demand We study a company named i – one of many companies in the economy. To be more concrete, let i=4711 • How much will the company sell (produce)? • What price will the company set? These two decisions are really just one: the company must choose a point on the demand curve 19 Price-setting: Demand Higher price leads to lower demand for a company’s product, that is, the company will face a downward sloping demand curve. Demand for a company’s product: Yi  D( Pi / P)Y Pi / P the company’s price relative the general price level Y aggregated income in the economy 20 Price-setting: Demand What happens to the demand for the product produced by firm 4711 if the price is raised, for a given P and Y? The answer depends on the degree of competition the company faces. How similar is the company’s product compared to the products of other firms? A measure of the ‘degree of competition’ is the price elasticity, which tells us by what percentage demand will decrease if the price is raised by one percent. dYi / Yi h= dPi / Pi ; we assume   1 21 Price-setting: Demand The inverted demand function is the relationship between company’s price and production/sales Pi  P(Yi , P, Y ) If the company wants to sell more it has to lower the price. 22 Price-setting: Profit maximisation Firm’s goal: greatest possible profit Profit maximisation requires: marginal revenue from selling one more unit = marginal cost of producing one more unit MR = MC 23 Price-setting: Profit maximisation Revenue: Yi  Pi  Yi  P(Yi , P, Y ) How much does the revenue increase if you sell one more unit? é ù é 1ù dPi dPi Pi dPi / Pi MR = Pi +Yi = Pi +Yi = ê1+ ú Pi = ê1+ ú Pi dYi dYi Pi ë dYi / Yi û ë hû Increase in revenue from selling one more unit Decrease in revenue from lower price → MR is positive but lower than the price (see figure). 24 Price-setting: Profit maximisation 25 Price-setting: Profit maximisation Profit maximisation: MR=MC é 1ù ê1+ ú Pi = MCi ë hû Pi = (1+ m ) MCi where Example: h = -5 Þ m = 0.25 1+ m = 1 >1 1+1 / h Mark-up is 25 percent Conclusions: • Optimal price is higher than MC • Mark-up is determined by the degree of competition. 26 Price-setting: Profit maximisation MC measures how much cost increases if a company sells (produces) one more product. The capital stock is given in the short run The firm can increase production by employing one more worker. Cost: Wi Production increase: MPLi Marginal cost: MC i = Wi MPLi Example? 27 Price-setting: Market equilibrium The firm’s optimal price then becomes: Pi = (1+ m ) Wi MPLi ... but we are doing macroeconomics: What is the average price level? Symmetry: The market consists of many companies. They all face the same conditions and set the same price: W P = (1+ m ) MC = (1+ m ) MPL 28 Price-setting + Cobb-Douglas Cobb-Douglas production function: a Y = K a E 1- a N 1- a æKö MPL = K a E1-a (1- a ) N -a = (1- a ) E1-a ç ÷ èNø -a æ ö W 1+ m K P = (1+ m ) MC = (1+ m ) = WE a -1 ç ÷ èNø MPL 1- a The price level is influenced by: • The wage level, W • Technology, E • The size of the mark-up, μ • The amount of capital per worker, K/N (+) (-) (+) (-) 29 Distribution of income: Introduction Questions: • How is the production level determined in the long run (= the natural level of production)? • How are real wages determined? • How is the distribution of income determined? 30 Distribution of income: Production in equilibrium L labour force = the number of people who have a job or are looking for work n equilibrium level for unemployment u Natural rate of employment: Production: N = (1- u )L n n ( Y n= F ( K, E N n ) = F K, E (1- un ) L ) 31 Distribution of income: Production in equilibrium 32 Distribution of income: Production in equilibrium What determines the equilibrium level of production? ( ( )) Y n = F K , E 1 - un L • • • • Amount of capital (K) Size of labour force (L) Equilibrium level of unemployment (un) Technology (E) (+) (+) (-) (+) 33 Distribution of income: Real wages Real wage = wage in terms of consumption = nominal wage divided by price level = W/P P = (1+ m ) W MPL Þ W MPL = P 1+ m 34 Distribution of income: Real wages for given capital stock 35 Distribution of income: Real wages Cobb-Douglas: a æKö MPL = (1- a ) E1-a ç ÷ èNø a W MPL 1- a 1-a æ K ö = = E ç n÷ èN ø P 1+ m 1+ m Real wage increases if: • Technology (E) is improved • Capital per worker (K/Nn) increases • The size of the mark-up (μ) decreases (competition increases) 36 Distribution of income: Introduction Closed economy: income = production Types of income in the model: • Wage income • Interest income on loans to firms • Dividends which are paid out to households (here = pure profits) 37 Distribution of income: Labour share Cobb-Douglas a Y 1-a æ K ö MPL = (1- a ) E ç ÷ = (1- a ) èNø N W MPL = P 1+ m Þ W 1- a Y = P 1+ m N Real wage is proportional to real GDP per capita Labour share of GDP WN 1- a = PY 1+ m 38 Distribution of income: Labour share Distribution of income: • Share of GDP to labour: WN 1- a = PY 1+ m • Share of GDP to capital owners (interest plus dividends = return on capital plus pure profits): 1- 1- a 1+ m 1- a 1+ m -1+ a a + m = = = 1+ m 1+ m 1+ m 1+ m 1+ m What affects the distribution of income? • Technology: α • Degree of competition on the product market: μ 39 Distribution of income: Labour share Wage share will be high if: • Labour is an important production factor • The degree of competition is high In developed countries the labour share of GDP at factor price is about 2/3; capital share is approximately 1/3. Social insurance fees (wage taxes) are included in the wage share. We consider the share of GDP at basic (≈factor) price because VAT goes neither to capital owners nor to workers. 40 Distribution of income: Labour share 41