Intermediate Macroeconomics

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1 Intermediate Macroeconomics ECON 3312 Lecture 2 William J. Crowder Ph.D.

2 Mercantilism Economic Nationalism Beggar-thy-neighbor policies Bullionism Regulate everything! Trade restrictions Monopoly rights Labor restrictions Immigration laws Protect Domestic Producers

3 Mercantilism Why did it fail? Governments just didn t have sufficient resources to enforce regs Black markets and smuggling flourished Coincided with rapid technological advances Ordinary folks decided they had enough (American and French Revolutions) It didn t work very well.

4 Adam Smith and the Classicals 1776 Free trade superior Gold is just money Resources are a nations true wealth David Hume s Price-Specie-Flow mechanism

5 Adam Smith - The Theory of Comparative Advantage Definition: a comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party.

6 The Geometry of Comparative Advantage There are two countries, A and B, who can each produce only food and textiles. Initially they do not trade with one another.

7 The Geometry of Comparative Advantage Textiles A production possibilities curve shows the various amounts of food or textiles that each country can make. The production possibilities of country A are such that if they concentrated 100% of their resources into the production of textiles, they could produce 180 million yards of textiles. 180 If country A chose to concentrate 100% of their resources into the production of food, they could produce as much as 300 million pounds of food. 300 Food Country A can produce any combination of food and textiles between these two points.

8 The Geometry of Comparative Advantage Textiles 180 We can find the equation describing the PPF fairly easily. If Food production is zero then Textiles are 180. That must be the intercept of our PPF. Our equation will look like this: Textile = 180 b*food b is the slope of the PPF and it tells us how many units of Textile must be given up to produce each unit of Food. Since 300 Food costs 180 Textile each unit of Food costs 0.6 units of Textile so b must equal PPF A Equation: Textile = *Food Food

9 The Geometry of Comparative Advantage Textiles As a practical matter, the citizens of country A must choose a point along their production possibilities curve; initially they choose 200 million pounds of food, and 60 million yards of textiles Food

10 The Geometry of Comparative Advantage Textiles The production possibilities of country B are such that if they concentrated 100% of their resources into the production of textiles, they could produce 240 million yards of textiles If country B chose to concentrate 100% of their resources into the production of food, they could produce as much as 900 million pounds of food ,200 Food

11 The Geometry of Comparative Advantage Textiles Find the equation describing the PPF for country B. PPF B Equation: Textiles = *Food Country B pays 0.27 Textiles for each unit of Food they produce ,200 Food

12 The Geometry of Comparative Advantage Textiles As a practical matter, the citizens of country B must choose a point along their production possibilities curve; initially they choose 600 million pounds of food, and 80 million yards of textiles ,200 Food

13 The Geometry of Comparative Advantage Textiles Country A enjoys a comparative advantage in textiles because they have to give up food at a lower rate than B when making textiles. Put another way, country B enjoys a comparative advantage in food because they have to give up textiles at a lower rate than A when making more food. Geometrically, a comparative advantage exists because the slopes of the production possibilities differ Food

14 The Geometry of Comparative Advantage Textiles If the countries specialize according to their comparative advantage, then country A should make textiles and trade for food, while country B should grow food and trade for textiles Food

15 The Geometry of Comparative Advantage Textiles Before trade, if both countries made only textiles, the combined production would be 420 million yards of textiles = Before trade, if both countries made only food, the combined production would be 1,200 million pounds of food = ,200 Food

16 The Geometry of Comparative Advantage Textiles The combined production possibilities curve of country A and B without trade are shown in the green line ,200 Food

17 The Geometry of Comparative Advantage Textiles Before trade, the combined production is 800 million lbs of food and 140 million yards of textiles ,200 Food

18 The Geometry of Comparative Advantage Textiles 420 County B can produce food at a lower opportunity cost, so let B produce the first 900 million pounds of food. Country A can produce textiles at a lower opportunity cost, so let them produce the first 180 million yards of textiles ,200 Food

19 The Geometry of Comparative Advantage Textiles 420 The combined production possibilities curve with trade is composed of the original curves joined as shown ,200 Food

20 The Geometry of Comparative Advantage Textiles 420 The gains from trade are shown by the increase in consumption available an extra 100 million pounds of food and 40 million yards of textiles are now available in excess of the pre-trade consumption ,200 Food

21 Why Free Trade is Best Comparative advantage and the gains from trade. Consumer sovereignty and the Invisible Hand Efficient allocation of resources

22 Price-Specie-Flow Mechanism Suppose Great Britain exported more to France than France imported from Great Britain. This cannot persist under a gold standard. Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France.

23 Say s Law Supply creates its own demand In order to produce output, firms must purchase factors of production. Factor payments are in the form of wages, rents and interest. Factor payments to households provide the income needed to purchase goods that have been produced by firms.

24 The Circular-Flow Diagram Market for Goods and Services Revenue Goods and services sold Goods and services bought Spending Firms Households Wage, rent, and profit Inputs for production Labor, land and capital Income Market for Factors of Production

25 Classical Output Determination The Classical model is a supply-side model. It focuses on the determination of output supplied assuming that demand will simply follow according to Say. Output supply depends on the supply and demand for the factors of production and the technology available to combine factors to produce output. These are all embodied in the Production Function.

26 The Production Function Factors of production Capital (K) Labor (N) Others (raw materials, land, energy) Productivity of factors depends on technology and management

27 The Production Function The production function Y = AF(K, N) Parameter A is total factor productivity (the effectiveness with which capital and labor are used)

28 The Production Function Application: The production function of the U.S. economy and U.S. productivity growth Cobb-Douglas production function works well for U.S. economy: Y = A K 0.3 N 0.7 Data for U.S. economy

29 The Production Function of the United States,

30 The Production Function Productivity growth calculated using production function Productivity moves sharply from year to year Productivity grew slowly in the 1980s and the first half of the 1990s, but increased since the mid-1990s

31 The Production Function The shape of the production function Two main properties of production functions Slopes upward: more of any input produces more output Slope becomes flatter as input rises: diminishing marginal product as input increases

32 The Production Function The shape of the production function Marginal product of labor, MPN = ΔY/ΔN Equal to slope of production function graph (Y vs. N) MPN always positive Diminishing marginal productivity of labor

33 The production function relating output and labor

34 The Production Function We can relate the production function to any of the factor inputs and derive the demand for that input in exactly the same way. For capital it becomes: Two main properties of production functions MPK is positive But is declining over the relevant range.

35 The Production Function Relating Output and Capital

36 The Production Function The shape of the production function Marginal product of capital, MPK = ΔY/ΔK Equal to slope of production function graph (Y vs. K) MPK always positive Diminishing marginal productivity of capital MPK declines as K rises

37 The marginal product of capital

38 The Production Function Supply shocks Supply shock = productivity shock = a change in an economy s production function Supply shocks affect the amount of output that can be produced for a given amount of inputs Shocks may be positive (increasing output) or negative (decreasing output) Examples: weather, inventions and innovations, government regulations, oil prices

39 The Production Function Supply shocks Supply shocks shift graph of production function Negative (adverse) shock: Usually slope of production function decreases at each level of input (for example, if shock causes parameter A to decline) Positive shock: Usually slope of production function increases at each level of output (for example, if parameter A increases)

40 An adverse supply shock that lowers the MPN

41 The Demand for Labor How much labor do firms want to use? Assumptions Hold capital stock fixed short-run analysis Workers are all alike Labor market is competitive Firms maximize profits

42 The Demand for Labor The demand for any factor of production is based on the profit maximizing behavior of firms. Profit function Total revenues minus total costs

43 The Demand for Labor All markets are assumed to be PCM. All participants are price takers. Firms maximize profit by varying the quantity of factors hired.

44 The Demand for Labor The profit maximizing relation is just the FOC for maximizing the profit function

45 The Demand for Labor How much labor do firms want to use? Analysis at the margin: costs and benefits of hiring one extra worker If real wage (w/p) > marginal product of labor (MPN), profit rises if number of workers declines If w/p < MPN, profit rises if number of workers increases Firms profits are highest when w/p = MPN

46 The Demand for Labor The marginal product of labor and the labor demand curve Labor demand curve shows relationship between the real wage rate and the quantity of labor demanded It is the same as the MPN curve, since w/p = MPN at equilibrium So the labor demand curve is downward sloping; firms want to hire less labor, the higher the real wage

47 The Demand for Labor Y Y 1 Y 0 A B F 0 (N) N 0 N 1 N

48 The Demand for Labor w/p w 0 /P A w 1 /P B MPN N 0 N 1 N

49 The Demand for Labor w A W 0 W 1 B N d (P 0 ) N 0 N 1 N

50 The Demand for Labor Factors that shift the labor demand curve Note: A change in the nominal wage causes a movement along the labor demand curve, not a shift of the curve Supply shocks: Beneficial supply shock raises MPN, so shifts labor demand curve to the right; opposite for adverse supply shock Size of capital stock: Higher capital stock raises MPN, so shifts labor demand curve to the right; opposite for lower capital stock Changes in the price of output

51 The Demand for Labor Aggregate labor demand Aggregate labor demand is the sum of all firms labor demand Same factors (supply shocks, size of capital stock) that shift firms labor demand cause shifts in aggregate labor demand

52 The Supply of Labor Supply of labor is determined by individuals Aggregate supply of labor is the sum of individuals labor supply Labor supply of individuals depends on laborleisure choice

53 The Supply of Labor The income-leisure trade-off Utility depends on consumption and leisure Need to compare costs and benefits of working another day Costs: Loss of leisure time Benefits: More consumption, since income is higher If benefits of working another day exceed costs, work another day Keep working additional days until benefits equal costs

54 The Supply of Labor Characteristics of the utility function: increasing in C decreasing in N declining marginal utility of C increasing marginal disutility of N

55 The Supply of Labor Maximize utility subject to your budget (income) constraint FOC

56 The Supply of Labor The second FOC is the important one for labor supply the Greek letter λ is the shadow price of income and equals 1/P. So the above FOC can be rewritten as workers are willing to suffer the loss of utility associated with work effort as long as they are compensated with a real wage that exceeds their marginal disutility

57 The Supply of Labor w/p MU N B W 1 A W 0 N 0 N 1 N

58 The Supply of Labor W N s (P 0 ) B W 1 A W 0 N 0 N 1 N

59 The Supply of Labor Real wages and labor supply An increase in the real wage has offsetting income and substitution effects Substitution effect: Higher real wage encourages work, since reward for working is higher Income effect: Higher real wage increases income for same amount of work time, so person can afford more leisure, so will supply less labor Can lead to backward-bending labor supply curve for an individual.

60 The Supply of Labor Aggregate labor supply Aggregate labor supply rises when current real wage rises Some people work more hours Other people enter labor force Result: Aggregate labor supply curve slopes upward

61 Labor Market Equilibrium Classical model of the labor market real wage adjusts quickly Determines full-employment level of employment and market-clearing real wage Problem with classical model: can t study unemployment

62 Labor Market Equilibrium W N s (P 0 ) A W 0 N d (P 0 ) N 0 N

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