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National Income:
Where It Comes From and
Where It Goes

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Chapter Three

The circular flow of income

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Chapter Three

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 The circular flow of income - examples
• Examples of factor payments, consumption, government
purchases?
• What is government deficit and where should it be placed in
the chart?

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Chapter Three

Assumptions:
• Buyers and sellers pursue their own self-interest
• Market competition and market balance with flexible
wages/prices (and total employment)
• Origin of classical theory: Adam Smith (1776)
• Wealth of Nations
invisible hand”
• The economy is controlled by the “invisible hand
– market forces instead of government
Copyright 1997 Dead Economists Society

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Chapter Three

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 Key questions:
1. Firms: what determines their level of production (and
thus, the level of national income).

2. The markets for the factors of production: how do they

distribute this income to households ?

3. Households: how much of this income do households

consume and how much do they save ?

4. Demand arising from investment and government

purchases.

5. Finally: how are the demand and supply for goods and
services brought into balance?
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Chapter Three

An economy’s output of goods and services (GDP) depends on:

(1) quantity of inputs

(2) ability to turn inputs into output

• Inputs used to produce goods and services.

• The two most important factors of production are capital (K) and
labor (L).
• Assumption: these factors are given fixed values: K and L
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Chapter Three

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 1. The available production technology determines how much
output is produced from given amounts of capital (K) and
labor (L).
2. The production function represents the transformation of
inputs into outputs.
3. A key assumption: the production function has constant
returns to scale (i.e. if we increase inputs by z, output will also
increase by z) Assume that capital and labor
4. The production function is: are fixed,
Then Y (output) is fixed, too.
Y = F (K,L)

Income is our given inputs

some function of
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Chapter Three

• Total output of an economy equals total income.

• The factors of production and the production function
together determine the total output of goods and services,
• They also determine national income.

• The distribution of national income is determined by factor

prices.
• Factor prices are the amounts paid to the factors of production
• the wages workers earn and
• the rent the owners of capital collect.
• Because we have assumed a fixed amount of capital and
labor, the factor supply curve is a vertical line.
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Chapter Three

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 Market for factors of production
The price paid to any factor of production depends on the supply and demand
for that factor’s services.
Assumed: supply is fixed, the supply curve is vertical.
The demand curve is downward sloping. The intersection of supply and demand
determines the equilibrium factor price.

Factor Factor supply

Price
(Wage or
Rental
Rate)

Equilibrium
Factor demand
factor price
Quantity of Factor
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Chapter Three

Profit maximising behaviour of the firms

The firm needs two factors of production, capital and labor.
The firm’s technology: the production function Y = F (K, L)
The firm sells its output at price P, hires workers at a wage W, and rents capital
at a rate R.
• The goal of the firm is to maximize profit:
• Profit is revenue minus cost.
• Revenue equals P • Y.
• Costs include both labor and capital costs.
• Labor costs = W • L ( wage • amount of labor)
• Capital costs = R • K (rental price of capital • amount of capital)
• Profit = Revenue - Labor Costs - Capital Costs
=P•Y - W•L - R•K
• How does profit depend on the factors of production? Y = F (K,L)
Profit = P • F (K,L) - W • L - R • K
Profit depends on P, W, R, L, and K.
The competitive firm
• takes the product price and factor prices as given
• and chooses the amounts of labor and capital that maximize profit. 10
Chapter Three

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 The firm will hire labor and rent capital
in the quantities that maximize profit.
What are those maximizing quantities?

The marginal product of labor (MPL) is the extra amount of output the firm
gets from one extra unit of labor, holding the amount of capital fixed and is
expressed using the production function:
MPL = F(K,L + 1) - F(K,L).
Most production functions have the property of diminishing marginal product:
holding the amount of capital fixed, the marginal product of labor decreases as the
amount of labor increases.
Y
The MPL is: F (K, L)
• the change in output when the labor MPL
input is increased by 1 unit. 1
• As the amount of labor increases, the
production function becomes flatter MPL
indicating diminishing marginal
product.
1
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Chapter Three L

• A profit maximizing firm, when deciding whether to hire an additional unit of

labor compares the extra revenue from the increased production that results from
the added labor to the extra cost of higher spending on wages:
∆ Profit = ∆ Revenue - ∆ Cost
• The increase in revenue: = P • MPL; The increase in cost: = W
• Thus, the firm’s demand for labor is determined by P × MPL = W, or MPL =
W/P, where W/P is the real wage
• The firm hires up to the point where the extra revenue = the real wage.

Units of
output • The MPL depends on the amount of labor.
• The MPL curve slopes downward because the MPL
declines as L increases.
Real • This schedule is also the firm’s labor demand curve.
wage
Quantity of labor demanded
MPL, labor demand
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Chapter Three Units of labor, L

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• The firm decides how much capital to rent in the same way it decides how
much labor to hire.
• The MPK is the amount of extra output the firm gets from an extra unit of capital,
holding the amount of labor constant:
MPK = F(K + 1,L) - F(K,L).
• Thus, the marginal product of capital is the difference between the amount of
output produced with K+1 units of capital and that produced with K units of
capital.
• Like labor, capital is subject to diminishing marginal product.
• The increase in profit from renting an additional machine is the extra revenue
from selling the output of that machine minus the machine’s rental price:
∆ Profit = ∆ Revenue - ∆ Cost = (P • MPK) - R
• To maximize profit, the firm continues to rent more capital until the MPK falls to
equal the real rental price, MPK = R/P.
• The real rental price of capital is the rental price measured in units of goods
rather than in dollars.
The firm demands each factor of production until that factor’s marginal product
falls to equal its real factor price.
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Chapter Three

• The income that remains after the firms have paid the factors of production is
the economic profit of the owners of the firms.
• Real economic profit is: Economic Profit = Y - (MPL • L) - (MPK • K)
• or to rearrange: Y = (MPL • L) + (MPK • K) + Economic Profit.
• Total income is divided among the returns to labor, the returns to capital, and
economic profit.
• HOW LARGE IS ECONOMIC PROFIT?
• If the production function has the property of constant returns to scale, then
economic profit is zero.
• This conclusion follows from Euler’s Theorem, which states that if the
production function has constant returns to scale, then
• F(K,L) = (MPK • K) + (MPL • L)
• If each factor of production is paid its marginal product, then the sum of these
factor payments equals total output.
• Constant returns to scale, profit maximization,and competition together imply
that economic profit is zero.
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Chapter Three

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 Recall from Chapter 2, the four
components of GDP:

Y = C + I + G + NX
Investment
Total demand Net exports
is composed spending by
for domestic or net foreign
of businesses and
output (GDP) demand
households
Consumption Government
spending by purchases of goods
households and services
Assumption: closed economy, eliminating the last term net exports NX.
So, the three components of GDP are:
Consumption (C), Investment (I) and Government purchases (G). 15
Chapter Three

C
C = C(Y- T) T)
( Y-
=C
C
depends disposable
on income
consumption Y-T
spending by
households The slope of the consumption function is the MPC.

The marginal propensity to consume (MPC) is the amount by which consumption

changes when disposable income (Y-T) increases by one dollar.
Example: a large value MPC= 0.99 means that for every extra dollar we earn after
tax deductions, we spend $0.99 of it.
MPC measures the sensitivity of the change in C with respect to a change in (Y-T). 16
Chapter Three

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 I = I(r)
Investment depends
spending real interest rate
on
• The quantity of investment depends on the real interest rate (r),
which measures the cost of the funds used to finance investment.
• The nominal interest rate (i) is the interest rate as usually reported; it
is the rate of interest that investors pay to borrow money.
• The real interest rate is the nominal interest rate corrected for the
effects of inflation ( r = i - π, real interest rate = nominal interest
rate – rate of inflation).
• The role of interest rates in the economy: real interest rate is
especially relevant when the overall level of prices is changing.
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Chapter Three

• The investment function relates the quantity

of investment I to the real interest rate r.
• Investment depends on the real interest rate (the
Real cost of borrowing).
interest • The investment function slopes downward:
rate, r when the interest rate rises, fewer investment
projects are profitable.

Investment function, I(r)

Quantity of investment, I
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Chapter Three

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 • We take the level of government spending and taxes as given.
• (here: T = taxes minus transfers, also called: net taxes)
• If government purchases equal taxes minus transfers, then G = T,
and the government has a balanced budget.
• If G > T, then the government is running a budget deficit.
• If G < T, then the government is running a budget surplus.

G=G
T=T

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Chapter Three

The following equations summarize the demand for goods and services:

1) Y = C + I + G Demand for Economy’s Output

2) C = C(Y-T) Consumption Function
3) I = I(r) Real Investment Function
4) G = G Government Purchases
5) T = T Taxes
• The demand for the economy’s output comes from consumption,
investment, and government purchases.
• Consumption depends on disposable income,
• Investment depends on the real interest rate;
• Government purchases and taxes are the exogenous variables set by
fiscal policy makers.
Supply: the output supplied to the economy: Y = F ( K,
L) = Y
Equilibrium: Y = C( Y -
T) + I(r) + G
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Chapter Three

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The role of the real interest rate
Y = C(Y-T) + I(r) + G

• The interest rate (r) is the only variable not already determined in
the equation.
• The interest rate must adjust to ensure that the demand for goods
equals the supply.
• The greater the interest rate,
• the lower the level of investment (I).
• and the lower the demand for goods and services, C + I + G.
• If the interest rate is too high, investment is too low, and the
demand for output falls short of supply.
• If the interest rate is too low, investment is too high, and the
demand exceeds supply.
• At the equilibrium interest rate, the demand for goods and services
equals the supply.
• Real interest rates are defined by the financial markets
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Chapter Three

• The national income accounts identity: Y - C - G = I.

• Y-C-G : the output that remains after household consumption and
government purchases, called national saving or simply, saving (S).
• The national income accounts identity shows that saving =
investment.
• Splitting national saving into two parts: the saving of the private
sector and the saving of the government:
• (Y-T-C) + (T-G) = I
• Private saving: (Y-T-C) = disposable income minus consumption,.
• Public saving: (T-G) = government revenue minus government
spending,.
• National saving is the sum of private and public saving, and is the
supply of loanable funds in financial markets
• Demand for loanable funds: Investment, I (r).
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Chapter Three

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 Equilibrium in the financial markets

• The national income accounts identity:

• Y - C (Y-T) - G = I(r)
• Note that G and T are fixed by policy and Y is fixed by:
the factors of production and the production function:Y - C (Y-T) - G = I(r)
S = I(r)
Real
interest Saving, S
The vertical line represents saving:
rate, r the supply of loanable funds.
The downward-sloping line
Equilibrium
represents investment: the demand
interest
for loanable funds. The intersection
rate
determines the equilibrium interest
rate.

Desired Investment, I(r)

S Investment, Saving, I, S 23
Chapter Three

An Increase in Government Purchases:

• If government purchases increase by ∆G, the immediate impact is to increase
the demand for goods and services by ∆G.
• But total output is fixed by the factors of production,
• The increase ∆G must be met by a decrease in some other category of demand.
• Because disposable Y-T is unchanged, consumption is unchanged.
• The increase ∆G must be met by an equal decrease in investment.
• To induce investment to fall, the interest rate must rise.
Hence, the rise in government purchases causes the interest rate to increase and
investment to decrease.
Thus, government purchases are said to crowd out investment.
A Decrease in Taxes:
• The immediate impact of a tax cut ∆T is to raise disposable income and thus
to raise consumption.
• Disposable income rises by ∆T, and consumption rises by ∆T • MPC.
• The higher the MPC, the greater the impact of the tax cut on consumption.
consumption
Tax cuts crowd out investment and raise the interest rate.
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Chapter Three

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 Real A reduction in saving, possibly the
interest S' Saving, S result of a change in fiscal policy,
rate, r shifts the saving schedule to the left.
The new equilibrium is the point at
which the new saving schedule crosses
the investment schedule.
A reduction in saving lowers the amount
of investment and raises the interest rate.
Desired Investment, I(r)
S Investment, Saving, I, S
Fiscal policy actions are said to crowd out investment.
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Chapter Three

• An increase in the demand

Real for investment goods shifts
interest Saving, S the investment schedule to
rate, r the right.
• At any given interest rate, the
amount of investment is
greater.
B • The equilibrium moves
from A to B.
A • Because the amount of
I2 saving is fixed, the increase
I1 in investment demand raises
the interest rate while
S Investment, Saving, I, S leaving the equilibrium
Now let’s see what happens to the interest amount of investment
unchanged.
rate and saving when saving depends on
the interest rate (upward-sloping
saving (S) curve). 26
Chapter Three

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 S(r)
Real
interest
rate, r

B
A I2
I1
Investment, Saving, I, S
1. When saving is positively related to the interest rate, as
shown by the upward-sloping S(r) curve,
2. a rightward shift in the investment schedule I(r), increases
the interest rate and the amount of investment.
3. The higher interest rate induces people to increase saving,
which in turn allows investment to increase. 27
Chapter Three

Factors of production Nominal interest rate

Production function Real interest rate
Constant returns to scale National saving
Factor prices (saving)
Competition Private saving
Marginal product of labor (MPL) Public saving
Diminishing marginal product Loanable funds
Real wage Crowding out
Marginal product of capital (MPK)
Real rental price of capital
Economic profit vs. accounting profit
Disposable income
Consumption function
Marginal propensity to consume
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Chapter Three

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