ECON 282: Chapter 3

Question 1

The Production Function Y=F(K,L)

Answer 1

-Shows how much output (Y) the economy can produce from K units of capital and L units of Labour
-Reflects the economy’s level of technology
-Exhibits constant returns to scale

Question 2

Returns to SCALE:

Answer 2

-Initally, Y1=F(K1, L1)
Scale all inputs by the same factor z:
If constant returns to scale, Y2 = zY1
If increasing returns to scale, Y2 >zY1
If decreasing returns to scale, Y2 < zY1

Question 3

Assumptions

Answer 3

1. Technology is fixed
2. The economy’s supplies of capital and labour are fixed at:
   K bar and L bar

Question 4

The distribution of national income

Answer 4

-determined by factor prices, the prices per unit firms pay for the factors of production
wage = price of L
rental price = price of K

Question 5

Notation: W, R, P, (W/P), (R/P)

Answer 5

W= nominal wage
R = nominal rental rate
P = price of output
W/P = real wage
R/P = real rental rate

Question 6

Demand for labour

Answer 6

-Assumes that markets are competitive, each firm takes W, R, and P as given
-A firm hires each unit of labour if the cost does not exceed the benefit
cost = real wage
benefit = marginal product of labour

Question 6

Marginal Product of Labour

Answer 6

The extra output the firm can produce using an additional unit of labour (holding other inputs fixed)
MPL = F(K,L +1) - F(K,L)

Question 7

Diminishing Marginal Returns

Answer 7

-As one input is increased (holding other inputs constant) its marginal product falls
- If L increases while holding k fixed, machines per worker falls, worker productivity falls

Question 8

Determining the rental rate

Answer 8

-MPL = W/P
- The same logic shows that MPK = R/P
Diminishing returns to capital: MPK falls as K rises
-The MPK cure is the firms demand curve for renting capital
Firms maximise profits by choosing K such that MPK = R/P

Question 9

Neoclassical theory of distribution

Answer 9

-States that each factor input is paid its marginal product

Question 10

How Income is distributed to L and K

Answer 10

Total capital income: W/PxL=MPLxL
Total capital income=R/PxK=MPKxK

Question 11

Cobb-Douglas Production Function

Answer 11

a = capitals share of total income
capital income = MPK x K = aY

Question 12

Explanation for rising inequality

Answer 12

-Technological progress has increased the demand for skilled relative to unskilled workers
-Rise in self-employment rates and a fall in the number of hours worked for low-skill

Question 13

Disposable income

Answer 13

Total income minus total taxes: Y-T

Question 14

Consumption function

Answer 14

C=C(Y-T)

Question 15

Marginal propensity to consume (MPC)

Answer 15

the change in C when disposable income increases by one dollar

Question 16

Investment function

Answer 16

I = I (r)
r = real interest rate (nominal interest rate corrected for inflation)
I depends negatively on r

Question 17

Real Interest Rate

Answer 17

-the cost of borrowing
-the opportunity cost of using one’s funds to finance investment spending

Question 18

Government Spending

Answer 18

-Government spending on goods and services
-G excludes transfer payments (For example, Canada pension plan payments, employment insurance benefits)
-Assume that government spending and total taxes are exogenous
G bar and T bar

Question 19

The market for goods and services equations

Answer 19

Aggregate demand: C(Ybar-Tbar) + I(r) + Gbar
Aggregate Supply: Ybar=F(Kbar, Lbar)
Equilibrium: Ybar= C(Ybar-Tbar) + I(r) + Gbar

Question 20

The loanable funds market

Answer 20

-A simple supply-demand model of the financial system
-demand for funds: investment
-supply of funds: saving
-price of funds: real interest rate

Question 21

The demand for loanable funds

Answer 21

-Comes from investment(firms borrow to finance, consumers to buy house, etc)
-depends negatively on r (r is the “price” of loanable funds (cost of borrowing)

Question 22

Supply of funds: Saving

Answer 22

-The supply of loanable funds comes from saving
-Households use their saving to make bank deposits and purchase bonds. These funds become available to firms to borrow and finance investment spending.
-the government may also contribute to saving if it does not spend all the tax revenue it receives

Question 23

Types of Saving

Answer 23

Private Saving= (Y-T)-C
Public Saving=(T-G)
National Saving=S

Question 24

National Saving

Answer 24

private saving + public saving
(Y-T)-C + T-G
=Y-C-G

Question 25

Budget Surplus

Answer 25

-If T > G
-(T-G)
public saving

Question 26

Budget Deficit

Answer 26

-If T < G, budget deficit
(G-T) and public saving is negative

Question 27

Balanced budget

Answer 27

T=G
public saving=0

Question 28

R

Answer 28

-adjusts to equilibrate the goods market and the loanable funds market simultaneously
-If the loanable funds market is in equilibrium, them Y-C-G=I
Add (C+G) to both sides to get Y=C+I+G

Question 28

Things that shift the loanable funds model

Answer 28

-public saving
-fiscal policy
-private saving

Question 29

Things that shift the investment curve

Answer 29

-some technological innovations
-tax laws that affect investment

Question 30

Saving and the interest rate

Answer 30

-An increase in desired investment
-raises the interest rate
-and raises equilibrium investment and saving