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Econ 100b

Created 4/30/1996
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Lecture Five

Production and Distribution in Equilibrium
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

January 29, 1996


The Idea of Equilibrium
Circular Flow Again
Factors of Production
Competitive Equilibrium
A Few Words on Income Distribution Over Time


The Idea of "Equilibrium"

Begin with the idea of "equilibrium"; everyone has expectations about the state of the economy--now and in the future. We consider how a model--toy--economy would work if everyone's expectations were satisfied and were correct; and if there were no pressures pushing economic magnitudes either up or down.

Under this "equilibrium" assumption--which is often very far from true, and which we will relax later on the course (not very much later on the course: starting next week, in fact)--we are going, today, to start looking at four questions:


This week has two other purposes:
The first is to lay out a whole bunch of definitions, and introduce you to a vocabulary of terms and concepts--or perhaps buzzwords--that we will be using throughout the course.
The second is to build a toy paper simulation of the economy--a "model" is the term that economists use--that we will use throughout the rest of the semester, largely as a benchmark against which to measure the performance of the economy once the "equilibrium" assumption is relaxed...


Circular Flow Again

The starting point is the same circular flow diagram we saw last week:


Or, at least, a close relative of that diagram. We have suppressed the foreign sector--assumed that net exports or imports (and not flows of capital out or in) are zero. We have added a little oval box called "financial markets" to better track the money flows. And we have added a box called "government". Government raises money from households (and from businesses too) by taxing them. It also raises money by borrowing--the government deficit is the amount of net borrowing done through financial markets by the government so that it can raise money to spend.

Money flows into financial markets through private saving (which includes "private" saving done by businesses on behalf of their stockholders when they do not pay all of their profits out in dividends). Money flows out of financial markets to the government (when the government borrows) or to businesses (when businesses borrow or issue stock).

From this circular flow diagram we get a bunch of accounting identities:









that will be very useful in constructing this week's toy model


Factors of Production

Now let's drop the circular flow for a second and look just at what goes on within firms, withint the process of production.

Let's think of a hypothetical economy in which there are just two kinds of resources used in production--capital (think of it as something like machine tools or assembly lines; large pieces of shaped metal out of which come final products), and the labor of those who tend the machines. Let's write capital K for the capital stock, and L for the inputs of labor-power into the production process. And let's suppose that the economy's "production function" is more-or-less as follows:

Why do we call it a "production function"? One reason is to make it difficult for political scientists (and others) to understand what economists are talking about. Seriously--establishing linguistic barriers that confuse your adversaries is one very important way to win arguments in this culture of ours, and you can often tell the good guys from the bad guys by who attempts to make their concepts understandable--to talk the language of the other--and who makes no concessions but attempts to bury the adversary under a blizzard of strange rhetoric.

A second reason is that it is appropriate to call it a "function". You see, a function is a machine: you feed something--or some things--into it, turn the crank, and something else comes out. Here we feed the function the economy's resources of labor and capital (and also, implicitly, the level of productive "technology"), and what comes out is the level of GDP that the economy can produce.


A few more words about constant returns to scale...

We are going to use the particular production function:



because it is simple to write down, allows us to do a number of experiments and consider a number of cases quickly, is in brief a powerful shorthand.

But always remember that the map is not the territory...


Competitive Equilibrium

Now, what will the earnings of workers (and the rate of return earned by owners of capital) be in this simple toy model?

We make the further assumption of competitive equilibrium: that firms compete against each other like ruthless dogs to attract the most labor and capital and sell the most products; that workers (and investors) similarly erase their collective monopoly power over distribution through ruthless competition. All entities in this economy take prices as given. They do not consider that their actions have any effect on the prices at which they can buy or sell.

Consider the typical firm. It can use the economy-wide technology to hire labor and acquire capital goods (financed by borrowing from banks, issuing bonds, and issuing stocks), and use them to produce output. The firm wants to maximize its profits, which are the difference between its revenues and its costs:



Now suppose the firm--that has already decided to use a fixed number, K, in units of capital and L units of labor--wonders whether it should hire another worker. The extra output that would be produced is called the marginal product of labor. The extra revenue that would be produced is equal to the price of output, P, times this marginal product of labor. And the extra cost incurred is the wage, W, of an additional worker.

So the rule for a typical firm is:




Add up all of the typical "representative" firms in the economy--figuring out each of their demands for labor, depending on the real wage and their capital stocks--we get a big economy-wide supply-and-demand curve:



A similar argument--symmetric, in fact--gets you the conclusion that the "rent" a firm pays for the use of a unit of capital is, in equilibrium, simply the economy-wide marginal product of capital...

"Wait a minute," you may say. "I understand how a firm's demand for labor is determined by itsparticular marginal product, but where does this "economy-wide" stuff come in?

Think of it this way: suppose firms all set their capital stocks, and line up to bid for workers one at a time. First worker goes to the firm that has the highest valuation...
Eventually, the last worker is hired--at a wage that leaves the last firm nearly indifferent between employing him or her and leaving him or her out in the cold, and at a wage that leaves the worker nearly indifferent between being in or out of the labor force.

But in this toy model economy all firms are identical, right? So all must be using the same capital/labor ratio, right? So the marginal product of the worker in the marginal firm is determined not by that firm's peculiarities (because their are none) but by the "technology" of relative scarcities and productivies.

This is a very powerful idea: that you can read the distribution of income off of technological capabilities and relative factor scarcities.
A higher capital/labor ratio is going to boost workers' incomes...
A higher labor/capital ratio is going to boost investors' profits...


A Few Words on Income Distribution Over Time

A few words on the evolving distribution of income over time in the U.S. (with perhaps a deeper look back into history, if time remains...






>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/

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