ECON 3312 Lecture 02 - University of Texas at Arlington Lecture_02.pdf• Efficient allocation of resources Price-Specie-Flow Mechanism • Suppose Great Britain exported more to France

Intermediate Macroeconomics

ECON 3312

Lecture 2

William J. Crowder Ph.D.

Mercantilism

• Economic Nationalism• Beggar-thy-neighbor policies• Bullionism• Regulate everything!

– Trade restrictions– Monopoly rights– Labor restrictions– Immigration laws– Protect Domestic Producers

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.

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

• Definition: a comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party.

Adam Smith - The Theory of Comparative Advantage

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.


300Food

Textiles

180

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.

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.

Country A can produce any combination of food and textiles between these two points.


300Food

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 0.6.

PPFA Equation: Textile = 180 – 0.6*Food


300Food

Textiles

180

60

200

As a practical matter, the citizens of country A must choose a point along their production possibilities curve; initially theychoose 200 million pounds of food, and 60 million yards of textiles.


1,200300Food

Textiles

180

900

240

60

200

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.


1,200300Food

Textiles

180

900

240

60

200

Find the equation describing the PPF for country B.

PPFB Equation: Textiles = 240 – 0.27*Food

Country B pays 0.27 Textiles for each unit of Food they produce.


1,200300Food

Textiles

180

900

240

60

200 600

As a practical matter, the citizens of country B must choose a point along their production possibilities curve; initially theychoose 600 million pounds of food, and 80 million yards of textiles.

80


300Food

Textiles

180

900

240

60

200 600

80

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.


300Food

Textiles

180

900

240

60

200 600

80

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.


1,200300Food

Textiles

420

180

900

240

60

200 600

80

Before trade, if both countries made only textiles, the combinedproduction would be 420 million yards of textiles = 240 + 180.

Before trade, if both countries made only food, the combined production would be 1,200 million pounds of

food = 900 + 300.


1,200300Food

Textiles

420

180

900

240

60

200 600

80

The combined production possibilities curve of country A and B without trade are shown in the green line.


1,200300Food

Textiles

420

800

180

900

240

60

200 600

80

Before trade, the combined production is 800 million lbs of food and 140 million yards of textiles.

140


1,200300Food

Textiles

420

800

140

900

240

60

200 600

80

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.

180


1,200300Food

Textiles

420

800

140180

900

240

60

200 600

80

The combined production possibilities curve with trade is composed of the original curves joined as shown.


1,200300Food

Textiles

420

800

140180

900

240

60

200 600

80

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.

Why Free Trade is Best

• Comparative advantage and the gains from trade.

• Consumer sovereignty and the Invisible Hand

• Efficient allocation of resources

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.

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.

Market for Goods andServices

Revenue

Market for Factors ofProduction

Firms Households

Wage, rent,and profit Income

SpendingGoods andservices sold

Goods andservices bought

Labor, landand capital

Inputs forproduction

The Circular-Flow Diagram

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.

The Production Function

• Factors of production– Capital (K)– Labor (N)– Others (raw materials, land, energy)– Productivity of factors depends on technology

and management


• The production functionY = AF(K, N)

Parameter A is “total factor productivity”(the effectiveness with which capital and labor are used)


• 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 K0.3 N0.7

– Data for U.S. economy—

The Production Function of the United States, 1979-2007


• 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

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


• 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

The production function relating output and labor

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.

The Production Function Relating Output and Capital


• 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

The marginal product of capital


• 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


• 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)

An adverse supply shock that lowers the MPN

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


• The demand for any factor of production is based on the profit maximizing behavior of firms.

• Profit function – Total revenues minus total costs


• All markets are assumed to be PCM.• All participants are price takers.• Firms maximize profit by varying the

quantity of factors hired.


• The profit maximizing relation is just the FOC for maximizing the profit function


• 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


• 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


N

Y

F0(N)

N0

Y0A

B

N1

Y1

w/P

N

MPN

N0

w0/PA

Bw1/P

N1


w

N

Nd (P0)

N0

W0

A

BW1

N1



• 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


• 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

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 labor-

leisure choice

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

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

The Supply of Labor – Maximize utility subject to your budget

(income) constraint

– FOC

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

N

w/PMUN

N0

W0

A

BW1

N1

The Supply of Labor

N

WNs(P0)

N0

W0

A

BW1

N1

The Supply of Labor

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.

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

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

N

W

Nd(P0)

Ns(P0)

N0

W0

A

Labor Market Equilibrium

Documents

ECON 3312 Lecture 02 - University of Texas at Arlington Lecture_02.pdf• Efficient allocation of resources Price-Specie-Flow Mechanism • Suppose Great Britain exported more to France