Download Lecture 9

L11200 Introduction to Macroeconomics 2009/10
Lecture 9:
Markets, Prices, Supply and Demand II
Reading: Barro Ch.6
11 February 2010
Introduction
• Last time:
– Introduced fluctuations topic and foundations of
macroeconomic model.
– Households as producers, consumers, labour
suppliers, capital owners
• Today
– Build on budget constraint by developing
production decision
Last time: Budget Constraint
• Derived budget constraint in real terms
C  (1/ P)  B  K   / P  ( w / P) L  i  ( B / P  K )
nominal consumption + nominal saving = nominal income
(price per unit of consumption x number of units consumed) + change in value of
bonds + new spending on capital = profit from the household business + wages
earned supplying labour to the household business or others + rent earned leasing
capital to the household business or others
Decisions
• Each period the household has to decide:
– How much to produce
– From income earned: how much to consume /
save / invest
• Households do not have to decide:
– how many hours to work: assume fixed
– How much capital to use: assume all capital is
either used in family firm or leased to others
• Today: how much to produce
Profit Maximisation
• Households use capital and labour to make
output, which earns profit:
 / P  A F ( K d , Ld )  (w / P) Ld  ( R / P)  K d
real profit = output – real wage payments – real rental payments
• Households choose K and L to maximise profit.
– (w/P) and (R/P) are fixed for the firm (perfectly
competitive price takers)
Labour Market
• We know (from micro) that firms hire labour
up to the point where MPL = real wage
– MPL falls as more labour it added to production.
– Wage rate is constant
– So firm continues to hire workers until MPL = real
wage: at this point marginal profit = 0
– So at w/P firm will hire Ld workers.
Labour Market
• Labour supply is fixed
– Each household (one-person business) supplies a
fixed quantity of labour per week e.g. 37.5 hrs
– So supply is perfectly inelastic
– The market clears at (w/P)*
– Any change in labour demand (due to changes in
labour productivity) simply raises or lowers the
market-clearing wage
Capital Market
• Households have to decide how much capital
to utilise
– As with labour, they can hire their own capital or
hire other households’ capital
– Hired capital is paid a rent (R/P) per unit
– MPK is falling as more capital hired
– So decision to utilise capital identical to the
decision to utilise labour
Capital Supply
• Again, analogous to labour supply
– Households have an accumulated value of capital,
depending on their past investment decisions.
– All capital is leased to the market in every period:
supply is perfectly inelastic
– So position of demand curve determines price
(rental cost) charged on the market
Market Interest Rate
• Equilibrium price of capital (R/P*) also
determines equilibrium interest rate i*
– Households can choose to invest in capital or
bonds
– Capital gives a net returen of R/P - δ
– If i*>R/P*, investment in capital would fall, capital
holding would reduce so MPK would rise
– vice versa, until i*=MPK* - δ
Profit in Equilibrium
• We now know how much labour and capital
households will hire. In equilibrium
w / P  MPL
• So profit:
• Now:
R / P  MPK
 / P  A F ( K d , Ld )  (w / P) Ld  ( R / P)  K d
 / P  A F ( K , L)  MPL L  MPK  K
Profit is Zero
• Profit in equilibrium
– A cost of a unit of labour or capital is its MP
– The return to a unit of labour or capital is its MP
 / P  A F ( K , L)  MPL L  MPK  K
• So profit is zero: all of the value of inputs is
transferred to owners in rent payments
Explaining Profit
• This is a perfectly competitive market
– So no abnormal profit is made
• Households do earn income!
– They hire out their own labour to either their own
firm or another – so they earn the wage
– They similarly hire out their own capital, to
themselves or another – so they earn rent
– So household income isn’t zero, but ‘profit’ is.
Summary
• Explained the production decision
– Households maximise profit by equating the MP
of labour and capital with the MC
– This determines equilibrium wages, rents and
incomes to the household
• Next time: consume / save / invest decision
– Plus whether to save in bonds or invest in capital