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:
- What determines the level of real GDP?
- What determines the broad distribution of income--how is
income distributed among workers (including owners of "human
capital"), and owners of other forms of wealth?
- What determines how GDP is allocated to various uses--to
consumption, investment here at home, government purchases, and
net investment abroad (which is the same thing as "net exports")?
- What makes this "equilibrium" level, distribution, and
allocation of production stable--or at least not unstable, or
self-consistent?
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.
- You need capital to produce anything
- Diminishing returns to labor, holding capital fixed
- Diminishing returns to capital, holding labor fixed
- Constant returns to scale
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...
ley.edu
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