MACROECONOMICS (CH. 3, 8, 9)
Macroeconomics 11th Edition By N. Gregory Mankiw
CHAPTER 3
The most important macroeconomic variable is gross domestic product (GDP). As we have
seen, GDP measures both a nation’s total output of goods and services and its total income.
To appreciate the significance of GDP, one need only take a quick look at international data:
Compared with their poorer counterparts, nations with a high level of GDP per person have
everything from better childhood nutrition to more computers per household. A large GDP
does not ensure that all of a nation’s citizens are happy, but it may be the best recipe for
happiness that macroeconomists have to offer.
This chapter addresses four groups of questions about the sources and uses of a nation’s
GDP:
How much do the firms in the economy produce? What determines a nation’s total income?
Who gets the income from production? How much goes to compensate workers, and how
much goes to compensate owners of capital?
Who buys the output of the economy? How much do households purchase for consumption,
how much do households and firms purchase for investment, and how much does the
government buy for public purposes?
What equilibrates the demand for and supply of goods and services? What ensures that
desired spending on consumption, investment, and government purchases equals the level
of production?
To answer these questions, we must examine how the various parts of the economy interact.
A good place to start is the circular flow diagram. In Chapter 2 we traced the circular flow of
dollars in a hypothetical economy that used one input (labor) to produce one output (bread).
Figure 3-1 more accurately reflects how real economies function. It shows the linkages
among the economic actors — households, firms, and the government — and how dollars
flow among them through the various markets in the economy.
FIGURE 3-1
The Circular Flow of Dollars Through the Economy This figure is a more realistic version of
the circular flow diagram in Chapter 2. Each yellow box represents an economic actor —
households, firms, and the government. Each blue box represents a type of market — the
markets for goods and services, the markets for the factors of production, and financial
markets. The green arrows show the flow of dollars among the economic actors through the
three types of markets.
Let’s look at the flow of dollars from the viewpoints of these actors. Households receive
income and use it to pay taxes to the government, to consume goods and services, and to
save through financial markets. Firms receive revenue from the sale of goods and services
, MACROECONOMICS (CH. 3, 8, 9)
Macroeconomics 11th Edition By N. Gregory Mankiw
and use it to pay for the factors of production. Households and firms borrow in financial
markets to buy investment goods, such as houses and factories. The government receives
revenue from taxes and uses it to pay for government purchases. Any excess of tax revenue
over government spending is called public saving, which can be either positive (a budget
surplus) or negative (a budget deficit).
In this chapter, we develop a basic classical model to explain the economic interactions
depicted in Figure 3-1. We begin with firms and look at what determines their level of
production (and thus the level of national income). Then we examine how the markets for the
factors of production distribute this income to households. Next, we consider how much of
this income households consume and how much they save. In addition to discussing the
demand for goods and services arising from the consumption of households, we discuss the
demand arising from investment and government purchases. Finally, we come full circle and
examine how the demand for goods and services (the sum of consumption, investment, and
government purchases) and the supply of goods and services (the level of production) are
brought into balance.
3-1 What Determines the Total Production of Goods and Services?
An economy’s output of goods and services — its GDP — depends on (1) its quantity of
inputs, called the factors of production, and (2) its ability to turn inputs into output, as
represented by the production function.
The Factors of Production
Factors of production are the inputs used to produce goods and services. The two most
important factors of production are capital and labor. Capital is the set of tools that workers
use: the construction worker’s crane, the accountant’s calculator, and this author’s personal
computer. Labor is the time people spend working. We use the symbol K to denote the
amount of capital and the symbol L to denote the amount of labor.
In this chapter, we take the economy’s factors of production as given. In other words, we
assume that the economy has fixed amounts of capital and labor. We write
K=𝐾
L= 𝐿
The overbar means that each variable is fixed at some level. In Chapters 8 and 9, we
examine what happens when the factors of production change over time, as they do in the
real world. For now, to keep the analysis simple, we assume fixed amounts of capital and
labor.
We also assume here that the factors of production are fully utilized. That is, no resources
are wasted. Again, in the real world, part of the labor force is unemployed, and some capital
lies idle. In Chapter 7, we examine the reasons for unemployment, but for now we assume
that capital and labor are fully employed.
, MACROECONOMICS (CH. 3, 8, 9)
Macroeconomics 11th Edition By N. Gregory Mankiw
The Production Function
The available production technology determines how much output is produced from given
amounts of capital and labor. Economists use a production function to express this
relationship. Letting Y denote the amount of output, we write the production function as
This equation states that output is a function of the amounts of capital and labor.
The production function reflects the available technology for turning capital and labor into
output. If someone invents a better way to produce a good, the result is more output from the
same amounts of capital and labor. Thus, technological change alters the production
function.
Many production functions have a property called constant returns to scale. A production
function has constant returns to scale if an increase of an equal percentage in all factors of
production causes an increase in output of the same percentage. For example, if the
production function has constant returns to scale, then increasing both capital and labor by
10 percent results in 10 percent more output. Mathematically, a production function has
constant returns to scale if
for any positive number z. This equation says that if we multiply both the amount of capital
and the amount of labor by some number z, output is also multiplied by z. The assumption of
constant returns to scale will have an important implication for how the income from
production is distributed.
As an example of a production function, consider production at a bakery. The kitchen and its
equipment are the bakery’s capital, the workers hired to make the bread are its labor, and
the loaves of bread are its output. The bakery’s production function shows that the number
of loaves produced depends on the amount of equipment and the number of workers. If the
production function has constant returns to scale, then doubling the amount of equipment
and the number of workers doubles the amount of bread produced.
The Supply of Goods and Services
Together, the factors of production and the production function determine the quantity of
goods and services supplied, which in turn equals the economy’s output. To express this
mathematically, we write
Y= F(𝐾, 𝐿)
=𝑌
In this chapter, because we assume that technology and the supplies of capital and labor are
fixed, output is also fixed (at a level denoted as
, MACROECONOMICS (CH. 3, 8, 9)
Macroeconomics 11th Edition By N. Gregory Mankiw
). When we discuss economic growth in Chapters 8, 9, and 10, we will examine how
increases in capital and labor and advances in technology lead to growth in the economy’s
output.
3-2 How Is National Income Distributed to the Factors of Production?
As we discussed in Chapter 2, the total output of an economy equals its total income.
Because the factors of production and the production function together determine the total
output of goods and services, they also determine national income. The circular flow
diagram in Figure 3-1 shows that this national income flows from firms to households
through the markets for the factors of production.
In this section, we continue to develop our model of the economy by discussing how these
factor markets work. Economists have long studied factor markets to understand the
distribution of income. For example, Karl Marx, the noted nineteenth-century economist,
spent much time trying to explain the incomes of capital and labor. The political philosophy
of communism was in part based on Marx’s now-discredited theory.
Here we examine the modern theory of the distribution of national income among the factors
of production. It relies on the classical (eighteenth-century) idea that prices adjust to balance
supply and demand, applied here to the markets for the factors of production, and the more
recent (nineteenth-century) idea that the demand for each factor of production depends on
the marginal productivity of that factor. This theory, called the neoclassical theory of
distribution, is accepted by most economists today as the best place to begin understanding
how the economy’s income is distributed from firms to households.
Factor Prices
The distribution of national income is determined by factor prices. Factor prices are the
amounts paid to each unit of the factors of production. In an economy where the two factors
of production are capital and labor, the two factor prices are the rent the owners of capital
collect and the wage workers earn.
As Figure 3-2 shows, the price each factor of production receives for its services is
determined by the supply and demand for that factor. Because we have assumed that the
economy’s factors of production are fixed, the factor supply curve in Figure 3-2 is vertical.
Regardless of the factor price, the quantity of the factor supplied to the market is the same.
The intersection of the downward-sloping factor demand curve and the vertical supply curve
determines the equilibrium factor price.
FIGURE 3-2
