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Lecture 4 Signal Processing

This lecture discusses the determination and distribution of National Income (NI), focusing on the roles of firms and households in the economy. It covers the factors affecting production, demand for goods and services, and market equilibrium, emphasizing the cyclical flow of income and expenditures. Key concepts include the production function, factor prices, and the relationship between consumption, investment, and government spending in a closed economy.

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8 views8 pages

Lecture 4 Signal Processing

This lecture discusses the determination and distribution of National Income (NI), focusing on the roles of firms and households in the economy. It covers the factors affecting production, demand for goods and services, and market equilibrium, emphasizing the cyclical flow of income and expenditures. Key concepts include the production function, factor prices, and the relationship between consumption, investment, and government spending in a closed economy.

Uploaded by

es22btech11012
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Lecture 4

National Income: Where it


comes and where it goes
This lecture will cover the following questions,

What determines the total production of goods and services?


How is NI distributed among factors of production?
What determines the demand for goods and services?
What brings equilibrium in the market?

There are two main actors involved:

Firms: producers basically


Households: provide labor essentially

There are two markets:

Market for labour


Market for goods and services

The firm pays "factor payment", in this case, wage, to the household,
which will be its income.
Using said income, they will buy products from the firm, "consumption",
which will be the revenue for the firm.
Its like a cycle, money from firm to household back to firm.
But the household won't spend its entire income, It will save some of
it, "savings", in the bank.
The bank will use that money to invest, which goes into the market for
goods and services, and gets lent back to firms.
Out of the household's income, some if it goes to the government as
taxes.
Government will use the tax earnings to spend money to buy resources,
which is from the market for goods and services.
The government wont spend all its tax income, it will also put some into
the banks for savings, called "public savings".
Based on these factors and the cycle present here, we will model a
simple economic system, as shown below.

Factors Affecting Production


1. Factors of Production
1 Capital (K)
2 Labor (L)

These are our two key factors of production in our model.


Both these factors are assumed to be fixed at this moment.
We also assume that both are fully employed

2. Production Function
Y = f(K, L)

Y is the supply, for eg, the total amount of bread available at this
moment.
It is the technological relation between the output and the capital and
labor.
We assume that there is a "constant returns to scale"

zY = f(zK, zL)

Factors Affecting
Distribution
1. Factor Prices
Wage (W)
Rent (R)

Wage is determined by the demand and supply of labor, more the supply,
less the price, and vice versa. We will assume the relation to be linear
of the form,

wage = c1 - c2*(qty of labour)

where c1 and c2 are some constants.

Two Extreme Types of Markets

Monopoly - onyl one company making the product and they can set the
price of product and wage. In a monopoly prices can go up and wages
will go down. Pressure falls on the people.

Competitive - Many companies making the product, so prices and wage


are not determined by companies but by the market itself. When
markets are competitive, prices go down and wages go up. Pressure
falls on the company.

We will be assuming the market to be competitive

The goal of any competitive firm is to maximize profits.


Profit = Revenue - Cost
Profit = Y*P - W*L - R*K
= P*f(K,L) - W*L - R*K

Here, P is the price of the product.


Now, in a competitive market, the firm can only control L and K.
So they need to select an optimal value of L and K to maximize profit

2. Marginal Productivity of Labor


Basically, labor has diminishing returns, increasing labor doesn't have
a linear relationship with increasing output. Marginal productivity of
labor is a measure of this, basically how much can the next employee
contribute relative to the current amount of labor.

MP of L (MPL) = f(K,L+1) - f(K,L)

Now, we will check the change in profit,

del(P) = del(Revenue) - del(Cost)


= P*MPL - W

If del(P) is greater than zero, we will employ the person.


We will continue to employ until del(P) is zero. Then,

P*MPL = W
MPL = W/P

In a similar way, we can define Marginal Productivity of Capital (MPK)


as,

MPK = R/P

For equilibrium to be maintained in our model, we will assume,

R = MPK*P (In future we will write it as MPK only and the multiplication with
P is implied)
W = MPL*P (Same nomenclature as above)

Therefore,

Economic Profit = Y - (MPL*L) - (MPK*K)

(Note that for simplicity sake, I (this is what sir did, not me) have
written Y * P as Y only and the multiplication with P is implied, this
confused the fuck outta me for the entire goddamn class btw cuz for some
reason sir used P once and then never fucking again.)

What Determines Demand of


Goods and Services
We will assume a closed economy and ignore exports and imports
We also assume that the demand is equal to the supply (supply = price of
products produced = Y = f(K,L))

There are 3 main factors affecting demand,

1 National Consumption
2 Investment
3 Government Spending

1. National Consumption (C):


It is a function of disposable income of the people.

Total Income of All Households = Y

How is the Income of All Households Equal to the Total Value of


Products?

So, the Y here representing the income of all households is the same
Y representing the total price of products. Initially I thought the
total income of all households would be different from the total
value of products, but, if you think about it, it makes sense that
they're the same.
Basically, we assume that the firm sells all their product. So, the
firm earns Y in total. Now, the firm has to pay wages, which goes to
the household as income. They also have to pay rent on their
capital, and the capital is nothing but a product produced by a
different firm. So whatever is spent on rent goes back to firms,
which will then become either wages for households or profits for
the firm. Now, who does the profit from the firm go to? The
household of the person who owns the firm. Basically, all the money
earnt by firms eventually ends up in households. Thus, Y = total
income of households = value of all products produced by firms.

Amount Spent for Taxes = T

C = f(Y-T)
= a + b(Y-T)

where "a" would represent the minimum amount needed for people to
survive in a time period.

2. Investment
It is a function of Interest Rate (r)
We will assume investment rate and interest rate are inversely related
of the form

I = c1 - c2*r

3. Government Expenditure
It is a function of tax, in fact it should be equal to tax for
equilibrium.

If G > T, then government has overspent and is in a deficit.

We assume T is fixed, and so G will also be fixed in our model as we


will assume G = T

So, finally, we get,


Supply = Y = C + I + G = Demand
f(K,L) = C(Y-T) + I(r) + G

How is Investment Part of the Demand?

Even though investment isn't directly buying a "product" supplied by


the firm, you can think of it as buying a part of the firm itself,
which you can consider to be a product supplied by the firm. At
least that's how I got my head around it.

The left side is the supply, and the right side is demand
The only thing left in our model that can actually vary is r, the
interest rate. So for supply to equal demand, the interest rate is what
varies.

Interest rate is determined by the supply of loan and the demand of


loan.

Now,

Y = C + I + G
I = Y - C - G
I = Savings

Now, Savings are divided into two parts

Private Savings = Y-T-C


Public Savings = T-G

Now,

Savings = I(r)
Y - C(Y-T) - G = I(r)

We see that I(r) is fixed as all the factors on the left side
determining the national savings are fixed.
The interest rate will settle down at an equilibrium value to ensure
that Savings = Investment.

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