The Production Function and building blocks of the Flexible-Price Model

The Production Function:

The rule that tells us how greatly the economy can produce given its available productive resources. In the Cobb-Douglas type of the production function we learned, potential output (Y*) is defined by (i) the size of the labor force (L), (ii) the economy's capital stock (K), (iii) the efficiency of labor (E), and (iv) a parameter α that tells us how fast returns to investment diminish. The production function notify us that potential output is:
The supposition in this chapter that wages and prices are flexible was commonly made by the so-called “classical” economists who wrote back before World War II. Therefore this assumption is as well called the classical assumption. The classical supposition guarantees that markets work—that prices adjust rapidly to eliminate gaps between the quantities demanded and the quantities supplied. Therefore no businesses find their inventories of unsold goods piling up. Therefore there is full employment- everyone who wants a job (at the market-clearing level of wages) can get a job, and each business that wants to hire a worker (at the market-clearing level of wages) can hire a worker. And for the reason that there is full employment, actual output is equivalent to potential output: there is no gap among the economy’s productive potential and the level of output the economy does produce.

The classical assumption made in this section signifies that this section is devoted to full-employment flexible-price macroeconomics.

The flexible-price assumption it isn’t always a good one. Experience has given that a market economy doesn’t always work well and doesn’t always produce full employment. Consequently while the flexible-price assumption is key-element in this section, preliminary in Section III we will drop it and make instead the “Keynesian” assumption that wages as well as prices are sticky.

If the classical flexible-price assumption isn’t always a good one to make, why make it? It is a good assumption if wages as well as prices are relatively flexible and have enough time to adjust in order to balance supply and demand. The classical assumption makes simpler the analysis of several issues, making how the macro economy works easier to grasp. Generally it is better to start with the simpler cases before looking at more complicated ones. Furthermore the way an economy if the flexible-price assumption held provides a helpful baseline against which to assess economic performance. However, we should remember that this section presents only one model of the economy- the classical model. The Keynesian sticky-price model act very differently in a number of ways.

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