Question

Explain how output (GDP) is determined according to the classical model and how it is distributed among the factors of production according to the neoclassical model

Answer 1

In classical model the equilibrium GDP is equal yobthe potential orvthe full employment level and the AS curve is vertical at this full emoloyment level. Thus according to the classical model, the GDP is determined from the supply side and there is no relevance and importance given to the demand side for determining the Equilibrium level of GDP or income in the economy. This is because the classical model has foundation in a few assumptions that make demand irrelevant altogether in determining the Equilibrium GDP. These are:

1) Says law: which says that supply creates its own demand and the sellers are able to sell all that they produce and there is no dearth of demand. Thus changes in demand will have no influence on production decision and patterns.

2) the prices are flexible such that any changes in the money supply leads to an equivalent change in the price level thus maintaining the Equilibrium. This is money neutrality phenomenon.

3) the equilibrium GDP is determined by the full employment level. That is there is full employment of the resources and no extra shifts or no factor of production is left unused and thus equilibrium GDP will be at the potential level or the full employment level.

The distribution of income or GDP is determined by the Marginal productivity rule of the neoclassical model. This imply that the factors are paid according and equal to the Marginal value that they produce. Marginal value of their produce is equivalent to the price of output time the Marginal product of that factor. Thus the factor of production share equals GDP/value of Marginal product of the total factor employed. For the Cobb Douglas or a typical neoclassical production function determining the GDP of an economy such as; Y=K^aL^b

The share of capital in total GDP Y = a = Y/ pMPK

Where p is the price of output produced and MPL is the Marginal product of capital. Thus pMPk is the value of the total product produced by capital.