The Economy at Full Employment Economics NINTH EDITION Chapter 7 The Economy at Full Employment Prepared by Brock Williams

Learning Objectives 7.1 Identify the key assumption of classical models in macroeconomics. 7.2 Explain the concept of diminishing returns to labor. 7.3 Analyze how shifts in demand and supply affect wages and employment. 7.4 Explain how full employment is determined in a classical model. 7.5 Describe how changes in taxes can affect full employment. 7.6 Explain how countries must divide output across different uses.

7.1 WAGE AND PRICE FLEXIBILITY AND FULL EMPLOYMENT Classical models Economic models that assume wages and prices adjust freely to changes in demand and supply.

7.2 THE PRODUCTION FUNCTION (1 of 4) The relationship between the level of output of a good and the factors of production that are inputs to production. Stock of capital The total of all machines, equipment, and buildings in an entire economy. Labor Human effort, including both physical and mental effort, used to produce goods and services. When there are only two factors of production, capital and labor, the production function is written as follows: Y = F(K,L)

7.2 THE PRODUCTION FUNCTION (2 of 4) With capital fixed, output increases with labor input, but at a decreasing rate.

7.2 THE PRODUCTION FUNCTION (3 of 4) PRINCIPLE OF DIMINISHING RETURNS Suppose output is produced with two or more inputs, and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

7.2 THE PRODUCTION FUNCTION (4 of 4) When the capital increases from K1 to K2, the production function shifts up. At any level of labor input, the level of output increases.

7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR (1 of 3) Together, the demand and supply for labor determine the level of employment and the real wage. Real wage The wage rate paid to employees adjusted for changes in the price level.

7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR (2 of 3) Labor Market Equilibrium Panel C of Figure 7.3 puts the demand and supply curves together. At a wage of $15 per hour, the amount of labor firms want to hire—7,500 workers—will be equal to the number of people who want to work— 7,500 workers. This is the labor market equilibrium: The quantity demanded for labor equals the quantity supplied. Together, the demand and supply curves determine the level of employment in the economy and the level of real wages.

7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR (3 of 3) Changes in Demand and Supply MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost.

APPLICATION 1 THE BLACK DEATH AND LIVING STANDARDS IN OLD ENGLAND APPLYING THE CONCEPTS #1: How can changes in the supply of labor affect real wages? According to the research of Gregory Clark of the UC, Davis, the level of real wages for laborers in England was nearly the same in 1200 as it was in 1800. Yet, during the period from 1350 to 1550, they were higher—nearly 75 percent higher in 1450, for instance, than in 1200. Why were real wages temporarily so high during this period? The simple answer was the bubonic plague—also known as the Black Death Arrived from Asia in 1348 and caused a long decline in total population through the 1450s. With fewer workers, there was less labor supplied to the market. The result was higher real wages. In the era before consistent and rapid technological advance, changes in population was the primary factor controlling living standards. As the economist Thomas Malthus (1766–1834) observed, social maladies such as the Black Death would temporarily raise living standards until higher living standards led to increased population.

7.4 LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT Panel B determines the equilibrium level of employment at L and the real wage rate of W. Full-employment output in Panel A is Y. Full-employment output The level of output that results when the labor market is in equilibrium and the economy is producing at full employment.

7.5 USING THE FULL-EMPLOYMENT MODEL (1 of 2) Taxes and Potential Output In Panel A, a tax burden on labor shifts the labor demand curve to the left and leads to lower wages and reduced employment. In Panel B, the supply curve for labor is vertical, which means that wages fall but employment does not change.

7.5 USING THE FULL-EMPLOYMENT MODEL (2 of 2) Real Business Cycle Theory Real business cycle theory The economic theory that emphasizes how shocks to technology can cause fluctuations in economic activity. An adverse shock to technology will decrease the demand for labor. As a result, both real wages and employment fall as the market equilibrium moves from a to b.

APPLICATION 2 DO EUROPEAN SOCCER STARS CHANGE CLUBS TO REDUCE THEIR TAXES? APPLYING THE CONCEPTS #2: What evidence is there that taxes on high paid soccer stars in Europe affect their location decisions among countries? In 2009, a Portuguese soccer star moved from Manchester United in the United Kingdom to Real Madrid in Spain. Many speculated that the reason he moved was to avoid a top United Kingdom tax rate of 50 percent in favor of a flat 24 percent rate (with no deductions) created to entice foreigners to locate in Spain. While this is an interesting anecdote, is there any other evidence that the very top earners will move to countries with lower tax rates? In an interesting study, economists Henrik Jacobsen Kleven, Camille Landais,and Emmanuel Saez used changes in the market for international soccer stars to test for the effects of tax rates. Prior to 1995, the top European soccer clubs had limits on the number of foreign players on any one team. The European Court of Justice, however, ruled that these limits violated the treaty of the European community. The economists found that prior to 1995, taxes on high earners did not have much effect on mobility of soccer stars, but after 1995, top tax rates did matter. This type of evidence suggests that countries may not only be in competition for top athletes, but also for other highly paid individuals—from tennis players to corporate executives.

APPLICATION 3 GOVERNMENT POLICIES AND SAVINGS RATES APPLYING THE CONCEPTS #3: What explains Singapore’s high savings rate? In the United States, private consumption plus government consumption totals 84 percent of GDP. In Singapore, total consumption from the private sector and the government is only 47 percent. The World Bank estimates Singapore’s gross savings rate at 48 percent, compared to Hong Kong, which is only 27 percent. Singapore requires that all workers save a very high percentage of their income in government accounts called the Central Provident Fund. Singapore does not have a U.S. style Social Security system and the citizens rely on this system to finance their retirement years.

7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (1 of 5) International Comparisons

7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (2 of 5) Crowding Out in a Closed Economy Crowding out The reduction in investment (or other component of GDP) caused by an increase in government spending. PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it. Closed economy An economy without international trade. output = consumption + investment + government purchases Y = C + I + G

7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (3 of 5) Crowding Out in a Closed Economy Increased government spending crowds out consumption by consumers. The vertical bar highlights the time period during which crowding out occurred. SOURCE: U.S. Department of Commerce.

7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (4 of 5) Crowding Out in a Closed Economy Increased government spending also crowds out private investment spending. The vertical bar highlights the time period during which crowding out occurred. SOURCE: U.S. Department of Commerce.

7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (5 of 5) Crowding Out in an Open Economy Open economy An economy with international trade. Y = C + I + G + NX Increased government spending need not crowd out either consumption or investment. It could lead to reduced exports and increased imports. Crowding in The increase of investment (or other component of GDP) caused by a decrease in government spending.

KEY TERMS Classical models Closed economy Crowding in Crowding out Full-employment output Labor Open economy Production function Real business cycle theory Real wage Stock of capital