Chapter 2: Classical Macroeconomics: Output and Employment Macroeconomics originated in 1930s after the great depression in 1929. The problems of great depression added urgency to the study of macroeconomic questions. The book containing the theory, “The General Theory of Employment, Interest and Money” by J M Keynes published in 1936. J M keynes termed “Classicals” to refer all the economists who had written macroeconomic issues before 1936. They are; Adam Smith Wealth of nations 1776 David Ricardo Principles of Political Economy 1817 John Stauart Mill Principles of Political Economy 1848 A Marshall Principles of Economics 1920 A C Pigou Principles of Economics 1933.

Classical Macroeconomics: Equilibrium Output and Employment Classicals and Neoclassicals differ on Microeconomic issues However, they are same on the macroeconomic issues Classical economists emphasized the importance of real factors in determining the wealth of nations They believe on the free market mechanism concepts Money plays the role of facilitating transactions as the medium of exchange They also mistrusted the role of government Stressed the role of individual self interest in solving macroeconomic issues.

Classical Theory of Employment and Output - Outline The Production Function The Demand for Labor The Supply of Labor Labor Market Equilibrium

The Production Function The production function summarizes the relationship between total output and total input assuming a given technology. Y = F(K, N) (1) Parameters; y = total output K = stock of capital N = quantity of labour

The Demand for Labor How much labor do firms want to use? Firm owners are the purchasers of labour (demand for labour) Assumptions Hold capital stock fixed—short-run analysis Workers are all alike Labor market is competitive Firms maximize profits

The Demand for Labor The marginal product of labor and labor demand The firm owner will employ the labour till the point where the marginal cost of producing a single output = marginal revenue received from its sale.

Demand for labour MC = marginal labour cost (labour is the only input) MC = w/MPN Where w = wage and MPN = number of units produced by additional units of labour. With the condition of profit maximization as MC = P; P = W/MPN Or W/P = MPN Or W = MPN.P (MRPN) So, the firm owner will hire up to the point where revenue obtained from additional output produced by one more worker (MPN.P) is equal to the money wage paid to the worker. Copyright © Dorling Kindersley India Pvt. Ltd.

The Demand for Labor How much labor do firms want to use? Analysis at the margin: costs and benefits of hiring one extra worker If real wage (w)  marginal product of labor (MPN), profit rises if number of workers declines If w  MPN, profit rises if number of workers increases Firms’ profits are highest when w = MPN Note: w = (W/P)

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Summary

The Demand for Labor Labor demand curve shows relationship between the real wage rate and the quantity of labor demanded It is the same as the MPN curve, since W/P = MPN at equilibrium So the labor demand curve is downward sloping; firms want to hire less labor, the higher the real wage

The Demand for Labor Factors that shift the labor demand curve Note: A change in the wage causes a movement along the labor demand curve, not a shift of the curve Supply shocks: Beneficial supply shock raises MPN, so shifts labor demand curve to the right; opposite for adverse supply shock Size of capital stock: Higher capital stock raises MPN, so shifts labor demand curve to the right; opposite for lower capital stock

Aggregate labor demand The Demand for Labor Aggregate labor demand Aggregate labor demand is the sum of all firms’ labor demand Same factors (supply shocks, size of capital stock) that shift firms’ labor demand cause shifts in aggregate labor demand

Figure 3.6 The effect of a beneficial supply shock on labor demand

Summary

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The Supply of Labor Supply of labor is determined by individuals Aggregate supply of labor is the sum of individuals’ labor supply Labor supply of individuals depends on labor-leisure choice Which in turn the income-leisure trade-off Utility depends on consumption and leisure Need to compare costs and benefits of working another day Costs: Loss of leisure time Benefits: More consumption, since income is higher If benefits of working another day exceed costs, work another day Keep working additional days until benefits equal costs

Horizontal axis represents the leisure per day (24 hr. max) Vertical axis represents the real income (W/P) x (Number of hours worked). U1 U2 U3 are the indifference curves and shows the combination of income and leisure that the individual get equal satisfaction. The slope of the indifference curve gives the rate at which individual is willing to trade off leisure for income. Copyright © Dorling Kindersley India Pvt. Ltd.

All the points on U3 yields greater satisfaction than U2 than U1. Labour Supply The increase in income that the individual gains to be just well off after giving up an unit of leisure. The cost of choosing each hour of leisure is the real wage, as the individual is choosing not to work for each hour of leisure. All the points on U3 yields greater satisfaction than U2 than U1. Starting with 24 hours of leisure, the individual can trade off leisure for income at the rate equal to hourly real wage. Hence, the slope of the budget line is the real wage. Higher is the real wage, steeper is the budget line. A rise is the wage rate, goods become cheaper and leisure become costlier as each individual buys more goods than before. Copyright © Dorling Kindersley India Pvt. Ltd.

The Supply of Labor Real wages and labor supply The labor supply curve Increase in the current real wage should raise quantity of labor supplied  Labor supply curve relates quantity of labor supplied to real wage Real wage increases from 2 to 3 to 4, labour hour increases from 6 to 8 to 9. Labor supply curve slopes upward because higher wage encourages people to work more

The Supply of Labor An increase in the real wage has offsetting income and substitution effects Substitution effect: Higher real wage encourages work, since reward for working is higher Income effect: Higher real wage increases income for same amount of work time, so person can afford more leisure, so will supply less labor

The Supply of Labor The substitution effect and the income effect together: a long-term increase in the real wage The reward to working is greater: a substitution effect toward more work But with higher wage, a person doesn’t need to work as much: an income effect toward less work The longer the high wage is expected to last, the stronger the income effect; thus labor supply will increase by less or decrease by more than for a temporary reduction in the real wage

The Supply of Labor Empirical evidence on real wages and labor supply Overall result: Labor supply increases with a temporary rise in the real wage Labor supply falls with a permanent increase in the real wage.

Figure 3.4 The labor supply curve of an individual worker

Factors that shift the labor supply curve The Supply of Labor Factors that shift the labor supply curve Wealth: Higher wealth reduces labor supply (shifts labor supply curve to the left, as in Fig. 3.4) Expected future real wage: Higher expected future real wage is like an increase in wealth, so reduces labor supply (shifts labor supply curve to the left).

Figure 3.5 The effect on labor supply of an increase in wealth

Aggregate labor supply The Supply of Labor Aggregate labor supply Aggregate labor supply rises when current real wage rises Some people work more hours Other people enter labor force Result: Aggregate labor supply curve slopes upward

Aggregate labor supply Factors increasing labor supply The Supply of Labor Aggregate labor supply Factors increasing labor supply Decrease in wealth Decrease in expected future real wage Increase in working-age population (higher birth rate, immigration) Increase in labor force participation (increased female labor participation, elimination of mandatory retirement)

Summary

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Equilibrium Output and Employment: In the classical model the level of output and employment is determined by real forces. Monetary factors have no role to play in determining the level of output and employment. If price increases, the demand for labour curve will shift to right and creates gap between demand and supply and create pressures the wage to increase. So, wage will increase till the W/P is same as earlier to remove the gap between supply and demand. Copyright © Dorling Kindersley India Pvt. Ltd.

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Aggregate Supply Function: When the price increases from P1 to P2 to P3, the wage increases from W1 to W2 to W3, such that W1/P1 = W2/P2 = W3/P3. Hence, relating P and Y, the aggregate supply function is vertical. Whatever is the price, the output is not changed. Copyright © Dorling Kindersley India Pvt. Ltd.

Figure 3.10 Labor market equilibrium

Labor Market Equilibrium Classical model of the labor market—real wage adjusts quickly Determines full-employment level of employment and market-clearing real wage Problem with classical model: can’t study unemployment

Labor Market Equilibrium Full-employment output Full-employment output = potential output = level of output when labor market is in equilibrium affected by changes in full employment level or production function (example: supply shock, Figure below)

Figure 3.11 Effects of a temporary adverse supply shock on the labor market Sources: Producer price index for fuels and related products and power from research.stlouisfed.org/fred2/series/PPIENG; GDP deflator from research.stlouisfed.org/fred2/GDPDEF. Data were scaled so that the relative price of energy equals 100 in year 2000.

Unemployment Why there are always unemployed people? Frictional unemployment Search activity of firms and workers due to heterogeneity Matching process takes time Structural unemployment Chronically unemployed: workers who are unemployed a large part of the time Structural unemployment: the long-term and chronic unemployment that exists even when the economy is not in a recession One cause: Lack of skills prevents some workers from finding long-term employment Another cause: Reallocation of workers out of shrinking industries or depressed regions; matching takes a long time

Cyclical Unemployment: Unemployment is related to Business Cycle. Seasonal Unemployment: when people are unemployed in certain time of the year due to nature of the work. Voluntary Unemployment: when a person is unemployed due to his/her choice. Copyright © Dorling Kindersley India Pvt. Ltd.

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