The Economy at Full Employment Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. Immigration is an important part of the U.S. economy today. P R E P A R E D B Y FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU

A P P L Y I N G T H E C O N C E P T S 1 Although we normally think that increased immigration will reduce wages, what factors could cause it to raise wages? Immigration Affects Both the Demand and the Supply for Labor How can changes in the supply of labor affect real wages? The Black Death and Living Standards in Old England Do differences in taxes and government benefits explain why Europeans work substantially fewer hours per year than do U.S. workers or the Japanese? A Nobel Laureate Explains Why Europeans Work Less Than U.S. Workers or the Japanese 2 3

WAGE AND PRICE FLEXIBILITY AND FULL EMPLOYMENT 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.

THE PRODUCTION FUNCTION 7.2 THE PRODUCTION FUNCTION production function 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)

THE PRODUCTION FUNCTION 7.2 THE PRODUCTION FUNCTION FIGURE 7.1 The Relationship between Labor and Output with Fixed Capital With capital fixed, output increases with labor input, but at a decreasing rate.

THE PRODUCTION FUNCTION 7.2 THE PRODUCTION FUNCTION P R I N C I P L E O F D I M I N I S H I N G R E T U R N S 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.

THE PRODUCTION FUNCTION 7.2 THE PRODUCTION FUNCTION FIGURE 7.2 An Increase in the Stock of Capital When the capital increases from K1 to K2, the production function shifts up. At any level of labor input, the level of output increases.

WAGES AND THE DEMAND AND SUPPLY FOR LABOR 7.3  FIGURE 7.3 The Demand and Supply of Labor 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.

WAGES AND THE DEMAND AND SUPPLY FOR LABOR 7.3 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.

WAGES AND THE DEMAND AND SUPPLY FOR LABOR 7.3 Changes in Demand and Supply M A R G I N A L P R I N C I P L E 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. FIGURE 7.4 Shifts in Labor Demand and Supply Shifts to demand and supply will change both real wages and employment.

A P P L I C A T I O N 1 IMMIGRATION AFFECTS BOTH THE DEMAND AND THE SUPPLY FOR LABOR APPLYING THE CONCEPTS #1: Although we normally think that increased immigration will reduce wages, what factors could cause it to raise wages? A recent study by Gianmarco Ottaviano of the University of Bologna and Giovanni Peri of the University of California, Davis, estimated that during the 1990s immigration, on average, increased the average wage of U.S.-born workers by 2.7 percent. They took into account that increased immigration led to increases in the supply of labor and additional investment, and as a result, both the demand and the supply for labor shifted, with the shift in demand slightly outpacing the shift in supply. When they looked more closely at wages, they found the wages of high-school dropouts fell, while wages of workers with at least a high-school education increased. The reason for this difference was that high-school dropouts compete most directly with the new immigrants, whereas those workers with more education do not.

A P P L I C A T I O N 2 THE BLACK DEATH AND LIVING STANDARDS IN OLD ENGLAND APPLYING THE CONCEPTS #2: How can changes in the supply of labor affect real wages? According to the research of Professor Gregory Clark of the University of California, 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, wages were considerably higher—nearly 75 percent higher in 1450, for instance, than they were 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—that 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, although less total output. 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.

LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT 7.4 LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT FIGURE 7.5 Determining Full-Employment Output 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.

USING THE FULL-EMPLOYMENT MODEL 7.5 USING THE FULL-EMPLOYMENT MODEL Taxes and Potential Output FIGURE 7.6 How Employment Taxes Affect Labor Demand and Supply 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.

A P P L I C A T I O N 3 A NOBEL LAUREATE EXPLAINS WHY EUROPEANS WORK LESS THAN AMERICANS OR THE JAPANESE APPLYING THE CONCEPTS #3: Do differences in taxes and government benefits explain why Europeans work substantially fewer hours per year than do U.S. workers or the Japanese? On average today, the French (and other Europeans) work one-third fewer hours than do U.S. workers. In the early 1970s Europeans actually worked slightly more hours than did U.S. workers. What explains this dramatic turnaround in the space of just 20 years? Nobel-laureate Edward Prescott of the Federal Reserve Bank of Minneapolis and Arizona State University attributes the decreases in hours of work in Europe to: Increases in the tax burden that ultimately falls on workers. Government spending and transfers play a larger role in European economies than in the United States. Prescott notes that as the burdens of Social Security and Medicare increase, the United States may be tempted to increase its tax rates to European levels. What will happen if we do not make changes in the underlying programs and allow tax rates to increase?

7.5 Real Business Cycle Theory USING THE FULL-EMPLOYMENT MODEL real business cycle theory The economic theory that emphasizes how shocks to technology can cause fluctuations in economic activity. FIGURE 7.7 How an Adverse Technology Shock Affects Labor Demand and Supply Economics: Principles and Tools O’Sullivan, Sheffrin, Perez 6/e. 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.

7.6 International Comparisons DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT International Comparisons Economics: Principles and Tools O’Sullivan, Sheffrin, Perez 6/e.

output = consumption + investment + government purchases 7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT Crowding Out in a Closed Economy crowding out The reduction in investment (or other component of GDP) caused by an increase in government spending. P R I N C I P L E O F O P P O RT U N I T Y C O S T Economics: Principles and Tools O’Sullivan, Sheffrin, Perez 6/e. 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 Crowding Out in a Closed Economy DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT Crowding Out in a Closed Economy FIGURE 7.8 U.S. Consumption and Government Spending During World War II Increased government spending crowds out consumption by consumers. The vertical bar highlights the time period during which crowding out occurred. Economics: Principles and Tools O’Sullivan, Sheffrin, Perez 6/e.

7.6 Crowding Out in a Closed Economy DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT Crowding Out in a Closed Economy FIGURE 7.9 U.S. Investment and Government Spending During World War II Increased government spending also crowds out private investment spending. The vertical bar highlights the time period during which crowding out occurred. Economics: Principles and Tools O’Sullivan, Sheffrin, Perez 6/e.

7.6 Crowding Out in an Open Economy Crowding in DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT Crowding Out in an Open Economy open economy An economy with international trade. Y = C + I + G + NX Economics: Principles and Tools O’Sullivan, Sheffrin, Perez 6/e. Increased government spending need not crowd out either consumption or investment. It could lead to reduced exports and increased imports. Crowding in crowding in The increase of investment (or other component of GDP) caused by a decrease in government spending.

K E Y T E R M S 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