© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 22 Classical Economics: The Economy at Full Employment

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Classical Economics The study of how the economy operates at or near full employment is known as classical economics.The study of how the economy operates at or near full employment is known as classical economics. Classical economics is based on the principle that prices adjust in a natural way to bring the markets for goods and labor into equilibrium.Classical economics is based on the principle that prices adjust in a natural way to bring the markets for goods and labor into equilibrium. Supply-siders are a school of economists who emphasize the role of taxation for influencing economic activity.Supply-siders are a school of economists who emphasize the role of taxation for influencing economic activity.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Classical Economics This flexibility in wages and prices distinguishes the classical model from the Keynesian models.This flexibility in wages and prices distinguishes the classical model from the Keynesian models. In the classical model, wages and prices are assumed to adjust freely and quickly to all changes in demand and supply.In the classical model, wages and prices are assumed to adjust freely and quickly to all changes in demand and supply.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Aggregate Production Function for the Economy The aggregate production function shows how much output is produced from capital and labor.The aggregate production function shows how much output is produced from capital and labor. We assume that there are only two factors of productions: capital and labor.We assume that there are only two factors of productions: capital and labor. The stock of capital is the total of all machines, equipment, and buildings in the entire economy.The stock of capital is the total of all machines, equipment, and buildings in the entire economy. Labor consists of the efforts of all the workers in the economy.Labor consists of the efforts of all the workers in the economy.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Aggregate Production Function for the Economy The aggregate production function is written as follows:The aggregate production function is written as follows: In words, the math says that the output produced depends on the total amount of capital and labor available.In words, the math says that the output produced depends on the total amount of capital and labor available.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Relationship between Labor and Output with Fixed Capital Assuming that the stock of capital is fixed, only variations in the amount of labor can change the level of output in the economy.Assuming that the stock of capital is fixed, only variations in the amount of labor can change the level of output in the economy.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Relationship between Labor and Output with Fixed Capital Because the amount of labor can be changed over a short period, resulting in a corresponding change in output, also within a short time, this diagram is called the short-run production function.Because the amount of labor can be changed over a short period, resulting in a corresponding change in output, also within a short time, this diagram is called the short-run production function.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Relationship between Labor and Output with Fixed Capital As labor inputs are increased from L 1 to L 2, output increases from Y 1 to Y 2.As labor inputs are increased from L 1 to L 2, output increases from Y 1 to Y 2.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Relationship between Labor and Output with Fixed Capital The relationship between output and labor reflects the principle of diminishing returns.The relationship between output and labor reflects the principle of diminishing returns.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Relationship between Labor and Output with Fixed Capital 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.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Output and Labor Output Y (Output) L (Labor Input) As the amount of labor increases (from 3 to 4 units of labor), so does the amount of output produced (by 5 output units, from 10 to 15 output units).As the amount of labor increases (from 3 to 4 units of labor), so does the amount of output produced (by 5 output units, from 10 to 15 output units). Y (Output) L (Labor Input) Y (Output) L (Labor Input) Y (Output) L (Labor Input)

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Output and Labor Output As labor input increases from 4 to 5 labor units, output only increases by 4 output units, from 15 to 19 output units.As labor input increases from 4 to 5 labor units, output only increases by 4 output units, from 15 to 19 output units. Y (Output) L (Labor Input) As output increases, it increases at a diminishing rate.As output increases, it increases at a diminishing rate. Y (Output) L (Labor Input)

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Increase in the Stock of Capital When capital increases from K * to K **, the production function shifts up.When capital increases from K * to K **, the production function shifts up. At any level of labor input, the level of output increases.At any level of labor input, the level of output increases.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand and Supply for Labor Firms hire labor to produce output and make profits.Firms hire labor to produce output and make profits. The amount of labor they will hire depends on the real wage: The wage rate paid to workers adjusted for changes in prices.The amount of labor they will hire depends on the real wage: The wage rate paid to workers adjusted for changes in prices. To understand the demand for labor we use the marginal principle.To understand the demand for labor we use the marginal principle.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand and Supply for Labor Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost; reduce the level of an activity if its marginal cost exceeds its marginal benefit. If possible, pick the level at which the activity’s marginal benefit equals its marginal cost.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Labor The demand for labor is downward-sloping.The demand for labor is downward-sloping. As the real wage falls, firms will hire more labor.As the real wage falls, firms will hire more labor.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Labor The supply of labor is based on the decisions of workers. An increase in the real wage has two effects on the work-leisure trade-off:The supply of labor is based on the decisions of workers. An increase in the real wage has two effects on the work-leisure trade-off: Substitution effect: a higher real wage causes workers to substitute work for leisure.Substitution effect: a higher real wage causes workers to substitute work for leisure. Income effect: a higher real wage rate increases real income, thus workers can afford to have more leisure time.Income effect: a higher real wage rate increases real income, thus workers can afford to have more leisure time.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Labor We assume that the substitution effect dominates over the income effect, therefore, the supply of labor is upward- sloping.We assume that the substitution effect dominates over the income effect, therefore, the supply of labor is upward- sloping.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Labor A higher wage rate will lead to an increase in the quantity of labor supplied.A higher wage rate will lead to an increase in the quantity of labor supplied.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Labor Panel C puts the demand and supply curves together.Panel C puts the demand and supply curves together.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Labor At a wage of $15 per hour, labor market equilibrium is attained: The quantity demanded for labor equals the quantity supplied.At a wage of $15 per hour, labor market equilibrium is attained: The quantity demanded for labor equals the quantity supplied.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Shifts in Demand and Supply An increase in the stock of capital increases the marginal benefit from hiring workers. When this happens, the labor demand curve shifts to the right.An increase in the stock of capital increases the marginal benefit from hiring workers. When this happens, the labor demand curve shifts to the right.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Shifts in Demand and Supply An increase in the supply of labor—from an increase in immigration for example—shifts the supply of labor to the right.An increase in the supply of labor—from an increase in immigration for example—shifts the supply of labor to the right.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Shifts in Demand and Supply Real wages fall and the labor employed increases.Real wages fall and the labor employed increases. Real wages and employment increase.Real wages and employment increase.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Shifts in Demand and Supply As we have seen, the classical model helps us understand why workers would be reluctant to favor increased immigration, and why they would favor increases in the supply of capital.As we have seen, the classical model helps us understand why workers would be reluctant to favor increased immigration, and why they would favor increases in the supply of capital. The increased supply of capital increases labor demand and leads to higher real wages.The increased supply of capital increases labor demand and leads to higher real wages.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Labor Market Equilibrium and Full Employment The demand and supply of labor determine the real wage, W *, and identify the level of employment, L *.The demand and supply of labor determine the real wage, W *, and identify the level of employment, L *. That level of employment is used to determine the level of production, Y *.That level of employment is used to determine the level of production, Y *.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Labor Market Equilibrium and Full Employment Full-employment output is the level of output that results when the labor market is in equilibrium.Full-employment output is the level of output that results when the labor market is in equilibrium. Full-employment output is also known as potential output because a meaningful measure of an economy’s long-run productive potential will need to have the labor market in equilibrium.Full-employment output is also known as potential output because a meaningful measure of an economy’s long-run productive potential will need to have the labor market in equilibrium.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Classical Model in Historical Perspective Although the term “classical model” was first used by John Maynard Keynes, classical economics refers to the body of work developed over time starting with Adam Smith.Although the term “classical model” was first used by John Maynard Keynes, classical economics refers to the body of work developed over time starting with Adam Smith. Classical economics is often associated with Say’s Law: The doctrine that states that supply creates its own demand.Classical economics is often associated with Say’s Law: The doctrine that states that supply creates its own demand.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Keynesian and Classical Debates Keynes argued that there could be situations in which total demand fell short of total production in the economy.Keynes argued that there could be situations in which total demand fell short of total production in the economy. For the classical model to be true, wages and prices need to be fully flexible. If they are not fully flexible, then Keynes’ view is more likely to be true.For the classical model to be true, wages and prices need to be fully flexible. If they are not fully flexible, then Keynes’ view is more likely to be true. Over short periods of time, wages and prices are not fully flexible, thus making the insights of Keynes important.Over short periods of time, wages and prices are not fully flexible, thus making the insights of Keynes important.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Effects of Employment Taxes A tax on labor will make labor more expensive and raise the marginal cost of hiring workers. The demand for labor shifts leftward.A tax on labor will make labor more expensive and raise the marginal cost of hiring workers. The demand for labor shifts leftward.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Effects of Employment Taxes The size of the reduction in output as a result of the tax depends on the slope of the labor supply curve.The size of the reduction in output as a result of the tax depends on the slope of the labor supply curve.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Effects of Employment Taxes The tax reduces wages but has no effect on employment.The tax reduces wages but has no effect on employment. The tax results in lower wages and employment.The tax results in lower wages and employment.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Effects of Employment Taxes To understand the effects of taxes on output, we need information about the slope of the labor supply curve.To understand the effects of taxes on output, we need information about the slope of the labor supply curve.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Effects of Employment Taxes The entire area of taxation and economics is an active branch of economics research.The entire area of taxation and economics is an active branch of economics research. The Laffer curve, which is a relationship between tax rate and tax revenues that illustrates that high tax rates may not always lead to high tax revenues if high tax rates discourage economic activity, is one controversial policy debate about taxation.The Laffer curve, which is a relationship between tax rate and tax revenues that illustrates that high tax rates may not always lead to high tax revenues if high tax rates discourage economic activity, is one controversial policy debate about taxation. Capital gains tax rates remain a very active area of economic research.Capital gains tax rates remain a very active area of economic research.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Business Cycle Theory A school of economic thought, known as the real business cycle theory, emphasizes how shocks to technology can cause fluctuations in economic activity.A school of economic thought, known as the real business cycle theory, emphasizes how shocks to technology can cause fluctuations in economic activity. Changes in technology will usually change the level of full employment or potential output.Changes in technology will usually change the level of full employment or potential output.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Effects of an Adverse Technology Shock An adverse shock to the economy shifts the labor demand curve to the left.An adverse shock to the economy shifts the labor demand curve to the left. An adverse shock leads to lower wages, reduced employment, and reduced output.An adverse shock leads to lower wages, reduced employment, and reduced output.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Division of Output Among Competing Demands In a full-employment economy, total GDP is determined by the supply of factors of production.In a full-employment economy, total GDP is determined by the supply of factors of production. Crowding out is the reduction in consumption, investment, or net exports caused by an increase in government purchases.Crowding out is the reduction in consumption, investment, or net exports caused by an increase in government purchases.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Alternative Uses of GDP for 1998 (percent of total GDP) Consumption ( C ), investment ( I ), and government purchases ( G ) refer to total spending by residents of that country.Consumption ( C ), investment ( I ), and government purchases ( G ) refer to total spending by residents of that country. CIGNX Japan United States France Singapore Germany

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Alternative Uses of GDP for 1998 (percent of total GDP) Net exports (NX) is the difference between exports and imports.Net exports (NX) is the difference between exports and imports. CIGNX Japan United States France Singapore Germany

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Crowding Out in a Closed Economy Increased government spending “crowds out” other demands for GDP.Increased government spending “crowds out” other demands for GDP. PRINCIPLE of Opportunity Cost The opportunity cost of something is what you sacrifice to get it. At full employment, the opportunity cost of increased government spending is some other component of GDP.At full employment, the opportunity cost of increased government spending is some other component of GDP.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Crowding Out in a Closed Economy An economy without international trade is called a closed economy. In this economy, full-employment output is divided among three different demands:An economy without international trade is called a closed economy. In this economy, full-employment output is divided among three different demands: The supply of output (Y) is fixed, therefore, increases in government spending reduce, or crowd out, either consumption or investment, but usually both.The supply of output (Y) is fixed, therefore, increases in government spending reduce, or crowd out, either consumption or investment, but usually both.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Increased Government Spending Crowds Out Consumption

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Increased Government Spending Also Crowds Out Investment

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Crowding Out in an Open Economy In an open economy, an economy with international trade, full-employment output is divided among four uses:In an open economy, an economy with international trade, full-employment output is divided among four uses:

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Crowding In When governments cut spending, and the level of output is fixed, some other type of spending will be crowded in, or increase.When governments cut spending, and the level of output is fixed, some other type of spending will be crowded in, or increase. The nature of changes in government spending will have some effect on the type of spending that is crowded out (or crowded in).The nature of changes in government spending will have some effect on the type of spending that is crowded out (or crowded in).