CHAPTER 9 The Economy at Full Employment CHAPTER 9 The Economy at Full Employment Chapter 26 in Economics Michael Parkin ECONOMICS 5e

Slide 9-2 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the relationship between the quantity of labor employed and real GDP Explain what determines the demand for labor and the supply of labor Explain how labor market equilibrium determines employment, the real wage, and potential GDP

Slide 9-3 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain the influences on employment, the real wage rate, and potential GDP of an increase in the population, an increase in capital, and an advance in technology Explain what determines unemployment when the economy is at full employment

Slide 9-4 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the relationship between the quantity of labor employed and real GDP Explain what determines the demand for labor and the supply of labor Explain how labor market equilibrium determines employment, the real wage, and potential GDP

Slide 9-5 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment To produce more output, we must use more inputs. The quantity of capital and the state of technology are fixed. The relationship between leisure time and real GDP is a production possibility frontier.

Slide 9-6 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment The Production Function The production function shows how real GDP varies as the quantity of labor employed varies, other things remaining the same.

Slide 9-7 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment The Production Function (cont.) Because one more hour of labor employed means one less hour of leisure, the production function is like a mirror image of the leisure time-real GDP PPF.

Slide 9-8 Copyright © 2000 Addison Wesley Longman, Inc. Production Possibilities and the Production Function Real GDP (trillions of 1992 dollars per year) a 10 4 PPF Leisure is forgone to produce real GDP 0 Production Possibility Frontier Leisure (billions of hours per year)

Slide 9-9 Copyright © 2000 Addison Wesley Longman, Inc. Production Possibilities and the Production Function Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) a 10 4 An increase in labor hours brings an increase in real GDP Production function

Slide 9-10 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment When we talk about productivity, we usually mean labor productivity. Labor productivity: real GDP per hour of labor Three factors influence labor productivity: Physical capital Human capital Technology

Slide 9-11 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment Labor productivity: Physical capital The more physical capital we use, the greater is our labor productivity, other things remaining the same.

Slide 9-12 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment Labor productivity: Human capital The knowledge and skill that people have obtained from education and on-the -job training. Learning by doing can bring incredible increases in labor productivity.

Slide 9-13 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment Labor productivity: Technology Enormous impact of technology on productivity.

Slide 9-14 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP and Employment Any influence on production that increases labor productivity shifts the production function upward. Real GDP increases at each level of labor hours.

Slide 9-15 Copyright © 2000 Addison Wesley Longman, Inc. PF 1 Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) a 10 Effect of capital accumulation and technological change b 12 PF 0 4 An Increase in Labor Productivity 9 0 An increase in labor productivity 400

Slide 9-16 Copyright © 2000 Addison Wesley Longman, Inc. Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) a b 8.0 PF 96 PF An Increase in Labor Productivity The U.S. production function

Slide 9-17 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the relationship between the quantity of labor employed and real GDP Explain what determines the demand for labor and the supply of labor Explain how labor market equilibrium determines employment, the real wage, and potential GDP

Slide 9-18 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market The labor market determines the quantity of labor hours employed. To see how the labor market works, we must study: The demand for labor The supply of labor Labor market equilibrium

Slide 9-19 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market The quantity of labor demanded is the number of labor hours hired by all firms in the economy. The demand for labor is the relationship between the quantity of labor demanded and the real wage rate.

Slide 9-20 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market The real wage rate is the quantity of goods and services that an hour of labor earns. The money wage rate is the number of dollars that an hour of labor earns. The real wage rate is equal to the money wage rate divided by the price level multiplied by 100.

Slide 9-21 Copyright © 2000 Addison Wesley Longman, Inc. The Demand for Labor Quantity of labor demanded (billions of hours per year) Real wage rate (1992 dollars per hour) a b c

Slide 9-22 Copyright © 2000 Addison Wesley Longman, Inc. The Demand for Labor Marginal product of labor (1992 dollars per hour) Labor (billions of hours per year) MP a b c

Slide 9-23 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market The Marginal Product of Labor The marginal product of labor is the additional real GDP produced by an additional hour of labor when all other influences on production remain the same.

Slide 9-24 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market The Marginal Product of Labor Calculate the marginal product of labor as the change in real GDP divided by the change in the quantity of labor employed.

Slide 9-25 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market Diminishing Marginal Product The marginal product of labor diminishes as the quantity of labor employed increases because all the labor, both old and new, work with the same fixed amount of physical capital and given technology.

Slide 9-26 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market Diminishing Marginal Product As more labor hours are hired, the physical capital is worked more intensely and more breakdowns and bottlenecks arise. Eventually, as more labor hours are hired, workers get in each other’s way and output increases barely at all.

Slide 9-27 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market Diminishing Marginal Product and the Demand for Labor Because marginal product diminishes as the quantity of labor employed increases, the lower the real wage rate, the greater is the quantity of labor that a firm can probably hire.

Slide 9-28 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market Diminishing Marginal Product and the Demand for Labor The marginal product curve is the same as the demand for labor curve. When the firm pays a real wage rate equal to the marginal product of labor, it is maximizing profit.

Slide 9-29 Copyright © 2000 Addison Wesley Longman, Inc. + $3 trillion billion hours + $2 trillion The Marginal Product of Labor and the Demand for Labor Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) Marginal product of labor = $ billion hours PF Marginal product of labor = $20 0 The marginal product and the slope of the production function

Slide 9-30 Copyright © 2000 Addison Wesley Longman, Inc. The Marginal Product of Labor and the Demand for Labor Marginal product of labor (1992 dollars per hour) Labor (billions of hours per year) MP The marginal product curve

Slide 9-31 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market Changes in the Demand for Labor When the marginal product of labor changes, the demand for labor changes and the demand curve for labor shifts. An increase in capital and an advance in technology that increase productivity shifts the production function upward

Slide 9-32 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market The Supply of Labor The quantity of labor supplied is the number of labor hours that all the households in the economy plan to work. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same.

Slide 9-33 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor Real wage rate Quantity of labor supplied (1992 dollars per hour) (billions of dollars per year) a b c

Slide 9-34 Copyright © 2000 Addison Wesley Longman, Inc. LS The Supply of Labor Marginal product of labor (1992 dollars per hour) Labor (billions of hours per year)

Slide 9-35 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor The real wage influences the quantity of labor supplied because what matters to people is not the number of dollars they earn (the money wage rate) but what those dollars will buy.

Slide 9-36 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor The quantity of labor supplied increases as the real wage rate increases for two reasons: Hours per person increase Labor force participation increases

Slide 9-37 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor Hours Per Person In choosing how many hours to work, a household considers the opportunity cost of not working - the real wage rate. The higher the real wage rate, the greater is the household’s income. The higher the household’s income, the more leisure it wants to consume.

Slide 9-38 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor Hours Per Person The rise in the real wage rate has two opposing effects It makes the household want to consume less leisure and to work more. And by increasing the household’s income, it makes the household want to consume more leisure and to work fewer hours.

Slide 9-39 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor Hours Per Person For most households, the higher the real wage rate, the greater is the amount of work that the household chooses to do.

Slide 9-40 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor Labor Force Participation The higher the real wage rate, the more likely it is that a parent will choose to work and so the greater is the labor force participation rate.

Slide 9-41 Copyright © 2000 Addison Wesley Longman, Inc. The Supply of Labor Labor Supply Response A large percentage change in the real wage brings a small percentage change in the quantity of labor supplied.

Slide 9-42 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Describe the relationship between the quantity of labor employed and real GDP Explain what determines the demand for labor and the supply of labor Explain how labor market equilibrium determines employment, the real wage, and potential GDP

Slide 9-43 Copyright © 2000 Addison Wesley Longman, Inc. LD LS The Labor Market and Potential GDP Real wage rate (1992 dollars per hour) Labor (billions of hours per year) Labor market equilibrium 0 The labor market

Slide 9-44 Copyright © 2000 Addison Wesley Longman, Inc. The Labor Market and Potential GDP Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) PF Potential GDP Full Employment Potential GDP

Slide 9-45 Copyright © 2000 Addison Wesley Longman, Inc. Labor Market Equilibrium Long-run aggregate supply curve The relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP.

Slide 9-46 Copyright © 2000 Addison Wesley Longman, Inc. Labor Market Equilibrium Short-run aggregate supply curve The relationship between the quantity of real GDP supplied and the price level when the money wage rate and potential GDP remain constant.

Slide 9-47 Copyright © 2000 Addison Wesley Longman, Inc. The Aggregate Supply Curves Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS Price level rises and the money wage rate rises but the real wage rate is constant SAS As the price level rises, the real wage rate falls so employment and real GDP increase As the price level falls, the real wage rate rises so employment and real GDP decrease

Slide 9-48 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Explain the influences on employment, the real wage rate, and potential GDP of an increase in the population, an increase in capital, and an advance in technology Explain what determines unemployment when the economy is at full employment

Slide 9-49 Copyright © 2000 Addison Wesley Longman, Inc. Changes in Potential GDP Two influences on potential GDP An increase in population An increase in labor productivity

Slide 9-50 Copyright © 2000 Addison Wesley Longman, Inc. Changes in Potential GDP Two influences on potential GDP An increase in population As the population increases and the additional people reach working age, the supply of labor increases. With more labor available,the economy’s production possibilities expand.

Slide 9-51 Copyright © 2000 Addison Wesley Longman, Inc. LD LS 0 An Increase in Population Real wage rate (1992 dollars per hour) Labor (billions of hours per year) Effect of increase in population 0 LS Real wage rate falls Full employment increases The labor market

Slide 9-52 Copyright © 2000 Addison Wesley Longman, Inc. An Increase in Population Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) PF Potential GDP increases Potential GDP

Slide 9-53 Copyright © 2000 Addison Wesley Longman, Inc. Changes in Potential GDP Two influences on potential GDP An increase in population Increases potential GDP and decreases potential GDP per work hour.

Slide 9-54 Copyright © 2000 Addison Wesley Longman, Inc. Changes in Potential GDP Three factors increase labor productivity: 1. An increase in physical capital 2. An increase in human capital 3. An advance in technology

Slide 9-55 Copyright © 2000 Addison Wesley Longman, Inc. Changes in Potential GDP Three factors increase labor productivity: 1. An increase in physical capital Labor productivity increases. The economy’s production possibilities expand. The demand for labor increases. The real wage rate rises and the quantity of labor supplied increases. Equilibrium employment increases.

Slide 9-56 Copyright © 2000 Addison Wesley Longman, Inc. Changes in Potential GDP Three factors increase labor productivity: 2. An increase in human capital Labor productivity increases. The economy’s production possibilities expand. The real wage rate rises and the quantity of labor supplied increases. Equilibrium employment increases.

Slide 9-57 Copyright © 2000 Addison Wesley Longman, Inc. Changes in Potential GDP Three factors increase labor productivity: 3. An advance in technology Labor productivity increases. The economy’s production possibilities expand. The real wage rate rises and the quantity of labor supplied increases. Again, equilibrium employment increases.

Slide 9-58 Copyright © 2000 Addison Wesley Longman, Inc. LD 1 LD 0 Real wage rate (1992 dollars per hour) Labor (billions of hours per year) Increase in capital and advances in technology increase the demand for labor Real wage rate rises Full employment increases LS An Increase in Labor Productivity The labor market

Slide 9-59 Copyright © 2000 Addison Wesley Longman, Inc. PF 1 Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) … shifts the production function upward and increases potential GDP PF 0 2 An Increase in Labor Productivity Potential GDP

Slide 9-60 Copyright © 2000 Addison Wesley Longman, Inc. LS 98 LD 98 LS 84 LD 84 Real wage rate (1992 dollars per hour) Labor (billions of hours per year) The labor market Full Employment in the United States: 1984 and 1998

Slide 9-61 Copyright © 2000 Addison Wesley Longman, Inc. PF 98 PF 84 Real GDP (trillions of 1992 dollars per year) Labor (billions of hours per year) U.S. production function in 1984 and 1998 Full Employment in the United States: 1984 and 1998

Slide 9-62 Copyright © 2000 Addison Wesley Longman, Inc. Learning Objectives Explain the influences on employment, the real wage rate, and potential GDP of an increase in the population, an increase in capital, and an advance in technology Explain what determines unemployment when the economy is at full employment

Slide 9-63 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment Why is there always some unemployment? Two broad reasons: Job search Job Rationing

Slide 9-64 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment Job Search The activity of looking for an acceptable vacant job. Other forces on the amount of job search Demographic change Unemployment compensation Structural change

Slide 9-65 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment Demographic change An increase in the proportion of the population that is of working age brings an increase in the entry into the labor force and an increase in the unemployment rate. Another trend is an increase in the number of households with two paid workers.

Slide 9-66 Copyright © 2000 Addison Wesley Longman, Inc. LD LS Job Search Unemployment Marginal product of labor (1992 dollars per hour) Labor (billions of hours per year) Job search increases, and unemployment is above the natural rate Job search creates unemployment at the natural rate Job search decreases, and unemployment is below the natural rate

Slide 9-67 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment Unemployment Compensation An unemployed person who receives generous unemployment-insurance benefits faces a low opportunity cost of job search. In this situation, search is likely to be prolonged.

Slide 9-68 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment Structural Change The pace and direction of technology. Some industries may die and some regions may suffer while other industries are born and other regions flourish.

Slide 9-69 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment The real wage rate is not the only instrument for rationing jobs. In some industries, the real wage is set above the market equilibrium level. Job rationing is the practice of paying a real wage rate above the equilibrium level and then rationing jobs by some method.

Slide 9-70 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment Two reasons why the real wage rate might be set above the equilibrium level are: Efficiency wage Minimum wage

Slide 9-71 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment Efficiency wage An efficiency wage is a real wage rate that is set above the full-employment equilibrium wage rate that balances the costs and benefits of this higher wage rate to maximize the firm’s profit. A firm balances productivity gains from the higher wage rate against its additional cost - the efficiency wage.

Slide 9-72 Copyright © 2000 Addison Wesley Longman, Inc. Unemployment at Full Employment The Minimum Wage A minimum wage law determines the lowest wage rate at which a firm may legally hire labor. If the minimum wage is set above the equilibrium wage, the minimum wage is in conflict with the market forces.

Slide 9-73 Copyright © 2000 Addison Wesley Longman, Inc. The End