7 THE ECONOMY AT FULL EMPLOYMENT CHAPTER.

7 THE ECONOMY AT FULL EMPLOYMENT CHAPTER

Objectives After studying this chapter, you will able to
Describe the relationship between the quantity of labor employed and real GDP Explain what determines the demand for labor and the supply of labor and how labor market equilibrium determines employment, the real wage rate, and potential GDP This chapter provides the best coverage of the labor market’s link to the aggregate supply side of the economy of any introductory text on the market. It clearly explains to students how potential GDP is determined, what changes potential GDP and why there is ever-persistent unemployment in our economy. One way to motivate students in the study of the labor underpinnings of the macroeconomy is to address the topic of wages. Students readily understand the difference in money wages versus real wage rates. Ask them how much they think their money wages have increased during the past 12 months. Their answers provide an opportunity to work out the percentage change in their wages and then compare it to the percentage change in the CPI or GDP deflator. Use your own percentage increase in wages as an opening example if that’s not too depressing. If you’re like most professors, your real wage rate is falling! This real wage rate discussion then allows you to ask the class: why has your real wage rate fallen and why have real wage rates for some of the students and in other occupations gone up? And, on average, do they think real wage rates are going up or down? These questions always generate some interest, particularly if you pose another question about the future trend of real wage rates. They also let you introduce the idea that in macroeconomics, we’re concerned with the averages and aggregates rather than the details of the distribution. You can move from these introductory ideas to set up the need for the model in this chapter.

Objectives After studying this chapter, you will able to
Explain how an increase in the population, an increase in capital, and an advance in technology change employment, the real wage rate, and potential GDP Explain what determines unemployment when the economy is at full employment

Production and Jobs In 2001, each hour of work produced twice as much output as in Why? And how can output per hour increase even during a recession, as in 2001? What are the connections between capital accumulation, education, and technical change with employment, earnings, and potential GDP? What determines the level of unemployment at full employment?

Real GDP and Employment
Production Possibilities The production possibility frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot. Building and using a toolkit. As you introduce the tradeoff between goods (real GDP) and leisure time, use the opportunity to remind the students that learning economics is like building and using a toolkit. And here we use the PPF tool yet again. Keep reminding your students that economics is not a subject that you memorize (and forget after the exam). It is more like learning to drive a car—something that eventually comes naturally and is never forgotten. Making it personal. This topic is one that can benefit from drawing on the personal experiences of students who have jobs and who make some choices with respect to hours per week to work, study, and take leisure. They get the PPF for leisure and GDP quickly. Simple examples. Changes in labor productivity are conveniently illustrated with simple concrete examples. To see how physical capital increases productivity, contrast building a dam using shovels and buckets, then shovels and wheelbarrows, then a front-end loader and a truck. To see how human capital increases productivity, contrast the speed with which a student who has learned to type can produce an essay with the speed at which a two-finger typist can accomplish the same task.

Figure 7.1(a) illustrates a production possibility frontier between leisure time and real GDP. The more leisure time forgone, the greater is the quantity of labor employed and the greater is the real GDP.

The PPF showing the relationship between leisure time and real GDP is bowed out, which indicates an increasing opportunity cost. Opportunity cost is increasing because the most productive labor is used first and as more labor is used it is increasingly less productive.

The Production Function The production function is the relationship between real GDP and the quantity of labor employed, other things remaining the same. One more hour of labor employed means one less hour of leisure, therefore the production function is the mirror image of the leisure time-real GDP PPF.

Figure 7.1(b) illustrates the production function that corresponds to the PPF shown in Figure 7.1(a). Along the production function, an increase in labor hours brings an increase in real GDP.

Changes in Productivity Labor productivity is real GDP per hour of labor. Three factors influence labor productivity: Physical capital Human capital Technology

Human capital is the knowledge and skill that has been acquired from education and on-the-job training. Learning-by-doing is the activity of on-the-job education that can greatly increase labor productivity.

Shifts in the Production Function Any influence that increases labor productivity increases real GDP at each level of labor hours and shifts the production function upward. An increase in physical capital, human capital, or a technological advance all increase labor productivity.

Figure 7.2(a) illustrates an increase in labor productivity. The production function shifts upward from PF0 to PF1.

Figure 7.2(b) illustrates the increase in U.S. labor productivity and the associated shift in the production function between 1981 and 2001.

The Labor Market and Aggregate Supply
The Demand for Labor The quantity of labor demanded is the 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, other things remaining the same. 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 an hour of labor earns.

To calculate the real wage rate, we divide the money wage rate by the GDP deflator and multiply by 100. It is the real wage rate, not the money wage rate, that determines the quantity of labor demanded. Figure 7.3 shows a demand for labor curve.

The demand for labor depends on the marginal product of labor, which is the additional real GDP produced by an additional hour of labor when all other influences on production remain the same. The marginal product of labor is governed by the law of diminishing returns, which states that as the quantity of labor increases, but the quantity of capital and technology remain the same, the marginal product of labor decreases.

We calculate the marginal product of labor as the change in real GDP divided by the change in the quantity of labor employed.

Figure 7.4 shows the calculation of the marginal product of labor and illustrates the relationship between the marginal product curve and the production function. Marginal product of labor. Although you are teaching a macroeconomics course, you can’t neglect some crucial microeconomic underpinnings. And the marginal product of labor is one of these underpinnings. You can, though, avoid being too technical and can focus on the intuition. Some of your students might have completed the principles of microeconomics and seen the concept of marginal productivity before. This background enables you to encourage their participation in a classroom discussion on this topic. Also, drawing on the life experience of students with jobs whose work hours change from day to day or week to week can be useful. Get the students to see intuitively that it is not worthwhile for a firm to hire an hour of labor unless the value of the production of that labor at least covers the wage cost to the firm.

A 100 billion hour increase in labor from 100 to 200 billion hours brings a $4 trillion increase in real GDP—the marginal product of labor is $40 an hour.

A 100 billion hour increase in labor from 200 to 300 billion hours brings a $3 trillion increase in real GDP—the marginal product of labor is $30 an hour. The marginal product of labor is the slope of the production function.

Figure 7.2(b) shows the same information on the marginal product curve, MP. At 150 (midway between 100 and 200), marginal product is $40. At 250 (midway between 200 and 300), marginal product is $30.

The marginal product of labor curve is the demand for labor curve. Firms hire more labor as long as the marginal product of labor exceeds the real wage rate. With the diminishing marginal product of labor, the extra output from an extra hour of labor is exactly what the extra hour of labor costs, i.e., the real wage rate. At this point, the profit-maximizing firm hires no more labor.

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 at a given real wage rate. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate, all other things remaining the same. Labor supply. Your main goal in teaching this topic is to explain why, in total, hours increase as the real wage rate increases. Again, drawing on the life experience of students with jobs whose work hours change from day to day or week to week can be useful. The two key points are: Even though some workers might have backward-bending labor supply curves (playing golf on weekday afternoons when the wage rate rises enough), most have upward-sloping labor supply curves. The labor force participation rate increases as the real wage rate increases. These two features of individual behavior imply that the supply curve to labor in aggregate—the supply of aggregate hours—increases as the real wage rate rises, other things remaining the same.

Figure 7.5 illustrates a labor supply curve. The higher the real wage rate, the greater is the quantity of labor supplied.

The quantity of labor supplied increases as the real wage rate increases for two reasons: Hours per person increase Labor force participation increases

Hours per person increase because the real wage rate is the opportunity cost of not working. But a higher real wage rate increases income, which increases the demand for normal goods, including leisure. An increase in the quantity of leisure demanded means a decrease in the quantity of labor supplied. The opportunity cost effect is usually greater than the income effect, so a rise in the real wage rate brings an increase in the quantity of labor supplied.

Labor force participation increases because higher real wage rates induce some people who choose not to work at lower real wage rates to enter the labor force. The labor supply response to an increase in the real wage rate is positive but small. A large percentage increase in the real wage rate brings a small percentage increase in the quantity of labor supplied. The labor supply curve is relatively steep.

The labor market is in equilibrium at the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied. Labor market equilibrium is full-employment equilibrium. The level of real GDP at full employment is potential GDP.

Figure 7.6(a) illustrates labor market equilibrium. Labor market equilibrium occurs at a real wage rate of $35 and an employment of 200 billion labor hours.

At a full employment level of 200 billion hours, potential GDP is 10 trillion dollars.

The long-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level when the money wage rate and potential GDP remain constant.

Figure 7.7 illustrates the long-run and short-run aggregate supply curves (LAS and SAS). LAS is a vertical line at potential GDP.

As the price level changes, the money wage also changes to keep the real wage rate at the full-employment equilibrium level. With no change in the real wage rate, there is no change in real GDP.

Along the SAS curve, as the price level rises, the money wage remains the same, so the real wage rate falls. As the real wage rate falls, the quantity of labor demanded increases and real GDP increases.

As the price level falls, the money wage remains the same, so the real wage rate rises. As the real wage rate rises, the quantity of labor demanded decreases and real GDP decreases.

When the economy is above potential GDP, the real wage rate is lower than the equilibrium real wage rate. When the economy is below potential GDP, the real wage rate is greater than the equilibrium real wage rate.

Production is efficient in the sense that the economy is on its PPF, but is inefficient in the sense that the economy is not at a sustainable point on the PPF. The sustainable point on the PPF is at the full-employment equilibrium.

Changes in Potential GDP
Real GDP increases if: The economy recovers from a recession Potential GDP increases Two factors that increase potential GDP are: An increase in population An increase in labor productivity

An Increase in Population An increase in population increases the supply of labor. The equilibrium real wage rate falls and the equilibrium quantity of labor increases. The increase in the equilibrium quantity of labor increases potential GDP. The potential GDP per hour of work decreases. Is immigration bad for us? Many people think that immigration is bad for existing citizens and lowers their living standard. Part of the popular political discussion, especially in Europe during 2002, has a racist dimension, which you will want to avoid. But the raw economic dimension is worth examining. When you show your students the effects of an increase in population in Figure 7.8, you will conclude that an increase in population, ceteris paribus, increases real GDP but lowers real GDP per person and lowers the real wage rage. You might then ask: does this outcome mean that immigration is bad for us? The answer, of course, is absolutely not. Historically, immigrants have brought capital and entrepreneurship, and have been some of the most creative sources of technological change. When you combine the effects of capital accumulation and technological change with an increase in population, you see that real GDP increases but the change in the wage rate is ambiguous. Add the historical fact that capital accumulation and technological change have outstripped population growth, and you reach the conclusion that immigration has been (and probably continues to be) a positive economic force.

Figure 7.8 illustrates these effects. The labor supply curve shifts rightward. The real wage rate falls. The equilibrium quantity of labor increases.

Potential GDP increases. Potential GDP per hour of work decreases. Initially, potential GDP per hour of work was $50. In the new equilibrium, potential GDP per hour of work is $43.33.

An Increase in labor Productivity Three factors increase labor productivity An increase in physical capital An increase in human capital An advance in technology An increase in labor productivity shifts the production function upward and increases the demand for labor. The equilibrium real wage rate, quantity of labor, and potential GDP all increase. Why the Luddites were wrong. This chapter provides you with a wonderful opportunity to explain to your students why the Luddites were wrong—and why the modern neo-Luddite movement is wrong. (You can learn more than you need to know about Luddism and the Luddites, ancient and modern, at Work through the example illustrated in Figure 7.9. Explain that more capital and more productive capital that uses new technologies increases productivity, shifts the production function upward, and shifts the demand for labor curve rightward. Real GDP increases and on the average, the real wage rate rises. You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor—complementary labor. People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before. New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the DVD. If you want to get side-tracked into philosophical disputes about man and machines, I can’t help you in that area!

Figure 7.9(a) illustrates these effects in the labor market.

Figure 7.9(b) shows the change in the production function. The production function shifts upward and the quantity of labor employed increases. Both changes increase potential GDP.

Population and Productivity in the United States Population and productivity in the United States have increased over time. Between 1981 and 2001, both years close to full employment: The working-age population increased from 170 million to 212 million–a 25 percent increase. Labor hours increased from 159 billion to 231 billion—a 45 percent increase.

Population and productivity in the United States have increased over time. Between 1981 and 2001, both years close to full employment: The capital stock increased from $15 trillion (1996 dollars) to $25 trillion—a 67 percent increase. Technology advanced—most notably the information revolution and the widespread computerization of production processes.

The percentage increase in labor hours exceeded the percentage increase in the population because the increase in capital and technological advances increased labor productivity, which increased the real wage rate, which in turn increased the labor force participation rate.

Figure 7.10 illustrates these events. The real wage rate increased from $18 an hour to $24 an hour. Aggregate hours increased from 159 billion a year to 231 billion a year.

Potential GDP increased from $5 trillion a year to $9.3 trillion a year.

Unemployment at Full Employment
The unemployment rate at full employment is called the natural rate of unemployment. Unemployment always is present for two broad reasons: Job search Job rationing

Job Search Job search is the activity of workers looking for an acceptable vacant job. All unemployed workers search for new jobs, and while they search many are unemployed.

Figure 7.11 illustrates the relationship between the amount of job search unemployment and the real wage rate. Where is unemployment in the demand and supply diagram? Thoughtful students often ask about the relationship between the (microeconomic-based) labor demand and labor supply model and unemployment. They can’t “see” any unemployment in labor market equilibrium. They want to know where it is. Explain that in the labor market, people use their time in two economically productive ways: they work and they job search. Working is supplying labor and this is the activity that the demand-supply model shows. It shows the quantity of labor demanded and supplied and the price (real wage rate) that equates the quantities demanded and supplied. The demand and supply model does not determine the quantity of job-search activity. People supply job-search activity because firms have imperfect information about job seekers and workers have imperfect knowledge about available jobs. During the time spent on job search, people are unemployed. You can draw a diagram if you wish that shows the quantity of job search on the x-axis and the real wage rate on the y-axis. The higher the real wage rate, other things remaining the same, the greater is the amount of job search activity. The equilibrium wage rate determined by demand and supply in the labor market determines the point on the job search curve at which the labor market operates and determines the quantity of job-search unemployment. Only if there were no uncertainty would the supply of job search (and unemployment) be zero. In such a case, a person out of work would not need to search for a new job. He or she would simply report to the new job on the day the worker knew that the job started! Thus, workers would never be unemployed because they would never search for jobs. Clearly, this happy state of affairs is not a description of reality.

Civilian population and labor force, 1941–1945 Year Civilian population Labor force Employment Unem-ploy-ment Not in labor force Labor force partici-pation rate Employ- ment-to-popula-tion ratio Unem-ploy-ment rate Thousands of persons 14 years of age and over Percent 1941 99,900 55,910 50,350 5,560 43,990 56.0 50.4 9.9 1942 98,640 56,410 53,750 2,660 42,230 57.2 54.5 4.7 1943 94,640 55,540 54,470 1,070 39,100 58.7 57.6 1.9 1944 93,220 54,630 53,960 670 38,590 58.6 57.9 1.2 1945 94,090 53,860 52,820 1,040 40,230 56.1 Source: Economic Report of the President, 2002 One way to dramatize the fact that natural unemployment never hits zero is to bring in data on unemployment rates during World War II. Here are the numbers for the United States. Tell the students that more than 6 million people, mainly men, were recruited into the armed forces and that millions of others, mainly women, were mobilized to produce arms. Ask the students to guess the unemployment rate at the peak of war activity in 1944. Few will guess the unemployment rates correctly. (It is pretty remarkable that the rate could have fallen to such a low level.) [To use this slide in the classroom, unhide it by clicking Slide Show, Hide Slide.]

The amount of job search unemployment changes over time and the main sources of these changes are: Demographic change Unemployment compensation Structural change

Demographic change As more young workers entered the labor force in the 1970s, the amount of frictional unemployment increased as they searched for jobs. Frictional unemployment may have fallen in the 1980s as those workers aged. Two-earner households may increase search, because one member can afford to search longer if the other has an income.

Unemployment compensation The more generous unemployment benefit payments become, the lower the opportunity cost of unemployment, so the longer workers search for better employment rather than any job. More workers are covered now by unemployment insurance than before, and the payments are relatively more generous.

Structural change An increase in the pace of technological change that reallocates jobs between industries or regions increases the amount of search.

Job Rationing Job rationing occurs when employed workers are paid a wage that creates an excess supply of labor. Job rationing can occur for two reasons: Efficiency wage Minimum wage

An efficiency wage is a real wage rate that is set above the full-employment equilibrium wage that balances the costs and benefits of this higher wage rate to maximize the firm’s profit. The cost of a higher wage is direct. The benefit of a higher wage is indirect: it enables a firm to attract high-productivity workers, stimulates greater work effort, lowers the quit rate, and lowers recruiting costs.

A minimum wage is the lowest wage rate at which a firm may legally hire labor. If the minimum wage is set below the equilibrium wage rate, it has no effect. If the minimum wage is set above the equilibrium wage rate, it does affect the labor market.

Job Rationing and Unemployment If the real wage rate is above the equilibrium wage, regardless of the reason, there is a surplus of labor that adds to unemployment and increases the natural unemployment rate. Most economists agree that efficiency wages and minimum wages increase the natural unemployment rate. David Card and Alan Krueger have challenged this view and argue that an increase in the minimum wage works like an efficiency wage, making workers more productive and less likely to quit.

Dan Hamermesh argues that firms anticipated increases in the minimum wage and cut employment before the minimum wage increased. Therefore, looking at the effects of minimum wage changes after the change occurs misses the effects—an example of the post hoc fallacy. Finis Welch and Kevin Murphy say Card and Krueger failed to take into account some regional differences in economic growth that hide the effects of the change in the minimum wage—an example of ceteris paribus not holding.

7 THE ECONOMY AT FULL EMPLOYMENT CHAPTER THE END

7 THE ECONOMY AT FULL EMPLOYMENT CHAPTER.

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7 THE ECONOMY AT FULL EMPLOYMENT CHAPTER.

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