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TOPIC 2
The Supply Side of the Economy
Goals of Lecture 2
• Introduce the supply side of the macro economy.
• Discuss how countries grow and why some countries grow faster than others.
• Discuss labor productivity
o What does it mean?
o How does it respond coming out of recessions?
• Determine how wages are set in an economy. Determine why people work.
• Understand where unemployment comes from.
2
The Production Function
•
GDP (Y) is produced with capital (K, price-weighted) and labor (N, hours):
Y = A F(K,N)
•
Sometimes, I will modify the production function such that:
Y = A F(K,N, other inputs) – where other inputs include energy/oil!
•
Realistic Example is a Cobb Douglas function for F(.):
Y = A K1-α Nα
A is Total Factor Productivity (TFP), an index of efficiency (technology)
MUST READ: NOTES 3 (my text posted on the teaching page) on the aggregate
production function
3
Measurement
•
Y is GDP (measured in dollars). As noted above, we want to measure Y in “real”
dollars.<<you should know what this means from Notes 1 of the text>>.
•
For our Cobb Douglas production function (previous slide), N and K are both measured
in dollars.
– N often is measured in total wage bill
– K often is measured as the replacement cost of capital
• However, in practice, N can be measured in different ways (hours worked,
number of workers).
– Wage bill is the preferred method (takes into account “skill” differentials).
– However, we will often talk about “standard of living” which is income per capita
(Y/N ; where Y is income and N is some population measure).
4
Features of the Aggregate Production Function
Define MPN = Marginal Product of Labor = dY/dN
Define MPK = Marginal Product of Capital = dY/dK
Math Note: You should be comfortable taking these simple partial derivatives– if you are
not, practice this for the quizzes and exams.
Diminishing Marginal Products
From Cobb-Douglas: MPN = α A (K/N)1-α = α (Y/N)
Fixing A and K, MPN falls when N increases
MPK = (1-α) A (N/K)α = (1-α) (Y/K)
Fixing A and N, MPK falls when K increases
Complementarity Across Inputs
Increasing A or K, increases MPN
Increasing A or N, increases MPK
5
Labor Share With Cobb-Douglas
Labor Share of Income = Income earned by workers divided by GDP
= [(W/P)*N/]Y
• In equilibrium, real wages of workers will equal MPN (more on this below)
• Substituting
(W/P) = MPN into above yields:
Labor Share of Income = (α) * (Y/N) * (N/Y)
(MPN)
=α
• Cobb-Douglas predicts a constant labor share of α.
• Historically, α was stable at a level of about 0.7 (in notes, I often just set α =
6
0.7).
US Labor Share: 1947Q1 – 2016Q2
Sharp
Decline
After
2000
Roughly Stable through 2000
7
Manufacturing “Labor Share”: 1988Q1 – 2014Q2
8
Sub-Section A
Economic Growth
Two Measures of Productivity
•
Labor Productivity = Y/N = A (K/N)1-α
Driven by A and K/N (usually reported in press)
•
Total Factor Productivity (TFP) = A = Y/F(K,N)
•
Basically TFP is a ‘catch-all’ for anything that affects output other than K and N.
–
–
–
–
–
–
–
–
Work week of labor and capital
Quality of labor and capital
Regulation
Infrastructure
Competition
Specialization
Innovation (including innovation in management practices)
Changes in “discrimination” or “culture”
•
Some components of TFP tend to be pro-cyclical
•
(Definition of Pro-cyclical: Variable increases when Y is high, decreases when Y is low)
10
Growth Accounting
Y = A K1-α N α (our production function)
%ΔY = %ΔA + (1-α)%ΔK + α%ΔN
Output, in a country grows from:
Growth in TFP (see entrepreneurial ability, education, roads, technology, etc.)
Growth in Capital (machines, equipment, plants)
Growth in Hours (workforce, population, labor participation, etc).
Perhaps, we care about growth in Y/pop or Y/N (per capita output).
%Δ(Y/pop) = %ΔA + (1-α)%Δ(K/pop) + α%Δ(N/pop)
or
%Δ(Y/N) = %ΔA + (1-α)%Δ(K/N)
11
How is TFP Measured
The way TFP (A) is usually measured is via a statistical decomposition (referred
to as the “Solow Residual”).
Remember our assumed production function:
•
Y = AK1-αNα
Math Note: We are going to transform the production function to make it a
little easier to work with (you should get comfortable with this) by taking
the logs:
ln(Y) = ln(A) + α0ln(K) + α1ln(N) (where α0 = 1 – α1 ≈ 0.3)
(1)
•
Given that we measure Y, K and N in the data, we can estimate (1) using
standard regression techniques.
•
ln(A) is the constant from the regression. This is our standard TFP
measure.
12
US TFP Growth: 1970Q1 – 2014Q1
13
Measuring TFP
Because A (TFP) is a catch-all term for anything that affects production, the
assumed production function does not impose any structure on how to measure
the components of TFP.
Economists are very good at measuring the extent to which TFP changes over
time within a country.
It is much harder to measure “why” TFP has changed over time.
Economists try to measure this by using detailed firm-level and household-level
data to measure production and wages.
14
How is Labor Productivity Measured

Labor Productivity is easier to measure: Y/N

Y is usually “real GPD”

N is usually total hours worked
15
Nonfarm Business Labor Productivity Growth: 1988Q1 – 2016Q2
Puzzle?
16
Manufacturing Labor Productivity Growth: 1988Q1 – 2016Q2
Puzzle?
17
Labor Productivity Growth Over Time
 1900-1972:
2.4% per year
 1972-1996:
1.4% per year.
 1996-2004:
2.6% per year. (“Internet boom”)
 2005-2016:
1.1% per year
 2013-2016:
~0% per year
Data from Robert Gordon (Professor at Northwestern)
18
Why is Labor Productivity/TFP Growth Lower
 Demographics?
 Slower growth in schooling?
 Innovations with less spill-overs on productivity (but huge spill-overs on
leisure)
 What productivity growth we have seen replaces lower skilled workers.
Contributing to inequality within the economy.
 Have we moved from big innovations in market productivity (electricity,
assembly lines, transportation, manufacturing techniques, etc.) to big
innovations in leisure technology (facebook, internet, games, etc.).
19
New Paper of Mine
“The Allocation of Talent and Economic Growth”
Question 1:
How much of the observed TFP growth in the U.S. since 1960 is due to better
labor market outcomes (including human capital formation) for blacks and
women?
o
A better allocation of resources leads to higher economic growth.
o
There have been large changes in the allocation of women and minorities to
occupations in the labor market since 1960.
Question 2:
How much of the convergence of the U.S. south to the U.S. north is due to a
decline in discrimination of the south?
20
Occupational Sorting Over Time: An Overview
•
Fraction of group (white men, white women, black men, black women) aged
25-55 working in the following occupations:
Executives, Mgmt, Architects, Engineers, Math/Computer Science,
Natural Scientists, Doctors, and Lawyers.
White Men
White Women
Black Men
Black Women
Data:
1960
2010
21.2%
23.5%
3.0 (7.3)
17.4 (21.0)
2.8
14.6
1.0 (2.1)
13.0 (15.2)
U.S. Census and American Community Survey
Occupational Sorting Over Time: An Overview
•
Where were the other groups working in 1960?
•
53% of working white women worked in Nursing, Teaching, Sales,
Secretarial and Office Assistances, and Food Prep/Service.
o
•
55% of working black men worked as Freight/Stock Handlers, Motor
Vehicle Operators, Machine Operators, Janitorial Services, and Personal
Services.
o
•
The comparable number for white men was 14% (mostly sales)
The comparable number for white men was 19%
47% of working black women worked in Household Services, Personal
Services, and Food Prep/Services.
o
The comparable number for white men was 2%
Wage Gaps Over Time: An Overview
•
Log difference in annual earnings of full time workers, conditional on
experience, hours and occupation controls (relative to White Men)
1960
1980
2010
White Women
-0.56
-0.47
-0.26
Black Men
-0.37
-0.21
-0.16
Black Women
-0.82
-0.47
-0.31
Findings
Macro Implications:
o
25% − 30% of per capita earnings in the U.S. between 1960 and 2010 was due
to declining frictions for white women, black women, and black men. (Shines
some light into the black box of TFP growth)
o
Other interesting results:
- Wage growth in the 1970s and the 2000s would have been negative
absent the labor market improvements for blacks and women.
- About 40% of the convergence of the south to the northeast between
1960 and 1980 is due to declining labor market frictions.
- Not much remaining room for growth from this mechanism. Can explain
some of the slow down in productivity since 2000.
Crazy Idea I have on Productivity Slowdown
Did Early 2000 Finance Boom “Cause”
a Fall in STEM Employment?
Sub-Section A1
Cross-Country Growth
The Role of Investment and Growth
Does a one time increase in investment today increase Y/N today? YES!
Does a one time increase in investment today cause a sustained increase in Y/N
into the future? No!
Back of our mind equations:
S = I + NX (From the first lecture).
Notice the link between saving
and investment.
K(t+1) = (1-δ) K(t) + I(t)
or
ΔK(t, t+1) = I(t) - δ K(t)
Definition of Capital Stock Evolution
All else equal (i.e. holding N constant), increasing I causes K tomorrow to
increase causing K/N tomorrow to increase (i.e. Y/N tomorrow increases).
28
Time Path of Capital Stock: One Time Increase in I
K
No investment
No investment
t+1
time
Suppose there is a one time increase in investment at time t (perhaps due to an investment
tax credit). Suppose no investment either prior to or after the tax credit.
29
Can Higher Investment Lead to Infinite Growth?
Does a sustained increase in investment increase Y/N today? YES!
Does a sustained increase in investment cause a sustained increase in Y/N? No!
Suppose I is fixed at a high level and that K initially is sufficiently small.
K grows if I > δ K: But, notice that δK is also growing each period.
(Summary: To start, higher I will lead to higher K and Y/N will increase).
Eventually, however, I will converge towards δK. More and more of the
investment is going to replace outdated capital and the capital stock will grow
by smaller and smaller rates. The increase in Y/N will converge back to zero.
Summary: High levels of investment will increase the capital stock and output,
but both K and Y will eventually converge to a fixed level.
30
Time Path of K: Permanent Increase in I
K
The new level of investment has successively less effect
due to growing depreciation of the capital stock.
No investment
t+1
time
Suppose there is a permanent increase in investment at time t. Suppose no investment
prior to t. In all periods after t, the level of investment remains fixed at the level in t.
31
Can Higher Investment Growth Cause Infinite Growth?
If a one time increase in I gives an increase in Y, why not continuously raise I to
higher and higher amounts??? Answer: Diminishing MPK!!!
MPK = .3 A (N/K) .7; As K increases, MPK falls.
As K goes to infinity, MPK goes to zero (Y stops increasing).
Suppose, we keep rising I (each year), K will increase by the amount of I (after
controlling for depreciation), but Y will increase by continuously smaller and
smaller amounts.
Remember Y = C + I + G + NX. I/Y (investment rate) is bounded by 1 (if you
invest all your output). This caps the increase in I. I cannot grow forever!
Continuously increasing I will NOT lead to sustained economic growth.
NOTE:
Investment decisions are NOT made in the dark (i.e.
something must drive firm investment!)
32
What Causes Sustained Growth ?
Sustained Increases in the growth of A are the only thing that can cause a
sustained growth in Y/N.
Empirically, when a country exhibits faster Y/N growth …..
33% typically comes from growth in K/N
67% typically comes from growth in A
(where N = employment (not hours) - limited data).
33
Growth Across Countries
Most developed economies grow at the same rate that the “technological frontier”
grows.
Some helpful definitions:
Convergence – countries inside of the technological frontier move towards the
technological frontier.
Divergence – countries inside of the technological frontier grow at a rate less than
the technological frontier.
34
Distribution of World GDP in 2015 (IMF, $)
35
Distribution of World GDP in 2015 (IMF, $)
Top 10
Other Notable
Bottom 10
Qatar
132,099
Lithuania
28,359
Madagascar
1,462
Luxembourg
98,987
Russia
25,411
Eritrea
1,297
Singapore
85,253
Chile/Argentina
23,000
Guinea
1,214
Brunei
79,587
Turkey
20,438
Mozambique
1,186
Kuwait
70,166
Venezuela
16,673
Malawi
1,124
Norway
68,430
Brazil
15,615
Niger
1,080
UAE
67,617
China
14,107
Liberia
873
Switzerland
58,551
South Africa
13,165
Burundi
818
Hong Kong
56,701
Ukraine
7,519
Congo
770
USA
55,805
India
6,162
Cent. Afric. Repub
630
36
Some Data: Distribution of World GDP in 2000
From Barro, 2003 – includes 147 countries. Horizontal axis is a log scale.
All data are in 1995 U.S. dollars.
37
Some Data: Distribution of World GDP in 1960
From Barro, 2003 – includes 113 countries. Horizontal axis is a log scale.
All data are in 1995 U.S. dollars.
38
Growth Rate of GDP Per Capita: 1960 - 2000
From Barro, 2003 – includes 111 countries.
39
GDP per Capita in the United States, the United
Kingdom, and Japan, 1870–2009 (Weil 2015)
Sources: Maddison (1995), Heston, Summers, And Aten (2011).
The Distribution of Growth Rates, 1975–2009
(Weil 2015)
Convergence of Income Across U.S. States: 1940 - 1980
Historical Trends in Convergence
Unadjusted 1940-1960
1
MS
.8
ARAL
ND
SD
OK
KY
NC
GA NM
TN
LA
SC
KS
NE
TX
.6
WV
UT
MOCO
IA
MNWI
ID
VA AZ
IN
WY
FL
NHOR
VT MT
ME
WA
OH
PA MI
IL
.4
MD
CA
NV
MA NJ NY
CT
RI
.2
DE
2000
4000
6000
8000
Per Capita Income 1940
Fitted values
10000
12000
gr_ipc_40_60
42
Convergence of Income Across U.S. States: 1980 - 2000
Recent Trends in Convergence
Unadjusted 1980-2000
.5
MA
NH
CT
NC GA
NJ
.4
VT
SCNDSD TN
ME
AL
KY
MS
MO
IN
.3
AR
UTID
WV
.2
RI
NE
NM
IA
AZ
MN
VA
PA
FL
TX
MI
WI
OH
KSOR
NY
CO
WAIL
DE
CA
LA
MT
MD
NV
OK
.1
WY
15000
20000
Per Capita Income 1980
Fitted values
25000
gr_ipc_80_00
43
Source of GDP Growth
Latin America – Brazil, Chile, Columbia, Mexico, Peru, Uruguay, Bolivia, Ecuador, Paraguay, Venezuela
Emerging Asia – Indonesia, Malaysia, Philippines, Thailand, and China
Advanced Exporters – Australia, Canada, New Zealand, and Norway.
From Sosa et al. (2013), IMF Report
44
Per Capita GDP vs. Life Expectancy (Acemoglu 2005)
45
Sub-Section B
The Labor Market
Labor Market: Firm Profit Decisions
• In a competitive market, a firm can sell as much Y as it wants at the going
price p, and can hire as much N as it wants at the going wage w.
• Facing w and p, a profit maximizing firm will hire N to the point were MPN =
w/p (the benefit from an additional worker (in terms of additional output) must
equal the cost which they are paid). <<This is straight from micro>>
• With Cobb-Douglas: MPN = .7 Y/N = .7 A (K/N).3
• If firms maximize profits: w/p = .7 Y/N = .7 A (K/N).3
• If MPN > w/p then the firm can increase profits by increasing N.
• If MPN < w/p then the firm can increase profits by decreasing N.
Reading: Notes 4 from the supplemental notes
47
The Labor Demand Curve
real wage
w/p *
MPN = Nd
N*
N
48
Notes on the Labor Demand Curve
• Nd slopes downward (Nd = MPN = .7 A * (K/N).3)
• Nd rises with A and K (assumed complementarity across inputs)
• Assumption: Y is not Fixed! Firms optimally choose N, K, Y and (to some
extent) A to maximize profits.
• Caveat: Who says that there is a demand for more Y?
– Need to look at the demand side of economy (introduced last -discussed in depth
throughout the course).
49
The Other 1/2 of the Labor Market: Labor Supply
• Labor Supply (Ns) Results from Individual Optimization Decisions
• Households compare benefits of working (additional lifetime resources) with
cost of working (forgone leisure)
• Factors Affecting Labor Supply
–
–
–
–
–
–
The Real Wage (w/p)
The Household’s Present Value of Lifetime Resources (PVLR)
The Marginal Tax Rate on Labor Income (tn)
The Marginal Tax Rate on Consumption (tc)
Value of Leisure (reservation wage) - non- ‘work’ status (VL)
The Working Age Population (pop)
50
The Labor Supply Curve
Ns(PVLR, tc, tn, pop, VL)
w/p
N
51
Labor Supply Notes (Most Derived From Scratch in Lecture)
•
In terms of ‘wages and earnings’, there is both an income and substitution effect - we
will look at them separately – BUT in the real world, they often occur jointly!!!!
•
The Real Wage - HOLDING PVLR fixed: A higher w/p encourages individuals to
substitute away from leisure and toward work (leisure becomes more expensive). This
is a substitution effect. <<This is why the labor supply curve slopes upwards!!>>
– Estimating this substitution effect is difficult since PVLR is not easily held constant.
Estimates range from 0 - 2% (For a 1% increase in after-tax w/p holding PVLR fixed, labor
supply either increases by 0% or 2%). Very Wide Range – little consensus.
•
PVLR = initial wealth + present discounted value of earnings
– A higher PVLR induces individuals to work less (lower Ns) for a given after-tax wage,
allowing them to enjoy more leisure (If leisure is preferred to work – as I get richer, I can
afford to work less).
– PVLR is net of taxes and non-work governmental transfers and inclusive of all other
transfers.
52
Labor Supply Notes
• Marginal tax rate on labor income - Should have same substitution effect as the
before tax real wage. Studies of the 1986 U.S. Tax Reform found that only
high-earning married women worked more in response to lower marginal
income tax rates.
• Marginal tax rate on consumption - see above
• Value of Leisure - If leisure/no-work becomes more/less attractive, households
will work less/more (reservation wage). (Welfare programs, child care, etc.).
• Working Age Population: Usually defined as 16-64. (Includes changes in
Labor Force Participation Rates)
53
Recap on Labor Supply
• Substitution Effect:
– For a given PVLR, a higher after tax wage increases NS.
(This is why Labor Supply Curve Slopes Upward)
• Income Effect
– For a given after-tax wage, higher PVLR decreases Ns.
• Evidence:
– Weak Consensus is that, with equal (%) increase in PVLR and the after-tax wage,
Ns falls (income effect dominates).
54
Temporary Increase in A
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p *
N d(A,K)
N*
N
55
Permanent Increase in A
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p *
N d(A,K)
N*
N
56
Can Technological Progress Destroy jobs?
Facts:
A, N, w/p are trending up over time.
N/pop is trending down (except in U.S. since 1980).
Higher A countries have higher w/p and lower N/pop.
Implications:
Adjusting for pop, higher A goes with lower N.
Higher A reduces Nd and destroys jobs? - NO!
Labor Demand Increases.
Higher A increases PVLR and reduces Ns - The Effect on Labor Supply
is to fall.
57
Permanent Increase in Population
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p *
N d(A,K)
N*
N
58
Population and Jobs
More People = More Jobs
1990 Employment (000s)
1000000
100000
10000
1000
100
100
1000
10000
100000
1000000
1990 Working-Age Population (000s)
59
Temporary Increase in Taxes (tc or tn)
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p *
N d(A,K)
N*
N
60
Permanent Increase in Taxes (tc or tn)
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p *
N d(A,K)
N*
N
61
Labor Market Equilibrium (in long run!)
•
We define Long Run Equilibrium in macroeconomics as occurring when the labor
market clears.
•
By definition, long run macro equilibrium exists when N = N*.
•
At N*, labor demand = labor supply. So, by definition, all workers who want a job
(the suppliers) are able to find a firm looking for a worker (the demanders).
•
•
•
Implies that cyclical unemployment = zero at N*.
Long run equilibrium is characterized by zero cyclical unemployment!
It is an equilibrium in that there is no incentive for real wages to change at N*
•
Real wages (w/p) has two components: nominal wages (w) and the price
level (p).
•
Note:
•
Y* is the long run equilibrium level of output (output where labor market is in
equilibrium)
Y* (by definition) = A K.3(N*).7
62
Our First Aggregate Supply Curve….
•
Suppose prices (p) increase. What happens in the labor market?
•
•
•
In terms of equilibrium, nothing happens!
Increasing prices have no effect on labor demand (A and K do not change).
Increasing prices have no effect on labor supply (taxes, population, etc. do
not change).
•
You may ask “Doesn’t PVLR change when prices increase???” No!
•
•
•
As long as nominal wages adjust, real wages will be unchanged when p
increases.
The % change in prices will be match exactly by the % change in
nominal wages – real wages will not change (so PVLR will not change).
No effect on labor supply.
•
Key: Because real wages will not change, changes in prices will have NO
effect on the labor market (i.e., it will have no effect on N*).
•
Conclusion: Changing prices will have NO effect on Y* (since N* is
constant).
63
Our First Aggregate Supply Curve……
LRAS – Long Run Aggregate Supply Curve
p
Y*
Y
•
If labor market clears, changes in prices will lead to equal changes in nominal wages.
As a result, there will be no change in N* and hence, no change in Y*.
•
Leads to a vertical LRAS curve. Prices do not affect production in the long run! 64
What Shifts Y*? (the LRAS)
•
Anything that affects the labor market will affect Y*!
•
If N* increases, Y* will shift to the right.
•
If N* decreases, Y* will shift to the left.
•
Summary: Y* will shift right if:
–
–
–
–
–
A increases
K increases
population increases
labor income taxes fall (and income effect is small relative to substitution effect)
labor income taxes rise (and income effect is large relative to substitution effect)
Note:
The long run aggregate supply curve (LRAS) is NOT the labor supply curve.
We have lots of different markets in this class. There will be lots of different
supply and demand curves. You need to keep track of them!
65
Things to Remember!
•
The demand side of the economy is NOT important for determining Y*!
–
All we need to know is A, K and N and we know Y*!
–
The demand side of the economy is not important for economic growth!
–
Key: If I ever ask you about what determines Y* (i.e., output/income/expenditure in the
long run), you should think about A, K and the labor market.
•
•
As a rule, K will be fixed unless I tell you otherwise (for simplicity, you will
see why soon).
Why do we care about the demand side of the economy?
–
–
–
In the long run, prices will be determined by demand.
Also, LRAS is dependent on labor market being in equilibrium. In the short run, labor
market need not be in equilibrium.
Demand will determine output in the SHORT RUN!
66
Summary….
•
In the long run – when labor markets clear.
–
Supply side of economy (labor market, K, A, other inputs like oil) determines
output.
–
Demand side of economy (C+I+G+NX) will determine prices.
•
In the short run – when labor markets do not clear:
–
Demand and Supply jointly determine prices and output (think of the simple
examples I gave graphically in the lecture for topic 1).
–
Three outstanding issues (we will get to them soon):
•
•
•
When is the labor market NOT in equilibrium?
What does the supply curve look like when labor market doesn’t clear?
What determines demand?
67
When are Labor Markets in Disequilibrium?
•
Labor market is in disequilibrium when labor demand is not equal to labor supply.
•
Any time labor demand = labor supply, there is no cyclical unemployment (by
definition)!
•
Nominal wages do not adjust to clear the labor market
– We refer to this as ‘sticky’ wages.
– Because of wage contracts (and uncertainty), nominal wages do not always adjust
immediately.
– Need a model for short-run disequilibrium --- we will do that in Topic 6.
68
Cyclical Unemployment in Labor Markets
•
When do we get cyclical unemployment in our models?
•
Cyclical unemployment occurs when there are no jobs available (labor demand) for
those with the skills and the desire to work (labor supply) at current wages.
•
Cyclical unemployment occurs only in disequilibrium! (when desired labor demand <
desired labor supply - at given wages)
Ns
w’/p’
a
b
Unemployment
N(1)
N(0)
Nd
69