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Chapter 8
A roadmap ahead:
So far we have studied how aggregate economic
performance is defined and measured.
In the next few chapters we will study the forces
that determine real GDP at full employment,
business cycle fluctuations in real GDP, and the
growth rate of real GDP over time.
Then we will study the factors that determine the
price level and inflation rate.
We start out by identifying the determinants of
potential GDP.
Recall that potential GDP is the level of real GDP that
the economy would produce if it were operating at full
employment, i.e., when the only unemployment is
frictional, structural and seasonal.
Real GDP is produced as a result of firms employing
factors of production – labor, capital, land and
entrepreneurship.
At any given moment in time, the quantities of capital,
land, entrepreneurship and the state of technology are
typically fixed, but the quantity of labor employed
varies. Therefore, in the short-run, real GDP depends
on the quantity of labor employed.
To characterize the relationship between the quantity
of labor employed and real GDP we use an analytical
device called an aggregate production function,
which shows the maximum amount of real GDP that
can be produced by any given amount of labor,
holding all other factors of production and the state of
technology constant.
This production function can be represented
graphically as follows:
The production function displays diminishing
returns, which means that each additional hour of
labor employed produces a successively smaller
increase in real GDP.
For example, the first 50 billion hours of labor
produces $4 trillion of real GDP. The second 50 billion
hours of labor produces an additional $3 trillion of real
GDP. The third 50 billion hours of labor produces an
additional $2 trillion of real GDP. The fourth 50 billion
hours of labor produces an additional $1 trillion.
The reason for diminishing returns is that the quantity
of capital and other factors of production, and the
state of technology, are fixed. As we move up the
production function, the quantity of labor employed is
increasing, but the additional labor is still working with
the same amount of capital and other factors.
Therefore, each additional hour of labor contributes a
successively smaller increase in real GDP.
If real GDP depends on how much labor is
employed, then potential GDP is determined by
the point on the production function that
corresponds to full employment of labor.
To find the full employment level of
employment, we need to study the labor
market.
Full employment occurs when the demand for labor is
equal to the supply of labor, i.e., when the labor
market is in equilibrium.
The demand for labor
The quantity of labor demanded is the
number of hours of labor that all firms in the
economy plan to hire during a given time
period at a given real wage rate.
The demand for labor is the relationship
between the quantity of labor demanded and
the real wage rate, holding constant all other
influences on firms’ hiring decisions.
The lower the real wage rate, the greater the quantity
of labor demanded.
To understand this relationship, consider the hiring
decision of an individual firm or employer:
To maximize profit, a firm will hire additional hours of
labor as long as each additional hour contributes at
least as much additional output as it costs the firm to
hire that hour of labor.
The increase in output produced by an additional
hour of labor, holding all other factors of production
constant, is called the marginal physical product of
labor (MPPL).
The cost to the firm of hiring an additional hour of
labor is the real hourly wage rate.
Therefore, to determine how many hours of labor to
hire, a profit maximizing firm will compare the MPPL
with the real hourly wage rate, and will hire additional
hours of labor as long as the MPPL is at least as great
as the real hourly wage rate.
We are assuming that the amount of capital and other
factors of production employed by the firm are fixed,
therefore the MPPL decreases as more labor is hired,
due to diminishing returns.
For an individual firm, the real hourly wage rate is the
amount of output that the firm must sell in order to
earn the dollars required to pay the nominal wage
rate.
Consider the following example of a firm that
produces beer:
The firm has a total product curve that shows output
of beer rising as more hours of labor are employed.
All other inputs are held constant, so output rises by
a smaller and smaller amount each time an
additional hour of labor is hired:
From the firm’s total product curve, we can derive
the firm’s MPPL curve:
Now, suppose that the nominal hourly wage rate for
brewery workers is $18, and that the price per sixpack
of beer is $3. Then the real hourly wage rate for the
firm is $18/$3 = 6 sixpacks.
Combining the real hourly wage rate with the MPPL,
we can determine how many hours of labor the firm
will hire in order to maximize profit:
The firm will employ the first hour of labor because it
produces 8 sixpacks of beer but costs only 6
sixpacks to hire. The firm will hire the second hour of
labor because it contributes 6 additional sixpacks of
beer and also costs 6 sixpacks.
But the firm will not hire the third hour of labor
because it contributes an increase in output of only
4 sixpacks but still costs 6 sixpacks to hire.
If the nominal hourly wage rate were now to
decrease to $12, assuming the price per sixpack
remains at $3, the real hourly wage rate confronted
by the firm would decrease to $12/$3 = 4 sixpacks.
Now it would be profitable for the firm to hire the third
hour of labor, whose MPP is 4 sixpacks.
Therefore, we see that a profit maximizing firm will
hire additional hours of labor up to the point where
the MPPL = real hourly wage rate.
This example also illustrates that, when the real
hourly wage rate falls, the firm responds by hiring
more hours of labor. Therefore we can conclude that
the quantity of labor demanded increases when the
real hourly wage rate falls.
In a competitive labor market, a firm’s MPPL is in fact
the firm’s demand curve for labor in the short run.
Since the MPPL decreases as more hours of labor
are employed, the firm’s demand curve for labor is
downward sloping.
The demand for labor in the whole economy is
obtained by adding up all of the individual firms’ labor
demand curves. Therefore the economy-wide labor
demand curve is also downward sloping: a decrease
in the real hourly wage rate causes an increase in the
quantity of labor demanded:
The supply of labor
The quantity of labor supplied is the number
of hours that all households in the economy
plan to work during a given time period at a
given real wage rate.
The supply of labor is the relationship
between the quantity of labor supplied and the
real wage rate, holding constant all other
influences on households’ labor supply
decisions.
The quantity of labor supplied increases as the real
hourly wage rate rises, i.e., the labor supply curve is
upward sloping. For example:
The quantity of labor supplied is determined by the
real hourly wage rate, not the nominal hourly wage
rate, because what matters to households is not the
number of dollars they earn but what those dollars
can buy.
There are two reasons why the quantity of labor
supplied increases when the real wage rate
increases:
Hours per worker increase
Labor force participation increases
Hours per worker
Here there are actually two contradictory effects, a
substitution effect and an income effect.
The substitution effect:
The real wage rate is the opportunity cost of not
working, e.g., of consuming leisure. If an individual
chooses to spend an hour not working, the
opportunity cost of doing so is the forgone earnings,
which is given by the real hourly wage rate.
The substitution effect means that, as the real hourly
wage rate rises, leisure and other non-work activities
become relatively more expensive compared to
working, therefore individuals substitute the relatively
cheaper activity (work) for the relatively expensive
activity (leisure).
Consequently, according to the substitution effect, the
quantity of labor supplied rises as the real hourly
wage rate rises.
The income effect:
As the real hourly wage rate rises, individuals’
incomes rise, and therefore they consume more of
all normal goods, including leisure. Since they are
consuming more leisure, they are supplying fewer
hours of labor, therefore, according to the income
effect, the quantity of labor supplied decreases as
the real hourly wage rate rises.
For most households, the substitution effect
dominates the income effect, so that a rise in the real
hourly wage rate, on net, causes an increase in the
quantity of labor supplied.
Labor force participation
Most individuals have opportunities to engage in nonmarket production, e.g., child care, household
production. They will choose to work in the labor
market only if the real wage exceeds the value to
them of non-market production. The higher the real
wage rate, the more likely it is that individuals will
choose to enter the labor force.
Other factors influencing the labor supply
decision
Income tax rate:
An increase in the income tax rate reduces the
after-tax wage rate and therefore reduces the
quantity of labor that workers offer to supply for any
given real hourly wage rate.
Unemployment benefits:
These benefits lower the cost of searching for a job
and therefore encourage unemployed workers to
search longer before accepting a job offer. The more
generous the unemployment benefits, the longer the
time workers spend searching and the lower the
quantity of labor offered at any given real hourly
wage rate.
Both an increase in the income tax rate and an
increase in unemployment benefits causes the
quantity of labor supplied to decrease for any given
real hourly wage rate. Therefore the labor supply
curve shifts to the left:
Labor market equilibrium
The labor market works just like any other market for
goods or services. The real hourly wage rate is the
“price” of labor.
When the quantity of labor supplied equals the
quantity of labor demanded, the labor market is in
equilibrium. Another way of saying that the market is
in equilibrium is to say that the market clears.
Market clearing means that, for every hour of labor
that a worker is offering to supply, there is an hour of
labor that an employer wishes to hire. That is, there
is a job vacancy for every job seeker. This is what is
meant by full employment.
When the labor market is in equilibrium, the economy
is at full employment.
Adjustment to labor market equilibrium occurs through
changes in the real hourly wage rate:
When the real hourly wage rate is above the market
clearing equilibrium wage, e.g., at $15, there is an
excess supply (surplus) of labor. Competitive forces in
the market will cause the real hourly wage rate to fall
toward equilibrium, eliminating the excess supply.
When the real hourly wage rate is below the market
clearing equilibrium wage, e.g., at $5, there is an
excess demand for labor (a shortage). Competitive
forces in the market will cause the real hourly wage
rate to rise toward equilibrium, eliminating the excess
demand.
Full employment and potential GDP
The aggregate production function tells us how
much real GDP any given amount of labor can
produce. Labor market equilibrium tells us the
full employment quantity of labor. Therefore,
we can now determine potential GDP:
The full employment quantity of labor is 150 billion
hours per year. If this is the quantity of labor
employed, then, from the aggregate production
function, we can obtain potential GDP, which is $9
trillion.
When the labor market is in equilibrium, the economy
is at full employment and real GDP equals potential
GDP.
Determinants of the natural rate of
unemployment
Recall that the natural rate of unemployment is the
unemployment rate when the economy is operating at
full employment, i.e., when all of the unemployment is
frictional, structural and seasonal.
Therefore, to explain what determines the natural
rate of unemployment, we must explain what
determines frictional and structural unemployment.
The two fundamental causes of unemployment are:
Job search
Job rationing
Job search
When people enter or re-enter the labor force, or
move between jobs, they are normally involved in
search activity until they find a suitable job. When
industries decline and firms shut down, people are
laid off, and they normally take some time to search
for new jobs in expanding industries. While they are
searching, job seekers are classified as unemployed.
The greater the number of people searching or the
longer the average duration of search, the higher is
the natural rate of unemployment.
The amount of job search depends on:
Demographic change
Unemployment benefits
Structural change
Demographic change:
An increase in the proportion of the population of
working age causes increased entry into the labor
force and therefore an increase in search
unemployment. Aging of the population causes a
decrease in new entrants, and search unemployment
decreases.
An increase in the number of households with two
incomes causes an increase in search
unemployment. With a second income-earner in the
household, an unemployed member of the household
can take longer searching.
Unemployment benefits:
The more generous these benefits, the lower is the
opportunity cost of job search, therefore the longer
the duration of search and the higher the natural
rate of unemployment.
Structural change:
Technological change can work to either increase or
decrease search unemployment.
If technological change causes some industries to
decline while others are expanding, and the newly
created jobs are not a good match for the workers
laid off from the older industries, then the duration of
job search increases and search unemployment
rises.
However, if technological change creates many new
jobs that are a good match for the workers losing their
jobs in older industries, then there is less job search
and the natural rate of unemployment falls.
Job rationing
In a competitive goods market, adjustments of the
market price ration scarce resources, which means
that price adjustments ensure that scarce resources
are allocated to their highest-valued users.
In a competitive labor market, the real hourly wage
rate (the “price” of labor) similarly adjusts to ration
jobs, i.e., to ensure that the number of job vacancies
equals the number of job seekers.
However, in some industries, the real hourly wage
rate is set above the full-employment equilibrium
wage. In these cases, since the real hourly wage
rate is stuck above the market-clearing wage rate
and is prevented from adjusting downward, there
will be an excess supply (surplus) of labor.
In such situations, the real hourly wage rate is no
longer performing its rationing function. Some
other mechanism, therefore, must be found to
ration the number of available jobs. This
mechanism is unemployment.
Three reasons why the real hourly wage rate might
be set above the full-employment equilibrium wage
rate:
Efficiency wage
Minimum wage
Union wage
Efficiency wage:
An efficiency wage is a real wage rate that is set
above the market-clearing equilibrium wage in order
to create an incentive for worker effort.
Minimum wage:
If a government minimum wage law sets the minimum
wage above the market-clearing equilibrium wage
rate, then the quantity of labor demanded will
decrease, the quantity supplied will increase, and
there will be an excess supply of labor, i.e.,
unemployment.
Union wage:
A union wage is a wage rate that is negotiated
through collective bargaining between a labor union
and an employer. Union wages often exceed those
that would prevail in a competitive labor market.
Whether because of efficiency wages, a minimum
wage law or union wages, if the real hourly wage
rate is stuck above the market-clearing equilibrium
wage rate, there will be an excess supply of labor,
i.e., unemployment.
Job rationing causes the level of employment to be
below full employment. Therefore the level of real
GDP will be below potential GDP: