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ECONOMICS 5e
Michael Parkin
CHAPTER
9
The Economy at Full
Employment
Chapter 26 in Economics
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
Copyright © 2000 Addison Wesley Longman, Inc.
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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
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
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
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
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.
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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.
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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.
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Production Possibilities and the
Production Function
Production Possibility Frontier
10
a
7
Leisure is forgone
to produce real GDP
4
PPF
0
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250 Leisure (billions of hours per year)
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Production Possibilities and the
Production Function
10
Production function
a
7
An increase in labor
hours brings an
increase in real GDP
4
0
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100
200
300
400
500
Labor (billions of hours per year)
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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
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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.
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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.
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Real GDP and Employment
Labor productivity:
Technology
Enormous impact of technology on
productivity.
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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.
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An Increase in Labor Productivity
12
An increase in labor productivity
PF1
10
b
9
PF0
7
a
Effect of capital
accumulation and
technological change
4
0
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100
200
300
400
500
Labor (billions of hours per year)
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Real GDP (trillions of 1992 dollars per year)
An Increase in Labor Productivity
8.0
1996
b
6.9
PF96
PF80
4.6
a
1980
The U.S.
production function
2.0
0
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100
175
300
218
Labor (billions of hours per year)
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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
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
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
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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.
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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.
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The Demand for Labor
Real wage
rate
Quantity of
labor demanded
(1992 dollars per hour)
(billions of hours per year)
a
30
150
b
25
200
c
20
250
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Marginal product of labor (1992 dollars per hour)
The Demand for Labor
50
40
a
30
b
25
c
20
10
MP
0
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100 150
200
250
400
500
300
Labor (billions of hours per year)
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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.
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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.
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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.
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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.
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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.
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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.
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Real GDP (trillions of 1992 dollars per year)
The Marginal Product of Labor
and the Demand for Labor
Marginal product
of labor = $20
10
PF
9
+ $2 trillion
7
Marginal product
of labor = $30
+ 100 billion hours
+ $3 trillion
4
+ 100 billion hours
0
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100 150
The marginal product
and the slope of the
production function
200 250 300
400
500
Labor (billions of hours per year)
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The Marginal Product of Labor
and the Demand for Labor
50
The marginal
product curve
40
30
20
10
MP
0
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100
400
150 200 250
300
500
Labor (billions of hours per year)
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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
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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.
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The Supply of Labor
Real wage
rate
(1992 dollars per hour)
Quantity of
labor supplied
(billions of dollars per year)
a
11
150
b
25
200
c
45
250
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(1992 dollars per hour)
Marginal product of labor
The Supply of Labor
LS
50
45
40
30
25
20
10
0
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100
400
150 200 250
300
500
Labor (billions of hours per year)
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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.
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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
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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.
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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.
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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.
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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.
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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.
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Slide 9-‹#›
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
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
The Labor Market and
Potential GDP
50
LS
The labor market
Labor market
equilibrium
25
LD
0
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100
150 200 250
400
300
500
Labor (billions of hours per year)
Slide 9-‹#›
Real GDP (trillions of 1992 dollars per year)
The Labor Market and
Potential GDP
Potential GDP
10
PF
Potential
GDP
8
7
6
4
Full
Employment
2
0
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100 150
200 250
400
500
300
Labor (billions of hours per year)
Slide 9-‹#›
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.
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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.
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Price level (GDP deflator, 1992 = 100)
The Aggregate Supply Curves
Price level rises and
the money wage rate rises
140but the real wage rate is
constant
LAS
SAS
130
120
110
100
90
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
0
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6.0
7.0
8.0
Slide 9-‹#›
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
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
Changes in Potential GDP
Two influences on potential GDP
• An increase in population
• An increase in labor productivity
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Slide 9-‹#›
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.
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Slide 9-‹#›
An Increase in Population
Real wage rate (1992 dollars per hour)
The labor market
50
Effect of
increase in
population
40
LS0
LS1
30
Real wage
rate falls
25
15
Full employment
increases
10
LD
0
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100
200
300
400
500
Labor (billions of hours per year)
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An Increase in Population
Real GDP (trillions of 1992 dollars per year)
Potential GDP
10
PF
9
Potential GDP
increases
7
6
4
2
0
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100
200
300
400
500
Labor (billions of hours per year)
Slide 9-‹#›
Changes in Potential GDP
Two influences on potential GDP
An increase in population
Increases potential GDP and decreases potential
GDP per work hour.
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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
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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.
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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.
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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.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
Real wage rate (1992 dollars per hour)
An Increase in Labor Productivity
The labor market
50
Increase in capital and
advances in technology
increase the demand
for labor . . .
40
35
30
25
LS
Real wage
rate rises
Full employment
increases
LD1
10
LD0
0
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100
200 220 300
400
500
Labor (billions of hours per year)
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Real GDP (trillions of 1992 dollars per year)
An Increase in Labor Productivity
12
Potential GDP
10
PF1
PF0
8
7
… shifts the production
function upward and
increases potential GDP
6
4
2
0
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100
200 220 300
400
500
Labor (billions of hours per year)
Slide 9-‹#›
Real wage rate (1992 dollars per hour)
Full Employment in the United
States: 1984 and 1998
The labor market
LS84
LS98
19
LD98
16
LD84
0
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100
150 185
227 250
300
Labor (billions of hours per year)
Slide 9-‹#›
Full Employment in the United
States: 1984 and 1998
8.0
U.S. production function
in 1984 and 1998
PF98
7.6
PF84
6.0
5.10
4.0
2.0
0
100
150 185
227 250
300
Labor (billions of hours per year)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
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
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
Unemployment at
Full Employment
Why is there always some unemployment?
Two broad reasons:
• Job search
• Job Rationing
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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
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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.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 9-‹#›
Marginal product of labor (1992 dollars per hour)
Job Search Unemployment
50
Job search increases,
and unemployment is
above the natural rate
35
LS
Job search creates
unemployment at
the natural rate
25
Job search decreases,
and unemployment is
below the natural rate
15
LD
0
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100
200
300
400
500
Labor (billions of hours per year)
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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.
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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.
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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.
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Unemployment at
Full Employment
Two reasons why the real wage rate might
be set above the equilibrium level are:
• Efficiency wage
• Minimum wage
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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.
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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.
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The End
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