CHAPTER

1. 7 THE ECONOMY AT FULL EMPLOYMENT CHAPTER

2. 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

3. 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

4. Production and Jobs • In 2001, each hour of work produced twice as much output as in 1961. 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?

5. 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.

6. Real GDP and Employment • 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.

7. Real GDP and Employment • 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.

8. Real GDP and Employment • 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.

9. Real GDP and Employment • 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.

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

11. Real GDP and Employment • 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.

12. Real GDP and Employment • 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.

13. Real GDP and Employment • Figure 7.2(a) illustrates an increase in labor productivity. The production function shifts upward from PF0 to PF1.

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

15. 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.

16. The Labor Market and Aggregate Supply • 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.

17. The Labor Market and Aggregate Supply • 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.

18. The Labor Market and Aggregate Supply • We calculate the marginal product of labor as the change in real GDP divided by the change in the quantity of labor employed.

19. The Labor Market and Aggregate Supply • 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.

20. The Labor Market and Aggregate Supply • 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.

21. The Labor Market and Aggregate Supply • 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.

22. The Labor Market and Aggregate Supply • 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.

23. The Labor Market and Aggregate Supply • 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.

24. The Labor Market and Aggregate Supply • 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.

25. The Labor Market and Aggregate Supply • Figure 7.5 illustrates a labor supply curve. • The higher the real wage rate, the greater is the quantity of labor supplied.

26. The Labor Market and Aggregate Supply • The quantity of labor supplied increases as the real wage rate increases for two reasons: • Hours per person increase • Labor force participation increases

27. The Labor Market and Aggregate Supply • 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.

28. The Labor Market and Aggregate Supply • 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.

29. The Labor Market and Aggregate Supply • 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.

30. The Labor Market and Aggregate Supply • 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.

31. The Labor Market and Aggregate Supply • At a full employment level of 200 billion hours, potential GDP is 10 trillion dollars.

32. The Labor Market and Aggregate Supply • Aggregate Supply • 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.

33. The Labor Market and Aggregate Supply • Figure 7.7 illustrates the long-run and short-run aggregate supply curves (LAS and SAS). • LAS is a vertical line at potential GDP.

34. The Labor Market and Aggregate Supply • 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.

35. The Labor Market and Aggregate Supply • 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.

36. The Labor Market and Aggregate Supply • 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.

37. The Labor Market and Aggregate Supply • 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.

38. The Labor Market and Aggregate Supply • 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.

39. 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

40. Changes in Potential GDP • 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.

41. Changes in Potential GDP • Figure 7.8 illustrates these effects. • The labor supply curve shifts rightward. • The real wage rate falls. • The equilibrium quantity of labor increases.

42. Changes in Potential GDP • 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.

43. Changes in Potential GDP • 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.

44. Changes in Potential GDP • Figure 7.9(a) illustrates these effects in the labor market.

45. Changes in Potential GDP • 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.

46. Changes in 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.

47. Changes in Potential GDP • 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.

48. Changes in Potential GDP • 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.

49. Changes in Potential GDP • 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.

50. Changes in Potential GDP • Potential GDP increased from $5 trillion a year to $9.3 trillion a year.