Chapter 7: Classical Economics

1. Chapter 7: Classical Economics The Economy at Full Employment

2. Issues in 2006 for the Midterm Elections How does increased immigration affect wages and the level of output in the economy? What are the benefits of increased investment? What happens to wages, jobs, GDP if employers must pay higher taxes for hiring labor? If our government spends more, does this mean we must have a lower level of consumption or investment in the economy?

3. Classical Economics • A school of thought that provides insights into the economy when it operates at or near full employment.

4. Supply-Siders • Economists / politicians who emphasize the role of taxation for influencing economic activity. • Favored by the Republican Party

5. New School: Real Business Cycle Theory • Tries to explain why there are booms and busts in the economy.

6. REMEMBER! • With the classical model, wages and prices are assumed to adjust freely and quickly according to the laws of supply and demand. • No Keynsian price controls

7. KISS: What determines output? • Stock of Capital (K) • The total of all machines, equipment and buildings in the economy. • Labor (L) • The total effort of all employed workers in an economy • Y = F(K,L) • Y = Income = GDP

8. Y = F (K,L) • Aggregate Production Function: How much output is produced from the inputs of capital or labor. • More inputs of either leads to increased output. • Could this be a factor in the immigration battles?

9. Aggregate Production Function • In most situations we assume capital is fixed at a constant level! • LABOR is the only variation that changes the level of output in the economy!

10. SO: What is the relationship between labor and Output? • If capital is fixed? • Increases at a decreasing rate. • WHY? • See page 133 for graph 7.1

11. Principle of Diminishing Returns • Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed. • Beyond some point – called the point of diminishing returns – output will increase at a decreasing rate. • See pgs. 133 - 135

12. Short-Run Production Function • Show how much output is produced when capital stock is constant and labor varies.

13. The Demand and Supply of Labor • Firms hiring depends on the REAL WAGE. • The wage paid to workers adjusted for changes in prices. • What determines the REAL WAGE?

14. The Marginal Principle determines the Real Wage • Marginal Benefit > Marginal Cost • Increase level of activity • Marginal Cost > Marginal Benefit • Reduce activity • Marginal Cost = Marginal Benefit • IDEAL!

15. Huh!? • Marginal Benefit: Benefit a firm receives from hiring an additional worker is the VALUE of the EXTRA OUTPUT from the hiring.

16. Huh?! • Marginal Cost: Is the REAL WAGE a firm pays to hire the additional worker • See page 135 for wage scenario.

17. Here’s the Payoff • If real wages fall, then MB > MC and more people can get employed. • Is that why some politicians / employers favor undocumented workers?

18. Changes in Real Wages Affect Workers Two Ways: • SITUATION: Workers have to decide how many hours they want to work and how much leisure time they want.

19. #1 Way: Increasing Real Wages • Make working more attractive and raise the opportunity costs of NOT working. • SUBSTITUTION EFFECT: Substitution of work for leisure time.

20. #2 Way: Raising Real Wages • Higher wage raises workers income for the same hours worked. Workers may choose more leisure over work. • INCOME EFFECT: Leads to decreased supply of labor.

21. Substitution Effect v. Income Effect • Do NOT work together. • See pages 136 – 137 scenarios.

22. Capital Stock Changes? • Marginal Benefit for hiring workers increases. • Workers are becoming more productive with the additional capital.

23. Labor Market Equilibrium and Full Employment • Read scenario pg. 138 - 139

24. SO: Y = F (K,L) Potential output increases as the supply of labor increases or the stock of capital increases. Liberal immigration plans will shift the labor curve RIGHT and lead to higher level of employment. OUTPUT increases. Investors are happy Voters are happy

25. Make sure to read VARIATIONS IN LABOR SUPPLY Page 140.

26. Other Names in Classical Economics • Jean Baptiste Say, David Ricardo, John Stuart Mill, Thomas Malthus, etc. • ACTUALLY a term created by Keynes to contrast his theory from “theirs.” • Theories from 18th– early 20th Century.

27. Say’s Law • The doctrine that states that supply creates its own demand. • Demand would always be sufficient to purchase the goods and services produced.

28. Questions to ponder: • Why would Say’s Law appeal to classical economists? • Could you give an example of Say’s Law? • Why would Say’s Law apply to the labor situation in the US? • Would you agree or disagree with the statement that “undocumented workers do the jobs Americans don’t want to do.”

29. Role of Taxes in Classical Economics • What do you think Republicans / Classical Economists think about taxes? • Taxes only to cover infrastructure (small) • More independence for individuals / businesses • Trickle-down taxes • Regressive taxing not progressive. • Reason? • MC>MB = less jobs

30. Can a tax cut create more government revenue? • Economist Arthur Laffer said YES! • KEEP IN MIND! Laffer’s example was with net exports and tariffs. • Politicians applied it to income taxes / payroll taxes!

31. Laffer’s Curve • IF government RAISES the tariff taxes on imports – they will actually collect LESS tax, because no one can afford the goods. • Inverse relationship

32. Laffer’s Curve and Capital Gains Taxes • Capital Gains: Profit you get from selling a stock at a higher price than you bought it at. • Since the tax on capital gains is too high, people don’t sell their stock – bringing down Y and decreasing govt. revenue.

33. Laffer’s Curve and Capital Gains Taxes • Some politicians say lowering – or removing – the capital gains tax would increase Y and maybe other ways to tax people since they will have more jobs.

34. Real Business Cycle Theory • What causes fluctuations in economic activity? • Natural disasters • Shifts in technology • Small shocks at the same time

35. Real Business Cycle Theory • Theory that emphasizes how shocks to technology an cause fluctuations in economic activity.

36. Examples of Real Business Cycle Theory • Changes in technology will change the level of full employment or potential output. • Adverse developments will cause shocks that cause output and employment to fall.

37. Real Business Cycle School of Thought • Very influential • Very controversial • Doesn’t explain some historical situations. • Makes the assumption that labor is always at equilibrium between demand and supply.

38. Proponents of Real Business Cycle Theory • Other models handle unemployment. • So far, it hasn’t made it into the macro policy circles. • BUT it is an area of active research in classical economics.

39. Division of Output Among Competing Demands • Y = f(L,K) • In a full employment economy, total GDP is determined by the factors of production (K).

40. Division of Output Among Competing Demands • Full-employment must be divided up between C, I , G, X-M • OR C + I + G + NX • Governments – for whatever reasons – increase government spending.

41. Division of Output Among Competing Demands • Government spending might affect other types of expenditures (C, I, X-M) • CROWDING OUT.

42. Crowding Out (See pg. 145) • NOTE: US Consumes 67% of its GDP and invests a smaller portion than Germany or Japan. • Is it due to savings rates cutting into consumption? • Is it due to higher payroll taxes cutting into Consumption?

43. Closed Economy: GDP = C+I+G+X • Closed Economy: No international trade. • Increasing government spending comes at the expense of other uses of GDP. • Higher taxes means less money to spend. • Crowding out

44. Crowding Out in an Open Economy: GDP = C+I+G+X-M • An economy with international trade. • Government spending does not need to crowd out either C or I • What does get crowded out? • Net exports

45. Crowding In? • IF output (GDP) is fixed: • Decreases in Govt. spending means other aspects of C, I, X-M are going to “crowd in” • Net exports could increase.

46. Crowding In in a Closed Economy • C or I will increase if G decreases. • BUT inflationary pressures will be on. • There is no “leakage” for the excess money.