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Chapter 3

Chapter 3. Productivity, Output, and Employment. Chapter Outline. The Production Function The Demand for Labor The Supply of Labor Labor Market Equilibrium Unemployment Relating Output and Unemployment: Okun’s Law. The Production Function. Factors of production

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Chapter 3

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  1. Chapter 3 Productivity, Output, and Employment

  2. Chapter Outline • The Production Function • The Demand for Labor • The Supply of Labor • Labor Market Equilibrium • Unemployment • Relating Output and Unemployment: Okun’s Law

  3. The Production Function • Factors of production • Output (Y) => real output produced in a given period of time • Capital (K) => the quantity of capital used in the period • Labor (N) => the number of workers employed in the period • A => is a parameter that measures “total factor productivity” – the effectiveness with which capital and labor are used (a number of measuring overall productivity – technology & management) Y=AF(K,N) ____ Production Function

  4. The Production Function 2. The Shape of the Production Function • To graph the production function, one of the two factors of production must be held constant, either capital or labor. (Y vs. one input; hold other input and A fixed) • So, it shows the relationship between output and capital or labor.

  5. The Production Function • Two main properties of production functions • Slopes upward (from left to right): more of any input produces more output • Slope becomes flatter as input rises: diminishing marginal product as input increases- more of any input produces more output but at a decreasing rate.

  6. The Production Function 3. The marginal product • Marginal product of capital: MPK = Y/K • Equal to slope of production function graph (Y vs. K) • MPK always positive • Diminishing marginal productivity of capital – MPK declines as K rises

  7. The Production Function • Marginal product of capital, MPK = Y/K • Equal to slope of production function graph (Y vs. K) • MPK always positive • Diminishing marginal productivity of capital MPK declines as K rises • Marginal product of labor, MPN = Y/N • Equal to slope of production function graph (Y vs. N) • MPN always positive • Diminishing marginal productivity of labor MPN declines as N rises

  8. The Production Function • The production function relating output & labor

  9. The Production Function 4. Supply shocks • Supply shock = productivity shock = a change in an economy’s production function • Supply shocks affect the amount of output that can be produced for a given amount of inputs which may be: • +ve (increasing output- shift the production function upward) raises the Y/K • -ve (decreasing output- - shift the production function downward) reduces the Y/K - slope • Examples: weather, inventions and innovations, government regulations, changes in the supplies of factors of production other than K & N

  10. The Production Function • Supply shocks shift graph of production function • Negative (adverse) shock: Usually slope of production function decreases at each level of input (for example, if shock causes parameter A to decline) • Positive shock: Usually slope of production function increases at each level of output (for example, if parameter A increases)

  11. The Demand for Labor • How much labor do firms want to use? • Assumptions: • Capital stock held constant —short-run analysis (it is for long-lived) • Workers are all alike — homogenous (skills & knowledge) • Labor market is perfectly competitive — wage is determined by the market • Firms maximize profits — how many employees to employ? - Profit-maximizing amount labor => costs = benefits (MR = MC) Costs = cost of an extra worker, is the worker’s wage Benefits = benefits of an extra worker, is the value of the additional goods & services the worker produces Benefits>costs = hiring more labor will the firm's profits

  12. The Demand for Labor • MPN = Y/ N • Measures the benefits of employing an additional worker in terms of extra output produced. • MRPN = p * MPN • Measures the benefits of employing an additional worker in terms of extra revenue produced. (4) Marginal Revenue product of labor, MRPN = MPN * p (when P = 10 per grooming) M P N 110 90 70 50 30 10

  13. The Demand for Labor • In terms of real: • MPN = MRPN /P • w = W/p (W = P * w) • MPN = w • (MR = MC) • In terms of Nominal: • MPN = Y/ N • MRPN = P  MPN • W = nominal wages • MRPN = W (MR = MC)

  14. The Demand for Labor If P = 10 and the wage pay per day is W = 80 @ w = 8 profits costs • In this case the profit-maximizing level of employment at W = 80 is 2 workers > > NOMINAL REAL

  15. The Demand for Labor • The MPN & DL: How much labor do firms want to use? • A change in the wage =>nominal: • Begin at equilibrium where W = MRPN • A rise in the wage rate means WMRPN, unless N is reduced so the MRPN rises • A decline in the wage rate means WMRPN, unless N rises so the MRPN falls • Analysis at the margin: costs and benefits of hiring one extra worker => real: • If real wage (w)  marginal product of labor (MPN), profit rises if number of workers declines • If wMPN, profit rises if number of workers increases • Firms’ profits are highest when w = MPN

  16. Summary

  17. 6. The determination of labor demand The Demand for Labor • Labor demand curve shows relationship between the real wage rate (w) & the quantity of labor demanded (It is identical to the MPN curve, as w = MPN at equilibrium) • So the labor demand curve is downward sloping (-ve); showing that the quantity of labor demanded falls as the real wage rises N*= w*@ MPN = w @ highest profits Point A determined the quantity of labor demanded

  18. The Demand for Labor • The MPN & ND curve: • If at employment level less than N*, the MPN curve exceeds the curve of real wage (MPN > w) –so firm can increase its profit by expanding the amount of labor it uses. • If at employment level greater than N*, the MPN curve less than the curve of real wage (MPN < w) –so firm can increase its profit by reducing the amount of labor it uses. • w = N* => MPN intersects real wage (w), where firm will be satisfied

  19. The Demand for Labor 7. Factors that shift the labor demand curve • Note that a change in the real wage causes a movement along the labor demand curve, not a shift of the curve. • The labor demand curve shifts in response to factors that change the amount of labor that firms want to employ at any given level of the real wage. • Supply shocks: Beneficial supply shock raises MPN, so shifts labor demand curve to the right; increase the amount of labor that firms want to employ at any given level of the real wage. Opposite for adverse supply shock • Size of capital stock: Higher capital stock raises MPN, so shifts labor demand curve to the right; opposite for lower capital stock

  20. The Demand for Labor

  21. The Demand for Labor 8. Aggregate labor demand • Aggregate labor demand is the sum of all firms’ labor demand in an economy. • As the aggregate demand for labor is the sum of firms’ labor demand, the same factors determine the aggregate demand for labor. e.g supply shocks, size of capital stock

  22. The Supply of Labor 9. Supply of labor is determined by individuals • Aggregate supply of labor is the sum of individuals’ labor supply • Labor supply of individuals depends on income – leisure choice =>Leisure; for all off-the-job activities (sleeping, eating, spending time with family and friends) • Need to compare costs and benefits of working another day • Costs: Loss of leisure time • Benefits: More consumption, since income is higher • If benefits of working another day exceed costs, work another day • Keep working additional days until benefits equal costs

  23. The Supply of Labor • Real wages and labor supply • Real wage is the income receives in exchange for giving up a unit of leisure for work. • Substitution effect: Higher real wage encourages work, since reward for working is higher • Income effect: Higher real wage increases income for same amount of work time, so person can afford more leisure, so will supply less labor • Note that the substitution and income effects of higher real wage operate in opposite directions: the substitution effect tending to raise the quantity of labor supplied & the income effect tending to reduce it

  24. The Supply of Labor • Real wages and labor supply • A pure substitution effect: a one-day rise in the real wage • A temporary real wage increase has just a pure substitution effect, since the effect on wealth is negligible • A pure income effect: winning the lottery • Winning the lottery doesn’t have a substitution effect, because it doesn’t affect the reward for working • But winning the lottery makes a person wealthier, so a person will both consume more goods and take more leisure; this is a pure income effect

  25. The Supply of Labor • The substitution effect&the income effect together: a long-term increase in the real wage: • The reward for working is greater: a substitution effect toward more work • But, with higher wage, a person doesn’t need to work as much: an income effect toward less work • Which effect wins? Based on the length of time that the expected new higher wage to last: • If the high wage is expected to not last very long, the income effect is weak (substitution effect become greater) thus labor supply will increase • The longer the high wage is expected to last, the stronger the income effect; to reduce the amount of time that he works.

  26. The Supply of Labor • Empirical evidence on real wages and labor supply: A summary • Labor supply increases with a temporary rise in the real wage – confirmed the substitution effect: if reward for working rises for a short period, people will take advantage of the opportunity to work more. • Labor supply falls with a permanent increase in the real wage – confirmed the income effect: if permanently higher wages make workers much better off, they will choose to work less, where income effect outweighs the substitution effect

  27. The Supply of Labor 10. The labor supply curve: Individually curve • Increase in the current real wage should raise quantity of labor supplied • Labor supply curve slopes upward because higher wage encourages people to work more • Labor supply curve relates quantity of labor supplied to real wage

  28. The Supply of Labor • Factors that shift the labor supply curve • Wealth:Higher wealth reduces labor supply (shifts labor supply curve to the left) • Expected future real wage:Higher expected future real wage is like an increase in wealth, so reduces labor supply (shifts labor supply curve to the left)

  29. The Supply of Labor 11. Aggregate labor supply • is the total amount of labor supplied by everyone in the economy. • Aggregate labor supply rises when current real wage rises: • Some people work more hours & Other people enter labor force • Result: Aggregate labor supply curve slopes upward • Factors increasing labor supply (shifts NS to the right) • Decrease in wealth • Decrease in expected future real wage • Increase in working-age population (higher birth rate, immigration) • Increase in labor force participation (increased female labor participation, elimination of mandatory retirement)

  30. The Supply of Labor Summary 4

  31. Labor Market Equilibrium 12. The Equilibrium of Labor Market • Equilibrium : Labor supply equals labor demand • The aggregate quantity of labor demanded = the aggregate quantity of labor supplied • The intersection of ND = NS

  32. Labor Market Equilibrium • Classical model of the labor market—real wage adjusts quickly to equate NS & ND • Full-employment level of employment, N and market-clearing real wage, w are determined after the complete adjustment of wages & prices. • Problem with classical model: can’t study unemployment, 0 unemployment, which never occurs (assuming that any worker who wants to work at the equilibrium real wage can find a job.)

  33. Effects of a temporary adverse supply shock on the labor market Labor Market Equilibrium

  34. Labor Market Equilibrium 13. Full-Employment Output • The combination of labor market equilibrium &production function, determine how much output firms want to supply. • Full-employment output = also known as potential output = level output that firms in the economy supply when wages& prices have fully adjusted = level of output when labor market is in equilibrium (aggregate employment = its full-employment output)

  35. Labor Market Equilibrium • Full-employment output, Y, can be defined using the production function as follows: • Y = full employment output • N = full employment level • K = constant capital stock • Thus, Y is determined by 2 factors: • N • The production function relating output to employment

  36. Labor Market Equilibrium • For example: supply shock that has negative impacts • It will lower the output directly - reducing the quantity of • output with any fixed amounts of capital and labor that • leads to reduce in the productivity measures. • It will reduces the demand for labor – leads to lowers the • full employment level of employment, N and decrease the • full-employment output Y

  37. Unemployment • Labor market in equilibrium = all workers are wiling to work at the • prevailing labor wage are able to find • jobs • But not everyone who would like to work has a job – brings to an • unemployment. • Measuring unemployment ( Each person over age 16): • Employed - the person work full-time @ part-time Unemployed - the person didn’t work but looked for job • Not in the labor force - the person didn’t work & didn’t looked for job • Labor Force = Employed + Unemployed • Unemployment Rate = Unemployed/Labor Force • Participation Rate = Labor Force/Adult Population • Employment Ratio = Employed/Adult Population

  38. Unemployment • Changes in employment status • Flows between categories • Discouraged workers: people who have become so discouraged by lack of success at finding a job that they stop searching

  39. Unemployment How long are people unemployed? • Unemployment spell = period of time an individual is continuously unemployed • Duration = length of time that an unemployment spell lasts • Most unemployment spells are of short duration • Most unemployed people on a given date are experiencing unemployment spells of long duration

  40. Unemployment • Why there are always unemployed people • There are two types of unemployment: frictional & structure that prevent the unemployment rate from ever reaching zero • Frictional unemployment: • Search activity of firms and workers due to heterogeneity • Matching process takes time • This reflects the unidentical feature between firms and workers. • Jobs continually creating & destroyed while workers continually entering & exiting labor force

  41. Unemployment • Structural unemployment: • Structural unemployment: the long-term and chronic unemployment that exists even when the economy is not in a recession but due to the change in the economy structure, i.e. movement from agriculture sector to the industry sector. • Chronically unemployed: workers who are unemployed a large part of the time • One cause: Lack of skills prevents some workers from finding long-term employment • Another cause: Reallocation of workers out of shrinking industries or depressed regions; matching takes a long time

  42. Unemployment • However, the existence of frictional & structural unemployment brings to the natural rate of unemployment ( ), which range 4% to 5% • natural rate of unemployment (NRU) = when output and employment are at full-employment levels, owing to frictional + structural causes • Cyclical unemployment: difference between actual unemployment rate (ARU), u, and natural rate of unemployment (NRU), u. => +ve when output and employment below full-employment levels -ve when output and employment exceed full-employment levels

  43. Okun’s law • When employment falls and unemployment rises, (the reduction in the number of people working) leads to a decline in the quantity of goods and services produced. • The quantitative impact on aggregate output change in the unemployment rate described by Okun’s law • Based on the Okun’s law, the gap between an economy’s full employment output and its actual level of outputincreases by 2 percentage points for each percentage point the unemployment rate increases;can be expressed as follows: • the percentage gap between potential & actual output = 2 times the cyclical unemployment rate

  44. Relating Output and Unemployment: Okun’s Law • Why is the Okun’s Law coefficient 2, and not 1? • 1 percentage point increase in unemployment rate @ 1%, leads to reduce in output that is about twice as large in percentage terms becauseincrease in cyclical unemployment will also lead to decrease other factors that determine output(e.g. number of people in labor force, the number of hours each worker works per week, the average productivity of labor) – magnifying the effect of increase in unemployment. • Other things happen when cyclical unemployment rises: Labor force falls, hours of work per worker decline, average productivity of labor declines • Result is 2% reduction in output associated with 1 percentage point increase in unemployment rate

  45. Relating Output and Unemployment: Okun’s Law • Okun’s law can be also demonstrated as follows: using an average growth rate of full-employment output at 3%: Y/Y = 3 – 2 u • Y/Y = percentage growth rate of output • u = change in the actual unemployment rate from one year to the next

  46. Figure 3.15 Okun’s Law in the United States: 1951-2005 • Okun’s law = OL line • -2 is the slope – 1% increase in the unemployment is associated with a 2% drop in output • 3 is the intercept – if no change occurs in the unemployment, the growth rate of actual output is 3%

  47. The end

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