Syllabus

Lecutres

Outlines

Assignments

Analyze factors that affect the economy's long-term performance
Develop a model of the economy
1. Three markets
a. Labor market (chapter 3)
b. Goods market (closed economy) (chapter 4)
c. Goods market (open economy) (chapter 5)
d. Long-run economic growth (chapter 6)
e. Asset market (chapter 7)

Chapter 3: Productivity, Output, and Employment

GOALS
o Analyze the determinants of the economy's production capacity
o Analyze the labor market and determinants of demand for/supply of labor
o Analyze the long-run view of the economy
o Define unemployment status and nature
o Introduce the Okun's law

How much does the economy produce?
Depends on two sets of factors:

I. Amount of Factors of Production
1. K: Physical Capital
2. N: Labor (# of workers)
4. R: Natural Resources)

II. Effective use of these factors (Total factor productivity, A);
Depends on technology and management skills.

The Production Function
1. Shows the economy's production capacity, given its factors of production and its total factor productivity
Y = A * F(K, N),
2. Production function for the U.S.:
Y = A K0.3 N0.7
3. Observable: Y, K, N;
Unobservable: A, is computed as
A = Y/ K0.3 N0.7

Data for the U.S. economy
Year Y K N A Growth in A
1980 4615 5032 99.3 14.31
1985 5324 5876 107.2 14.94 4.4
1990 6136 6650 118.8 15.44 3.4
1995 6762 7278 124.9 15.99 3.6
1997 7270 7734 129.6 16.45 2.8

Growth in total factor productivity
a. Is not constant, has changed sharply from year-to-year
b. It slowed down in the 1980s

The shape of the production function
Graph of production function:
Y vs. one input, holding other inputs and A fixed
Two main properties
o Slopes upward: more of any input produces more output
o Slope flatter as input rises: diminishing marginal product

Marginal product of labor
o MPN = Y/ N
o Equals the slope of the production function in (Y,N) diagram
o Is always positive but diminishes as N increases

The demand for labor
How much labor do firms want to hire?
Assumptions
o Capital stock is fixed at its optimum level
o Total factor productivity is given
o Workers are all alike
o Labor market is competitive (firms are wage takers)
o Firms maximize profits

Marginal Analysis: costs and benefits of one extra hiring
If real wage (w) > MPN, the marginal cost of last worker is more than its benefit. Firms reduce employment to increase profits.
o If real wage (w) < MPN, the opposite holds.
o Firms' profits are maximized when w = MPN.

The marginal product of labor and labor demand
o Labor demand curve: is the relation between real wages and quantity of labor demanded;
o Is the same as MPN curve, since at equilibrium, w = MPN;
o Is downward sloping; firms want to hire less labor, the higher the real wage.

Factors that shift the labor demand
Supply Shocks: Events that affect the economy's production through A.
o Can be positive (+ Y) or negative (- Y)
o Rotates the graph of production function
" Negative shocks: reduce the slope
" Positive shocks: increase the slope
o Affect marginal productivity of labor (weather, inventions, regulations, oil prices)

Capital stock: larger capital stock raises MPN, shift it to the right; opposite for smaller stock.

Aggregate labor demand
1. Sum of all firms' labor demand
2. Same factors that shift firm labor demand curve also shift market labor demand curve

The labor supply
o Supply of labor is determined by individual workers
o A worker's labor supply is the outcome of his/her labor-leisure choice
o Real wage (w) is the opportunity cost of leisure. As w rises, a worker allocates more hours to work and less hours to leisure

The labor supply curve
o Labor supply curve relates the quantity of labor supplied to real wage
o Is positively sloped; higher real wages encourage people to work more

Factors that shift the labor supply curve
o Wealth: Higher wealth reduces labor supply (shifts left)
o Expected real wage: higher expected real wage acts like an increase in wealth -- reduces labor supply.

Aggregate labor supply curve
Positively sloped; rises with a rise in current real wage,
a. Some people work more hours
b. Other people enter labor force

Factors that increase aggregate labor supply
o Decrease in wealth
o Decrease in expected future real wage
o Increase in working-age population (immigration, higher past birth rates)
o Increase in labor-force participation (female participation, elimination of early retirement

Labor market equilibrium
o Equilibrium: quantity of labor demanded equals quantity supplied
o Classical model: Assumes flexible real wages which adjust quickly to bring labor market to equilibrium.
o Outcome: equilibrium employment (N*) and real wage (w*)
o Shifts in labor demand/supply affect N* and w*

Full-employment output
" Is the level of output associated with equilibrium in labor market
" Can be represented as: Y* = A F(K, N*)
" Y* changes when there is a change in N*, K, or A

Real business cycle theory
z According to this theory, the primary cause of fluctuations in real output (recessions and booms) is exogenous supply shocks, which are outside of our control.
z These shocks affect Y through changes in total factor productivity (A)

Application: output, employment, and real wage during oil price shocks
o Sharp oil price increases in 1973-74, 1979-80, and 1990
o An example of adverse supply shocks; causes lower labor demand, employment, real wage, and full-employment level of output.

Application: technical change and wage inequality
1. Two features of U.S. labor market since 1970
a. Slowdown in growth of real wage
b. Increase in skilled/unskilled wage inequality
2. Causes of slowdown in wage growth
a. Increase in female labor force participation
b. Slowdown in labor productivity
3. Causes of wage inequality
Skill-based technical change (computerization) increased real wages of highly educated workers, but reduced real wages of unskilled workers

Unemployment
A. Measuring unemployment
o Categories: employed, unemployed, not in labor force
o Labor force = employed + unemployed
o U-rate = unemployed/labor force
o Participation rate = labor force/adult pop. Employment ratio = employed/adult pop.

Why are people unemployed?
o Frictional unemployment
y Due to search activity of firms and workers due to heterogeneity of workers
y Matching process takes time

o Structural unemployment
y Long-term, chronic unemployment
y Lack of skills prevents long-term employment
y Relocation of workers from depressed regions takes time

o Cyclical unemployment
y Short-term, due to business cycles (recessions)

The natural rate of unemployment (u*)
u* = the rate of unemployment consistent with equilibrium in labor market, and full-employment level of output,
o u* = frictional + structural unemployment
o Cyclical unemployment: actual minus natural rate of unemployment, (u-u*)

Okun's Law: Relating output and employment
o Relates cyclical output (Y-Y*)/Y* to cyclical unemployment rate (u - u*)
o Finds that (Y-Y*)/Y* = - 2.5 (u-u*)
o Every 1% rise in cyclical unemployment rate is associated with 2.5% fall in actual output below its full-employment level.
o Why coefficient 2.5, and not 1?
Other things happen when cyclical unemployment rises: labor force, hours of work per worker, and average labor productivity all fall.