I. Introduction
A. Objectives
1.Explain why productivity and real GDP grow
2. Explain how firms decide on how much labor to employ
3. Explain how households decide on how much labor to supply
4. Explain how wages, employment and unemployment are determined if wages are flexible.
5. Explain how wages, employment and unemployment are determined if wages are "sticky".
6. Derive the short run and long run aggregate supply curves.
7. Explain what makes aggregate supply and unemployment fluctuate.
B. Topics to be covered
1. Productivity and income growth
2. The demand for labor
3. The supply of labor
4. Aggregate supply and the labor market with flexible wages.
5. Aggregate supply and the labor market with sticky wages.
6. Unemployment
II. Productivity and Income Growth
A. Labor productivity equals total output per employed worker.
B. Labor productivity can be explained using the concept of a production function,
1. A production function shows how output changes as the use of inputs change.
a. It is a functional relationship between inputs and outputs
Q = f ( Labor, Capital, Land etc)
b. If we hold capital and land constant, then a production function (Total Product of Labor function) is the relationship between the total amount of labor input and the resulting output.
Q = f (Labor)
2. A short-run production function (TPL function) shows how output changes when the labor input is changed while holding constant:
a. the amount of capital, land and
b. the level of technology.
3. The short-run aggregate production function shows how real GDP (Y) changes when total employment changes, holding constant
a. the capital stock (K) and
b. the level of technology.
Y = f (Employment)
c. SR Aggregate Production Function can be illustrated by:
i. an equation
ii. a schedule
iii. a graph
d. An example
Labor Real GDP (TPL)
0 0
10 100
20 180
30 240
40 280
50 300
e. shape of the curve
i. Positively sloped
ii. Increasing at a decreasing rate
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A. The marginal product of labor (MPL) is the additional real GDP (Y) produced by an additional worker;
MPL = DELTA GDP / DELTA LABOR
1. The marginal product of labor (MPL) equals the slope of the production function.
a. An example (BETWEEN POINTS ON AG. PROD FN)
Labor Real GDP (TPL) MP of LABOR
0 0
100/10 = 10
10 100
80/10 = 8
20 180
60/10 = 6
30 240
40/10 = 4
40 280
20/10 = 2
50 300
B. Holding other inputs constant, as more workers are employed the marginal product of labor declines.
1. This reflects diminishing marginal product of labor.
C. The diminishing marginal product of labor is the tendency for the marginal product of labor to decline as the labor input increases, holding everything else constant.
1. Diminishing returns are due to the fact that average capital and land per worker declines as the number of workers increases.
a. K/L declines ,
i. bottlenecks
ii. less repair time
b. Land/Labor declines
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A. Over time, the aggregate production function (TPL function) shifts upward
1.--so that more output can be obtained from the same level of labor input
2. This happens--as a result of:
a. capital accumulation and
b. (land brought under cultivation)
c. technological advances.
3. Means that at every level of labor input - output is higher
a. An example:
Labor Real GDP (TPL) NEW TPL
0 0 0
10 100 120
20 180 210
30 240 290
40 280 360
50 300 420
4. Capital accumulation does not proceed at a constant pace
I / K is not constant
(fluctuations in I)
B. Technological advances involve invention and innovation
1. Invention is the discovery of a new productive technique;
2. innovation is putting the new technique to work.
C. Invention and innovation do not proceed at an even pace,
1. Invention can be rapid
2. Innovation takes time
3. Innovation often must be embodied in new capital goods
a. Requires Investment. (Low I = slow innovation)
D. Aggregate production can shift down due to negative shocks
1. Bad weather (floods and droughts)
2. OPEC oil embargo on exports
E. So the production function shifts at an uneven pace, that is,
1. economic growth occurs irregularly.
F. A major macroeconomic problem of the US is the slow growth of labor productivity.
1. Partly explained by OPEC oil shock.
a. High oil prices made much of US energy- inefficient capital obsolete and uneconomic to use.
b. Equivalent to massive destruction of parts of US capital stock.
2. Partly explained by shift of the industrial composition of US labor
a. away from high productivity growth agriculture to
b. low productivity growth services.
3. Partly explained by low rates of Saving and Investment in the US.
III. The Demand for Labor
A. The aggregate quantity of labor demanded (AQDL) is the "number of labor hours hired by all the firms in an economy;"
1. It is a variable
B. The demand for labor is a functional relationship showing the "aggregate quantity of labor demanded at each real wage rate (w) ."
AQDL = f (w)
1. It is a functional relationship
2. It can be illustrated by:
a. An equation
b. A schedule
c. a graph
C. The real wage rate (W) is the wage per hour expressed in constant monetary units (e.g. dollars or dong) while
D. The money wage rate or "the nominal wage rate" (WM) is the wage per hour expressed in current monetary units (e.g. dollars or dong).
E. The real wage equals the money the money wage divided by the price level.
W = WM / P
W = (WM / GDP Deflator) * 100
Example
WM GDP Deflator WR
10 50 20
10 100 10
10 200 5
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A. The quantity demanded of labor is an inverse function of the real wage rate (WR).
B. A firm will hire as long as MVP is greater than money wage
MVP = MPP * P (product) > MW
Example
Workers MPP P(product) MVP Money Wage
1 10 3 30 12
2 8 3 24 12
3 6 3 18 12
4 4 3 12 12
5 2 3 6 12
Divide through by Price of product
MPP = MW / Price (product)
At the macro level
MPP (labor) = MW / GDP Deflator * 100 = Real Wage
C. The aggregate quantity of labor demanded (AQLD) depends on the real wage rate (WR)
AQLD = f (W)
a. not the money wage rate (WM).
(If all wages and prices double, no change in real wage or the quantity of labor demanded)
D. The demand for labor curve is negatively sloped, indicating that
a. as more workers are employed,
b. the firm is willing to pay each added worker less.
c. This occurs because as more workers are hired
i. each additional worker produces less
ii. due to diminishing marginal product.
E. A change in the real wage (WR) causes a movement along the labor demand curve.
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A. When the marginal product of each hour changes, the labor demand curve shifts.
Workers MPP NEW MPP
1 10 15
2 8 13
3 6 11
4 4 9
5 2 7
B. The shift in the labor demand curve can be due, to:
a. a change in the capital stock or
b. a change in technology--
C. At every level of the real wage, more labor will be hired.
IV. The Supply of Labor
A. The aggregate quantity of labor supplied (AQLS) is the "number of hours of labor services the households supply to firms;"
1. The aggregate quantity of labor supplied (AQLS) is a variable.
B. The supply of labor is the "aggregate quantity of labor supplied (AQLS) at each real wage rate (W)."
AQLS = f (W)
1. The supply of labor curve is a positive function of the real wage rate (W).
2. The supply of labor can be illustrated by:
a. An equation
b. A schedule
c. a graph
C. A change in the real wage (W) will cause a change in the aggregate quantity of labor supplied for in two ways:
1. The hours per worker (per week) change and
2. The labor force participation rate (LFPR) changes.
3. For both reasons the supply of labor increases when the wage increases.
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A. An increase in the wage, changes the hours per worker (per week) via two opposing effects:
1. a substitution effect and
2. an income effect.
B. The substitution effect of an increase in the real wage rate raises the opportunity cost of not working.
1. This motivates workers to increase their supply of labor as their wage rate increase.
C. The income effect notes that a higher wage raises the worker's income.
1. The worker wants to buy more of all normal goods such as leisure, that is, time not spent at work.
2. Thus the income effect encourages workers to supply less labor when their wage rate increases.
D. On balance, the substitution effect is larger than the income effect, so:
1. higher wage rates cause more hours of work to be supplied.
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A. The labor force participation rate is the fraction of the population in the labor force,
a. either employed or
b. seeking work.
B. People have a reservation wage, the lowest wage at which they will supply labor.
a. An increase in the wage rate implies that more people's reservation wages are exceeded,
b. so the labor force participation rate (LFPR) increases.
C. Reservation wage depends on costs of working.
a. loss of leisure
b. loss of home production
c. costs of transportation to work
d. costs of food and clothing at work
D. e.g. if reservation wage is $3.00 per hour the individual will not join the labor force if standard wage is $2.00.
a. Two opposing theories about how labor markets work.
1. The flexible wage theory
2. The sticky wage theory
b. The flexible wage theory assumes that labor markets work like other markets and
1. quickly move to equilibrium.
c. The sticky wage theory assumes that wage contracts fix the money wage rates for long periods of time
1. preventing a move to the equilibrium wage.
V. Aggregate Supply and the Labor Market With Flexible Wages
A. The flexible wage theory assumes that the real wage moves so that the labor market remains in equilibrium
1. with the quantity of labor demanded (QLD) equal to the quantity supplied. (QLS)
QLD = QLS
a. This is illustrated to the right, where the level of employment is L.
2. This theory assumes that money wages are flexible enough so that the labor market remains in equilibrium.
3. Although many people have contracts that fix their money wage,
a. flexibility in the money wage is achieved by:
a. Increased pay for overtime work (in US it is 150%)
b. Varying size of occasional bonuses
c. Speeding up or slowing down promotions
4. Result is that the real wage is always at the equilibrium level.
a. If excess supply of labor, real wage falls
b. If excess demand for labor, real wage rises
B. Shifts in either the labor demand or labor supply curves change the real wage rate and level of employment.
1. Over time, the Supply of Labor has increased due to population growth.
2. Over time, the Demand for Labor has increased due to capital accumulation and technological change
3. In most countries, both quantity of labor employed and real wage have risen.
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A. The flexible wage theory of the labor market implies that the aggregate supply curve is vertical;
1. that is, the quantity of real GDP (Y) supplied is independent of the price level (P).
GDP is not f (P)
2. If the price level (P), rises
a. The flexible wage theory assumes that the money wage rate (WM) rises by the same proportion.
b. Hence the real wage (W) is constant.
W is not a f (P)
2. Since the real wage (W) is constant, neither the quantity supplied (AQLS) nor the quantity of labor demanded changes (AQLD).
a. Hence the quantity of employment is unchanged.
3. Because the level of employment does not change, the aggregate production function shows that output supplied is unchanged.
GDP is constant
4. Thus the amount of real GDP (Y) supplied does not change with the price level (P).
D. Shifts in either the supply of labor, or the demand for labor, change the level of employment.
1. Thus these change the amount of output produced ; that is, shift the aggregate supply curve.
2. Increase in Supply of Labor increases GDP
a. e.g. . Due to population growth
3. Increase in Demand for Labor increases GDP
a. e.g. due to technological advance
4. Increase in Price Level does not change GDP
a. Economy is always on its LRAS. (vertical)
VI. Aggregate Supply and the Labor Market With Sticky Wages
A. Most economists believe that wages are not flexible enough to guarantee:
1. equality between the quantity of labor supplied and the quantity demanded.
QLD = QLS
B. In the sticky wage theory of labor markets,
1. firms and workers set a money wage that is expected to result in a real wage where
2. the quantity of labor supplied equals the quantity demanded.
C. This depends on the expected price level (P).
D. Once set the money wage does not immediately change to restore the real wage to its market clearing value.
W = WM / P and WM is fixed so..........
W = f (P)
E. The actual real wage depends on the actual price level (P).
1. If the actual price level (P) exceeds what was expected (EP),
a. the actual real wage (W) is less than what was expected (EW),
If P > EP
then
W < EW
2. The real wage is more than was expected if the actual price level is lower than what was expected.
W > EW
if
P < EP
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A. Sticky wage theory assumes that the level of employment is determined by firms' demand for labor;
1. households supply whatever amount of employment is demanded.
2. If boss wants you to work overtime, you will do it.
a. Part of the wage bargain.
b. Boss agrees to hold wage rate fixed. Even if demand for his product falls.
2. This is illustrated to the right where the (sticky) real wage rate of W leads to employment of L'.
3. Note that L' differs from the flexible wage level of employment, L.
E. The sticky wage theory of the labor market generates an upward sloping short run aggregate supply curve (SRAS),
1. A rising price level lowers the real wage (W)
2. This increases the Aggregate Quantity of Labor Demanded (AQDL)
3. Workers supply all the labor that is demanded no matter what is the real wage.
AQSL = AQDL
4. More employment means greater total output according to the aggregate production function.
1. so that an increase in the price level (P) raises the aggregate quantity supplied.
F. If the price level (P) rises,
1. the money wage (WM) does not change so that
2. the real wage (P) declines.
3. The fall in the real wage causes firms to increase the amount of labor they employ.
4. As demonstrated by the aggregate production function, the increase in employment raises the quantity of real GDP (Y) supplied.
G. In the long run, the money wage (WM) changes to reflect the higher price level (P)
1. so that the real wage (WR) returns back to its initial level.
2. Thus real GDP (Y) also returns to its initial level
3. So that the long-run aggregate supply (LAS) curve is vertical.
H. All of the factors that shift the aggregate supply curve in the flexible wage model
1. also shift the long-run supply curve in the sticky wage model.
I. In the flexible wage model, the short run aggregate supply curve will intersect the LRAS at the expected price level (EP).
1. The wage bargain was based on the expected price level.
2. If actual Price Level (P) was equal to the expected price level (EP), the labor market would have been in equilibrium (full employment) (on LRAS).
SUMMARY
J. Changes in the price level (P) change real wages and GDP in the "Sticky Wage " model.
K. Changes in the Price level do not change real wages (W) and real GDP (Y) in the flexible wage model.
VII. Unemployment
A. A reduction in the demand for labor could result in
1. Fewer hours worked per person (underemployment) or
2. Fewer persons at work (unemployment)
A. There are four main reasons why unemployment occurs:
1. firms find it more profitable to vary employment by changing the number of people working full-time
a. rather than the number of hours each person works;
b. employing many people for short hours is inefficient
c. labor is an economically indivisible factor of production
d. It pays to hire labor in "lumps" discrete units.
2. firms have imperfect information about job seekers;
3. households have imperfect knowledge about available jobs;
4. and labor contracts prevent wage adjustments necessary to keep the quantity supplied of labor equal to the quantity demanded.
B. Unemployed workers are people who:
1. are actually searching for a job and
2. do not now have one.
C. The labor market is dynamic, with many different flows caused by the decisions of firms and workers.
1. There are flows into the labor market,
2. flows from employment to unemployment,
3. flows from unemployment to employment, and
4. flows out of the labor force.
D. One of the flows from the labor force is discouraged workers,
1. Discouraged workers are workers who were unemployed,
but stopped searching for a job because they became convinced no jobs were available.
2. They are not counted as being in the labor force
3. They are not counted as being unemployed
C. In the flexible wage model of the labor market,
1. all unemployment is part of the natural rate;
Unemployment rate = natural rate
2. But the Quantity of Labor Supplied (AQLS) will be less than the Labor Force at all real wage rates (W)
AQLS < LF
a. The difference is people in the labor force searching for a better paying job
2. that is, there are no sticky money wages. Hence they do not affect the unemployment rate.
D. In the flexible wage model of the labor market:
1. If the labor force increases, the level of employment and unemployment (U) rise.
2. Cycles in unemployment (U) result from business cycle fluctuations in the demand for labor that cause "ebbs and flows" of job creation and destruction.
3. Empirical evidence shows a strong correlation between fluctuations in the unemployment rate and cycles in job creation and destruction.
a. It is not clear if the observed fluctuations in the unemployment rate are:
i. caused by cycles in job creation and destruction, or
ii. respond to cycles in job creation and destruction.
D. In the sticky money wage model of the labor market
1. unemployment results from the same factors as in the flexible wage model plus
2. unemployment is also caused by changes in the price level (P)
a. which induced changes in the real wage (WR).
3. In the "sticky wage" framework the unemployment can be above or below its natural rate.
a. The natural rate of unemployment is assumed to be relatively constant.
b. The actual rate of unemployment is assumed to fluctuate around the natural rate depending on shifts in the real wage.
4. Aggregate demand management can limit price level movements and thus limit the fluctuations in unemployment.
A Note on Hysteresis and High Unemployment in Europe
Hysteresis - The short run history of the economy changes the long run equilibrium. Hence there aremany possible long run equilibria.
An economy experiences hysteresis when its long run equilibrium depends on the path it has followed in the short run.
Explaining persistent high unemployment in Europe in 1980s and 1990s.
1. The insider-outsider distinction.
Only the employed participate in wage bargaining. They push up their wages even though they know it will result in unemployment. But unemployed are outsiders and cant participate in wage bargaining. Hrnce a high wage - low employment equilibrium.
Only solution is breaking the power of the insiders. (Supply side measures)
2. Long term unemployment may have produced discouraged workers who stop looking for jobs. need to restore "work culture".
3. Workers and employers may become accustomed to low levels of search and give up easily on creating or finding jobs.
4. During the long recession less capital was built. low productivity of labor makes it profitable to higher fewer at any given real wage.
Policy implications of hysteresis.
1. Dangerous to try to solve long term unemployment simply by increasing demand. (major inflation)
2. Important to prevent major long term unemployment in the first place.
VIII. Summary of the lecture
Key Concepts
1. Demand for labor
2. Diminishing marginal product of labor
3. Innovation
4. Invention
5. Labor Force Participation Rate (LFPR)
6. Labor productivity
7. Marginal product of labor
8. Money wage rate (WM)
9. Production function
10. Quantity of labor demanded (QLD)
11. Quantity of labor supplied (QLS)
12. Real wage rate (WR)
13. Reservation wage
14. Short run aggregate production function
15.Short run production function
16. Supply of labor
Review Questions
1. What is the relationship between output and labor input in the short run? Why does the marginal product of labor diminish?
2. Explain why the demand for labor curve slopes downward.
3. Why does the participation rate rise as the real wage rises?
4. Explain what happens in the labor market with flexible wages when technological change increases the marginal product of labor for each unit of labor input.
5. Explain what happens in the labor market with sticky wages when technological change increases the marginal product of labor for each unit of labor input.
6. Explain how unemployment can arise if wages are flexible.
7. Explain how unemployment fluctuates around its natural rate.