THE ECONOMY AT FULL EMPLOYMENT. Objectives. Production and Jobs. Objectives. Real GDP and Employment. Real GDP and Employment CHAPTER

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1 THE ECONOMY AT 29 FULL EMPLOYMENT CHAPTER Objectives After studying this chapter, you will able to Describe the relationship between the quantity of labour employed and real GDP Explain what determines the demand for labour and the supply of labour and how labour market equilibrium determines employment, the real wage rate, and potential GDP Objectives Production and Jobs 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 In 2001, each hour of work produced twice as much output as in 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? 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. Figure 29.1(a) illustrates a production possibility frontier between leisure time and real GDP. The more leisure time foregone, the greater is the quantity of labour employed and the greater is the real GDP. 1

2 The PPF is bowed-out, which indicates an increasing opportunity cost of GDP. The opportunity cost of GDP is increasing because the most productive labour is used first and as more labour is used it is increasingly less productive. The Production Function The production function is the relationship between real GDP and the quantity of labour employed, other things remaining the same. One more hour of labour employed means one less hour of leisure, therefore the production function is the mirror image of the leisure time-real GDP PPF. Figure 29.1(b) illustrates the production function that corresponds to the PPF shown in Figure 29.1(a). Along the production function, an increase in labour hours brings an increase in real GDP. 2

3 Changes in Productivity Labour productivity is real GDP per hour of labour. Three factors influence labour productivity. Physical capital Human capital Technology 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 labour productivity. Shifts in the Production Function Any influence that increases labour productivity increases real GDP at each level of labour hours and shifts the production function upward. An increase in physical capital, human capital, or a technological advance all increase labour productivity. Figure 29.2(a) illustrates in increase in labour productivity. The production function shifts upward from PF 0 to PF 1. Figure 29.2(b) illustrates the increase in Canadian labour productivity and the associated shift in the production function between 1981 and

4 The Demand for Labour The quantity of labour demanded is the labour hours hired by all firms in the economy. The demand for labour is the relationship between the quantity of labour demanded and the real wage rate, other things remaining the same. The real wage rate is the quantity of good and services that an hour of labour earns. The money wage rate is the number of dollars an hour of labour earns. 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 labour demanded. Figure 29.3 shows a demand for labour curve. The demand for labour depends on the marginal product of labour, which is the additional real GDP produced by an additional hour of labour when all other influences on production remain the same. The marginal product of labour is governed by the law of diminishing returns, which states that as the quantity of labour increases, but the quantity of capital and technology remain the same, the marginal product of labour decreases. We calculate the marginal product of labour as the change in real GDP divided by the change in the quantity of labour employed. 4

5 Figure 29.4 shows the calculation of the marginal product of labour and illustrates the relationship between the marginal product curve and the production function. A 10 billion hour increase in labour from 10 to 20 billion hours brings a $400 billion increase in real GDP the marginal product of labour is $40 an hour. A 10 billion hour increase in labour from 20 to 30 billion hours brings a $300 billion increase in real GDP the marginal product of labour is $30 an hour. The marginal product of labour is the slope of the production function. 5

6 Figure 29.2(b) shows the same information on the marginal product curve, MP. At 15 (midway between 10 and 20), marginal product is $40. At 25 (midway between 20 and 30), marginal product is $30. The marginal product of labour curve is the demand for labour curve. Firms hire more labour as long as the marginal product of labour exceeds the real wage rate. With the diminishing marginal product of labour, the extra output from an extra hour of labour is exactly what the extra hour of labour costs, i.e. the real wage rate. At this point, the profit-maximizing firm hires no more labour. The of labour The quantity of labour supplied is the number of labour hours that all the households in the economy plan to work at a given real wage rate. The supply of labour is the relationship between the quantity of labour supplied and the real wage rate, all other things remaining the same. Figure 29.5 illustrates a labour supply curve. The higher the real wage rate, the greater is the quantity of labour supplied. 6

7 The quantity of labour supplied increases as the real wage rate increases for two reasons: Hours per person increase labour force participation increases Hours per person increase because the real wage rate is the opportunity cost of not working. But a higher real wage rates increase 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 labour 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 labour supplied. Labour force participation increases because higher real wage rates induce some people who choose not to work at lower real wage rates to enter the labour force. The labour 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 labour supplied. The labour supply curve is relatively steep. The labour market is in equilibrium at the real wage rate at which the quantity of labour demanded equals the quantity of labour supplied. labour market equilibrium is full-employment equilibrium. The level of real GDP at full employment is potential GDP. Figure 29.6(a) illustrates labour market equilibrium. Labour market equilibrium occurs at a real wage rate of $35 and an employment of 20 billion labour hours. 7

8 At a full employment level of 20 billion hours, potential GDP is $1,000 billion. Aggregate 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. Figure 29.7 illustrates the long-run and short-run aggregate supply curves (LAS and SAS). LAS is a vertical line at potential GDP. 8

9 As the price level changes, the money wage also changes to keep the real wage rate at the fullemployment equilibrium level. With no change in the real wage rate, there is no change in real GDP. 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 labour demanded increases and real GDP increases. 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 labour demanded decreases and real GDP decreases. 9

10 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. 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. Real GDP increases if 1. The economy recovers from a recession 2. Potential GDP increases. Two factors that increase potential GDP are An increase in population An increase in labour productivity An Increase in Population An increase in population increases the supply of labour. The equilibrium real wage rate falls and the equilibrium quantity of labour increases. The increase in the equilibrium quantity of labour increases potential GDP. The potential GDP per hour of work decreases. Figure 29.8 illustrates these effects. The labour supply curve shifts rightward. The real wage rate falls. The equilibrium quantity of labour increases. 10

11 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 $ An Increase in labour Productivity Three factors increase labour productivity An increase in physical capital An increase in human capital An advance in technology An increase in labour productivity shifts the production function upward and increases the demand for labour. The equilibrium real wage rate, quantity of labour, and potential GDP all increase. Figure 29.9(a) illustrates these effects in the labour market. 11

12 Figure 29.9(b) shows the change in the production function. The production function shifts upward and the quantity of labour employed increases. Both changes increase potential GDP. Population and Productivity in Canada Population and productivity in Canada have increased over time. Between 1980 and 1998, both years close to full employment: The working age population increased from 18.7 million to 23.2 million a 24 percent increase. Labour hours increased from 20 billion to 25 billion a 25 percent increase. Population and productivity in Canada have increased over time. Between 1980 and 1998, both years close to full employment: The capital stock increased from $1.4 trillion (1997 dollars) to $2.4 trillion a 71 percent increase. Technology advanced most notably the information revolution and the widespread computerization of production processes. The percentage increase in labour hours exceeded the percentage increase in the population because the increase in capital and technological advances increased labour productivity, which increased the real wage rate, which in turn increased the labour force participation rate. Figure illustrates these events. The real wage rate increased from $15.77 an hour to $19.66 an hour. Aggregate hours increased from 20 billion a year to 25 billion a year. 12

13 Potential GDP increased from $582 billion a year to $919 billion a year. The unemployment rate at full employment is called the natural rate of unemployment. Unemployment always is present for two broad reasons Job search Job rationing Job Search Job search is the activity of workers looking for an acceptable vacant job. All unemployed workers search for new jobs, and while they search many are unemployed. Figure illustrates the relationship between the amount of job search unemployment and the real wage rate. 13

14 Year Adult population Labour force Employed including armed services Unemployed Not in the labour force Unemployment rate Labour force participation rate ,131 4,658 4, , ,247 4,714 4, , ,352 4,762 4, , ,477 4,961 4, , ,587 5,283 5, , ,699 5,327 5, , ,784 5,256 5, , The amount of job search unemployment changes over time and the main sources of these changes are Demographic change Unemployment compensation Structural change Demographic change As more young workers entered the labour force in the 1970s, the amount of frictional unemployment increased as they searched for jobs. Frictional unemployment may have fallen in the 1980s as those workers aged. Two-earner households may increase search, because one member can afford to search longer if the other has an income. Unemployment compensation The more generous unemployment benefit payments become, the lower the opportunity cost of unemployment, so the longer workers search for better employment rather than any job. More workers are covered now by unemployment insurance than before, and the payments are relatively more generous. Structural change An increase in the pace of technological change that reallocates jobs between industries or regions increases the amount of search. 14

15 Job Rationing Job rationing occurs when employed workers are paid a wage that creates an excess supply of labour. Job rationing can occur for two reasons Efficiency wage Minimum wage An efficiency wage is a real wage rate that is set above the full-employment equilibrium wage that balances the costs and benefits of this higher wage rate to maximize the firm s profit. The cost of a higher wage is direct. The benefit of a higher wage is indirect: it enables a firm to attract high-productivity workers, stimulates greater work effort, lowers the quit rate, and lowers recruiting costs. A minimum wage is the lowest wage rate at which a firm may legally hire labour. If the minimum wage is set below the equilibrium wage rate, it has no effect. If the minimum wage is set above the equilibrium wage rate, it does affect the labour market. Job Rationing and Unemployment If the real wage rate is above the equilibrium wage, regardless of the reason, there is a surplus of labour that adds to unemployment and increases the natural unemployment rate. Most economists agree that efficiency wages and minimum wages increase the natural unemployment rate. David Card and Alan Krueger have challenged this view and argue that an increase in the minimum wage works like an efficiency wage, making workers more productive and less likely to quit. Dan Hamermesh argues that firms anticipated increases in the minimum wage and cut employment before the minimum wage increased. Therefore, looking at the effects of minimum wage changes after the change occurs misses the effects an example of the post hoc fallacy. Finis Welch and Kevin Murphy say Card and Krueger failed to take into account some regional differences in economic growth that hide the effects of the change in the minimum wage an example of ceteris paribus not holding. THE ECONOMY AT 29 FULL EMPLOYMENT CHAPTER THE END 15

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