Business, Government, and the World Economy

Output and Employment

Outline of Topics

Markets work (move to “equilibrium”)Long run equilibrium vs. short run adjustment

What factors measure long run economic performance?

OutputEmploymentPrices

The Ultimate Goal:Sustainable Economic Growth

Long-term consistent increases in output (GDP) is usually considered the most basic benchmark of economic health.Semester goal:

Establish how /why economic growth occurs

Production Function

The amount of output that an economy can produce is believed to be a function of the amount of capital used in a given period of time (K), the number of workers employed (N), and a productivity measure (A) or

Y = Af(K,N)Where f( ) is a mathematical function relating capital and labor to output.

An Example:The Production Function

Cobb Douglas Production Function

Y=AKaN(1-a)

Where: 0<a<1a = the share of income received by owners of capital 1-a = the share received by labor a = .3, 1-a = .7A = total factor productivity

Economic Growth

Long run growth in output can occur in multiple ways:

Increase in amount of laborIncrease in amount of capitalShifts in allocation of income (a) Increase in “A” total factor productivity

Constraints on Growth

Labor and capital exhibit diminishing marginal returns to scale

Each additional unit has a smaller impact on output than the previous one

Therefore consistent long-run economic growth depends upon increasing productivity.

Graphing the production function

Often it is helpful to look at the production function based on changes in one variable, keeping the other inputs constant.

Production Function

Marginal Product of Capital

Marginal Product of Capital (MPK)The additional increase in output resulting from a one unit increase in capital. From the graph each additional unit of capital results in a small increase in output.

Diminishing MPK

567

391307

Diminishing MPK

567

391307

Approximating MPK

567

391307

MPK

Marginal Product of Capital is positiveMarginal Product of Capital declines as capital stock increases.

Labor

The impact of increasing labor input is similar to the impact of increasing capitalWe can graph the production function based upon keeping the capital stock constant and changing labor (next slide)

Production Function (Changing Labor)

Supply Shock

Supply shocks (like the oil price shock we had before) cause the amount of output produced at a given level of output and labor to increase or decrease.This also impacts the MPK and MPN

Adverse Supply (productivity) Shock

Productivity Shocks

Changes in productivity also impact the marginal productivity of capital and laborGains in productivity can offset the declining marginal productivity of labor or capital.

US Total Factor Productivity

Shigehara 1992

The growth record

US Total output grew at a 2.54% average rate from 1929 – 48 and a 3.7% rate from 1948 – 1973 However from 1973 – 2001 it grew at an average of 1.9% Why???A similar decline occurred in other developed economies. One report shows a productivity growth rate of 0.0% from 1973 – 1990.

Quantity of Capital and Labor

Before investigating productivity in more detail – need to understand how the amount of labor and capital are determined.

The labor marketThe goods market (consumption and investment)

Demand for Labor

The amount of labor firms want to hireBasic Assumptions

Workers are identicalFirms view wages as being set by a competitive labor marketFirms will demand the amount of labor that maximizes profit (where MPN = real wage) Marginal Cost = wage, benefit = marginal productivity of worker – Or in nominal terms the marginal revenue product of labor)

Labor Demand Curve

The labor demand curve will have an inverse relationship with the real wage (which equals the MPN)

Labor Demand Curve

Labor

Real W

ag

e

Factors that Shift ND

An increase in Shifts ND to the

Why

Productivity Right MPN increases with positive supply shock

Capital Stock Right Higher capital stock increases

MPN

Labor Supply

The labor supply curve will have a direct relationship with the current real wage.The economic benefit of working is the real wage.

Labor

Real W

age

Shifts in the NS Curve

An increase in NS will shift

Why

Wealth Left Can afford more leisure

Expected Future Real

Wage

Left Can afford more leisure

Working Age Population

Right Increase in Labor Supply

Participation Rate

Right Increase labor supply

Labor Market Equilibrium

Labor

Real W

ag

e

NS

ND

N

Temp Adverse Supply Shock

Labor

Real W

ag

e

NS

NDND

Unemployment

The equilibrium level of labor represents the full employment level of labor (which is not zero). Putting the full employment level of labor into the production function provides the level of output at a given level of capital and total factor productivity.

Unemployment : NS>ND

Labor

Real W

ag

e

NS

ND

ND NS

Unemployment

Fast Adjustment of Real Wages

If unemployment exists, the firm has the ability to offer a lower real wage.This should move the amount of labor demanded to the amount of labor supplied (move the economy toward the full employment level of labor)

Measuring Unemployment

Household Survey vs. Establishment Survey (indicators next time)Distinguish between unemployed (actively looking for work) and not in the labor force (not looking for work and not employed)

Full Employment Output

The full employment level of output is then the output produced at the full employment level of N given as – given the current capital stock K and current level of productivity.Note – This is the theoretical level of employment – it does not depend upon the real interest rate level

K),N(A Y f

N

Okun’s Law

First stated by Arthur Okun (chairman of Council of Economic Advisors in Johnson Administration)Compares the level of full employment output to current output based on amount of unemployment above the full employment levelShould not be considered a “law” more of a general rule…

Okun’s Law

)(%4.05.2/%

)(5.2%%

grearrangin and rategrowth

at the lookingby ly Alternatve

)(5.2

GDPGDPu

or

uGDPGDP

uuY

YY

Okun’s Law restated

If the change in real GDP is 3.5% then the change in unemployment is zeroIn other words 3.5% is a long run sustainable growth rate for the economy.If percentage change in real GDP is zero, Unemployment increases by 1.4%

)(%4.04.1

)(%4.05.2/%

GDPu

GDPGDPu

Okun’s Law 1949 - 2008

Regression StatisticsR Square 0.75347824Standard Error 0.52509958Observations 60

CoefficientsStandard

Error t Stat P-valueIntercept 1.33481791 0.118896209 11.22675 3.58E-16Real Rate of Growth -0.38609966 0.028998644 -13.3144 2.76E-19

Graphical Representation

Policy Questions

What if there was a large negative productivity shock that left the economy at below the full employment level of output? (high unemployment)Could unemployment be decreased by undertaking expansionary fiscal policy (increasing government spending)?What are the possible negative outcomes?

Theory Questions

Why could unemployment persist? (why would wages not drop to bring the labor market to equilibrium?

Sticky Nominal Wages and Prices (menu costs)Sticky Real Wages and PricesSticky Real Wages (insider/outsider models)Sticky Real Wages (government restrictions)Wedges between private and social costsBarriers to firing and unemployment benefits

Sticky Nominal Wages and PricesMenu Costs

There is a cost associated with changing prices, this keeps nominal prices fixed in the short term.

Examples include remarking merchandise, updating web sites, etcMore important if markets are not perfect (in perfect competition having the “wrong” has large consequences)

Not all products meet the requirements of perfect competition (especially standardization of goods and large number of sellers)

“Kinked” demand curves With a small number of competitors, the firms will not change price unless the industry price has changed.

Institutional constraints

Sticky Nominal Wages and PricesMonopolistic / Oligopolistic Competition

Real Wage RigidityEfficiency Wages

Classical Argument – Most unemployment results from short term mismatches between workers and jobs (not all workers are identical)Keynesian Argument - Mismatches are only part of the problems. Unemployment can persist because wages are slow to adjust to a level that would clear the labor market.

Unemployment

Reasons why Unemployment might persistLegal barriers to decreasing wage

Minimum WagesUnion Contacts

Reduction of Turnover costsTraining is expensive

Paying a higher wage may increase worker productivity – Efficiency Wage model

Efficiency Wage Model

Shirking ModelIf worker is paid only minimum needed, there will not be much concern about being fired (especially if there are many other similar jobs)Employee is more likely to “shirk” responsibilities and be less productiveThe effort a employee puts forth depends upon the real wage received.

S shaped Effort Curve

As real wage increases (especially if it increases above the minimum the firm would need to pay, productivity of the worker increases.Staring from a real wage of 0 effort is very low then starts to increase for each increase in real wageAt some point there is diminishing effort for each increase in real wage.

Effort Curve

Effort

Real Wage

The firm will want to maximize the amount of effort per unit of real wage paid or E/w, In other words maximize the effort per dollar of real wage or the efficiency of the workerThe slope of a straight line from the origin will be equal to E/wAssume that the market clearing level of real wage is wA in the next graph However w* is the level that Maximizes E/w

Effort Curve

Effort

Real WageW*WA

EA

E*Effort Curve

Real Wage Rigidity

In the efficiency wage model, the real wage is dependent upon the effort curve, not the levels of labor supply and demand.It is possible for unemployment to persist at the efficiency wage.

Unemployment : NS>ND

LaborReal W

ag

e

NS

ND

ND NS

UnemploymentW*

Insider Outsider Relationships

Union negotiations pose restrictions on wage rates. They protect those who are a members of the organization (insiders)If wages increase faster than productivity, it is possible for the constraint to force firms to look for other sources of employment.

Barriers to market clearing wages

An increase in the minimum wage will have little impact if the wage is currently below the market clearing wage, if it increases above equilibrium it can reduce employment.Empirical evidence suggests that there is little evidence between the ration of minimum wages to average wages and inflation.

Wedges:Private and Social Costs

Taxes, social security etc create a wedge between what the employer pays and what the worker receives (the cost to the employer is much higher than the nominal benefit to the worker)The difference has a larger consequence if the worker does not recognize the benefit received (future pension, healthcare etc)A high level of these cots can create a disincentive to work.

Extensions of Sticky Wages and Prices

When responding to changes in demand firms react to changes in demand by changing the amount of production, not changing pricesIf this is the case firms will increase production if demand at a fixed price is higher than expected (This implies that the economy can produce above full employment in the short run)

Extensions of Sticky PricesEffective Labor Demand

If the firm is willing to meet demand at a given price, you need to look at the effective labor demand curve.Labor demand looks at the quantity of labor needed to produce a level of output at a given productivity level and capital stock.

Effective Labor Demand

Output

Labor N

Full Employment Output Revisited

The full employment level of output is then the output produced at the full employment level of N given as – given the current capital stock K and current level of productivity.Note – This is the theoretical level of employment – it does not depend upon the real interest rate level

K),N(A Y f

N

The FE line

We want to build a model based upon equilibrium in the labor, goods and asset market. Each market will be represented by a line representing equilibrium in the respective market on a graph with output (X axis) and real interest rates (Y Axis).

The FE line

The FE line is then a vertical line at the real level of output

Real In

tere

st R

ate

, r

Output, Y

FE Line

Y

Shifts in the FE line

Factors that shift the inputs in the production function will impact the FE line (assuming fast adjustment)

FE Shifts

Why?

Beneficial Supply Shock

(Productivity )

Right If MPN labor demand output for same inputs

Increase in Ns Right equil employment

Capital Stock Right Output with same labor and productivity

The FE Line:Increase in Capital Stock

Real In

tere

st R

ate

, r

Output, Y

FE0

Y

FE1

FE line with efficiency wages

If efficiency wages are correct, the level of output corresponds to the amount of labor demanded at the efficiency wage (There could be large amounts of unemployment for a long period of time)

Anything that shifts Labor Supply – will not impact FE because the Efficiency wage is slow to adjust. (productivity etc that move Labor demand still shifts FE)

Indicators of Labor Markets

Weekly Unemployment ClaimsContinuing Unemployment ClaimsUnemployment Rate

Household Survey (60,000 Homes)Establishment Survey (400,000 companies and agencies)

Help Wanted Advertising Index (conference board)ADP Employment Report (400,00 businesses)