1. Chapter 3 Productivity, Output, and Employment Copyright © 2012 Pearson Education Inc.

2. 3-2 The Production Function Factors of production are inputs to the production process: capital (factories, machines); labour (workers); raw materials and energy; technology and management.

3. Copyright © 2012 Pearson Education Inc.3-3 The Production Function (continued) A production function is a mathematical expression relating the amount of output produced to quantities of capital and labour utilized.

4. Copyright © 2012 Pearson Education Inc.3-4 The Production Function (continued) Y is real output produced A is a number measuring overall productivity K is the quantity of capital used (capital stock) N is the number of workers employed F is a function relating Y to K and N

5. Copyright © 2012 Pearson Education Inc.3-5 The Production Function (continued) Total factor productivity (productivity) is a measure of overall effectiveness with which capital and labour are used. An improvement in production technology allows capital and labour to be utilized more effectively.

6. Copyright © 2012 Pearson Education Inc.3-6 The Production Function (continued) Properties of production functions: they slope upward from left to right; the slope becomes flatter from left to right.

7. Copyright © 2012 Pearson Education Inc.3-7 The Marginal Product of Capital The marginal product of capital (MPK) is the increase in output produced resulting from a one-unit increase in the capital stock (other factors held constant).

8. Copyright © 2012 Pearson Education Inc.3-8 The Marginal Product of Capital (continued) The MPK equals the slope of the line tangent to the production function at a given point.

9. Copyright © 2012 Pearson Education Inc.3-9 The Marginal Product of Capital (continued) The properties of the production function: the MPK is positive; the MPK declines as the capital stock increases.

10. Copyright © 2012 Pearson Education Inc.3-10 The Marginal Product of Capital (continued) Diminishing marginal productivity is the tendency for the marginal product of capital to decline as the amount of capital increases.

11. Copyright © 2012 Pearson Education Inc.3-11 The Marginal Product of Labour The marginal product of labour (MPN) is the increase in output produced by each additional unit of labour (other factors held constant).

12. Copyright © 2012 Pearson Education Inc.3-12 The Marginal Product of Labour (continued) The marginal productivity of labour is diminishing for similar reasons as with capital. The properties of the production function are the same.

13. Copyright © 2012 Pearson Education Inc.3-13 The Production Function Supply Shocks A supply shock (productivity shock) is a change in an economy’s production function. A positive (beneficial) shock raises the amount of output which can be produced with each capital-labour combination.

14. Copyright © 2012 Pearson Education Inc.3-14 The Production Function Supply Shocks (continued) A negative (adverse) shock lowers the amount of output which can be produced with each capital-labour combination. Positive shocks shift the production function upward. Negative shocks shift the production function downward.

15. Copyright © 2012 Pearson Education Inc.3-15 The Production Function Supply Shocks (continued)

16. Copyright © 2012 Pearson Education Inc.3-16 The Demand for Labour Let’s assume the capital stock is fixed in the short run. It is long- lived and has been built over years. Let’s assume the amount of labour is variable in the short run. Firms may employ and lay off workers without much notice.

17. Copyright © 2012 Pearson Education Inc.3-17 The Demand for Labour (continued) Also let’s assume that: Workers are all alike. The wage is determined in a competitive market. A firm employs workers to earn the highest possible level of profit (up to MPN equals wage).

18. Copyright © 2012 Pearson Education Inc.3-18 The MPN and the Labour Demand The MPN measures the benefit of employing an additional worker in terms of the extra output produced.

19. Copyright © 2012 Pearson Education Inc.3-19 The MPN and the Labour Demand (continued) The marginal revenue product of labour (MRPN) measures the benefit of employing an additional worker in terms of the extra revenue produced. P is the price of output

20. Copyright © 2012 Pearson Education Inc.3-20 The MPN and the Labour Demand (continued) To an employer the benefit is MRPN and the cost is the nominal wage (W). In real terms the benefit is MPN and the cost is the real wage (w) - the nominal wage (W) divided by the price of output (P).

21. Copyright © 2012 Pearson Education Inc.3-21 The MPN and the Labour Demand Curve The relationship between the real wage and the quantity of labour demanded is negative. The MPN curve is downward sloping due to diminishing MPN.

22. Copyright © 2012 Pearson Education Inc.3-22 The MPN and the Labour Demand Curve (continued)

23. Copyright © 2012 Pearson Education Inc.3-23 The Labour Demand Curve Shifters Changes in the real wage are represented as movements along the labour demand curve. The labour demand curve shifts in response to factors that change the amount of labour that firms want to employ at any given level of real wage.

24. Copyright © 2012 Pearson Education Inc.3-24 The Labour Demand Curve Shifters (continued)

25. Copyright © 2012 Pearson Education Inc.3-25 Aggregate Labour Demand Aggregate labour demand is the sum of the labour demands of all the firms in the economy. The aggregate labour demand curve looks the same and behaves the same as a labour demand curve for an individual firm.

26. Copyright © 2012 Pearson Education Inc.3-26 The Supply of Labour Aggregate supply of labour is the sum of labour supplied by everyone in the economy. Each person must decide how much time to work for income versus how much time to allocate for leisure (off–work activities).

27. Copyright © 2012 Pearson Education Inc.3-27 The Supply of Labour (continued) The utility (happiness) from income for one more hour at work is compared to the cost (lost utility) of one less hour of leisure. Utility is maximized when these values are the same.

28. Copyright © 2012 Pearson Education Inc.3-28 Real Wages and Labour Supply The substitution effect of a higher real wage is the tendency of workers to supply more labour and reduce leisure hours in response to a higher real wage.

29. Copyright © 2012 Pearson Education Inc.3-29 Real Wages and Labour Supply (continued) The income effect of a higher real wage is the tendency of workers to supply less labour and increase leisure hours as they enjoy higher incomes.

30. Copyright © 2012 Pearson Education Inc.3-30 Real Wages and Labour Supply (continued) The two effects work in opposite directions. The substitution effect of a higher real wage is an increase in the quantity of labour supplied. The income effect is a decrease in the quantity of labour supplied.

31. Copyright © 2012 Pearson Education Inc.3-31 Real Wages and Labour Supply (continued) The longer an increase in the real wage is expected to last, the larger is the income effect.

32. Copyright © 2012 Pearson Education Inc.3-32 The Labour Supply Curve The labour supply curve is the curve which relates the amount of labour supplied to the current real wage (other factors held constant, including the real wage expected in the future).

33. Copyright © 2012 Pearson Education Inc.3-33 The Labour Supply Curve (continued) The labour supply curve is upward sloping. An increase in the current real wage leads to an increase in labour supplied.

34. Copyright © 2012 Pearson Education Inc.3-34 The Labour Supply Curve (continued) Except the real wage, any factor which changes the amount of labour supply will shift the labour supply curve.

35. Copyright © 2012 Pearson Education Inc.3-35 Aggregate Labour Supply Aggregate labour supply is the total amount of labour supplied in the economy.

36. Copyright © 2012 Pearson Education Inc.3-36 Aggregate Labour Supply (continued) An increase in the current economy wide real wage raises the aggregate quantity of labour supplied: people already working supply more hours; some people are induced to join the labour force.

37. Copyright © 2012 Pearson Education Inc.3-37 Labour Market Equilibrium The classical model of the labour market assumes that the real wage adjusts quickly to equate labour supply and labour demand.

38. Copyright © 2012 Pearson Education Inc.3-38 Labour Market Equilibrium (continued) The equilibrium level of employment after the complete adjustment of wages and prices is full-employment level of employment ( ). The corresponding market clearing real wage is ( ).

39. Copyright © 2012 Pearson Education Inc.3-39 Labour Market Equilibrium (continued) The corresponding market clearing real wage is ( ).

40. Copyright © 2012 Pearson Education Inc.3-40 Labour Market Equilibrium (continued) Aggregate labour demand or supply curve shifters affect: the equilibrium real wage; the full- employment level of unemployment.

41. Copyright © 2012 Pearson Education Inc.3-41 Labour Market Equilibrium (continued) The drawback of the model is that it implies that there is zero unemployment. Possible explanations of unemployment: The real wage could be slow to adjust. Matching people to jobs can be a time consuming process.

42. Copyright © 2012 Pearson Education Inc.3-42 Full-Employment Output Full-employment output (potential output),, the level of output that firms in the economy supply when wages and prices are fully adjusted.

43. Copyright © 2012 Pearson Education Inc.3-43 Full-Employment Output (continued) Effects of an adverse supply shock: The output is reduced directly by reduction in the productivity measure A. The MPN falls, employment falls, full employment output falls.

44. Copyright © 2012 Pearson Education Inc.3-44 Unemployment An employed person is someone who worked full-time or part-time during the past week. An unemployed person is someone who did not work during the past week, but who had actively sought work in the previous four weeks, and was available for work.

45. Copyright © 2012 Pearson Education Inc.3-45 Unemployment (continued) Someone not in the labour force is a person who did not work during the past week and did not look for work during the past four weeks. The labour force is all employed and unemployed workers. (Aug 2010 – 18.7 million) Not In Labour Force (Aug 2010 – 9.1 million) Working age population (Aug 2010 – 27.8 million) Unemployed Employed (Aug 2010 – 17.2 million) Unemployed (Aug 2010 – 1.5 million)

46. Copyright © 2012 Pearson Education Inc.3-46 Unemployment (continued) The unemployment rate is the fraction of the labour force that is unemployed. (Aug 2010 – 5.4%) The participation rate is the fraction of the labour force in the working-age population. (Aug 2010 – 67.4%) The employment ratio is the fraction of the employed in the working-age population. (Aug 2010 – 62.0%)

47. Copyright © 2012 Pearson Education Inc.3-47 Changes in Employment Status The labour market is in a constant state of flux. Workers lose and find jobs continuously. 61% of unemployed stay unemployed the following month.

48. Copyright © 2012 Pearson Education Inc.3-48 Changes in Employment Status (continued) Some workers become discouraged workers – people that are so discouraged by lack of success at finding a job that they stop searching.

49. Copyright © 2012 Pearson Education Inc.3-49 How Long are People Unemployed? An unemployment spell is the length of time that an individual is constantly unemployed. Its length is called the duration of the unemployment spell.

50. Copyright © 2012 Pearson Education Inc.3-50 How Long are People Unemployed? (continued) Most unemployment spells are of short duration, about two month or less. Most people who are unemployed on a given date are experiencing unemployment spells with long duration.

51. Copyright © 2012 Pearson Education Inc.3-51 Frictional Unemployment Frictional unemployment arises as workers search for suitable jobs and firms search for suitable workers. The search and match process takes time.

52. Copyright © 2012 Pearson Education Inc.3-52 Structural Unemployment Structural unemployment is a long-term and chronic unemployment that exists when the economy is not in a recession. Unskilled or low skilled workers are unable to find long-term jobs. Reallocation of labour among industries takes time.

53. Copyright © 2012 Pearson Education Inc.3-53 The Natural Rate of Unemployment The natural rate of unemployment ( ) is the rate of unemployment that prevails when output and employment are at their full- employment levels. The natural rate of unemployment exist due to frictional and structural causes.

54. Copyright © 2012 Pearson Education Inc.3-54 Cyclical Unemployment Cyclical unemployment is the difference between actual and natural unemployment rates

55. Copyright © 2012 Pearson Education Inc.3-55 Okun’s Law According to Okun’s law the gap between an economy’s full- employment and actual levels of output increases by about 2 percentage points for every 1 percentage point increase in the unemployment rate.

56. Copyright © 2012 Pearson Education Inc.3-56 Okun’s Law (continued) Okun’s law can also be expressed as: