Chapter 8 A roadmap ahead: So far we have studied how aggregate economic performance is defined and measured. In the next few chapters we will study the forces that determine real GDP at full employment, business cycle fluctuations in real GDP, and the growth rate of real GDP over time. Then we will study the factors that determine the price level and inflation rate.

We start out by identifying the determinants of potential GDP. Recall that potential GDP is the level of real GDP that the economy would produce if it were operating at full employment, i.e., when the only unemployment is frictional, structural and seasonal. Real GDP is produced as a result of firms employing factors of production – labor, capital, land and entrepreneurship. At any given moment in time, the quantities of capital, land, entrepreneurship and the state of technology are typically fixed, but the quantity of labor employed varies. Therefore, in the short-run, real GDP depends on the quantity of labor employed.

To characterize the relationship between the quantity of labor employed and real GDP we use an analytical device called an aggregate production function, which shows the maximum amount of real GDP that can be produced by any given amount of labor, holding all other factors of production and the state of technology constant. This production function can be represented graphically as follows:

The production function displays diminishing returns, which means that each additional hour of labor employed produces a successively smaller increase in real GDP. For example, the first 50 billion hours of labor produces $4 trillion of real GDP. The second 50 billion hours of labor produces an additional $3 trillion of real GDP. The third 50 billion hours of labor produces an additional $2 trillion of real GDP. The fourth 50 billion hours of labor produces an additional $1 trillion.

The reason for diminishing returns is that the quantity of capital and other factors of production, and the state of technology, are fixed. As we move up the production function, the quantity of labor employed is increasing, but the additional labor is still working with the same amount of capital and other factors. Therefore, each additional hour of labor contributes a successively smaller increase in real GDP.

If real GDP depends on how much labor is employed, then potential GDP is determined by the point on the production function that corresponds to full employment of labor. To find the full employment level of employment, we need to study the labor market. Full employment occurs when the demand for labor is equal to the supply of labor, i.e., when the labor market is in equilibrium.

The demand for labor The quantity of labor demanded is the number of hours of labor that all firms in the economy plan to hire during a given time period at a given real wage rate. The demand for labor is the relationship between the quantity of labor demanded and the real wage rate, holding constant all other influences on firms’ hiring decisions.

The lower the real wage rate, the greater the quantity of labor demanded. To understand this relationship, consider the hiring decision of an individual firm or employer: To maximize profit, a firm will hire additional hours of labor as long as each additional hour contributes at least as much additional output as it costs the firm to hire that hour of labor. The increase in output produced by an additional hour of labor, holding all other factors of production constant, is called the marginal physical product of labor (MPP L ). The cost to the firm of hiring an additional hour of labor is the real hourly wage rate.

Therefore, to determine how many hours of labor to hire, a profit maximizing firm will compare the MPP L with the real hourly wage rate, and will hire additional hours of labor as long as the MPP L is at least as great as the real hourly wage rate. We are assuming that the amount of capital and other factors of production employed by the firm are fixed, therefore the MPP L decreases as more labor is hired, due to diminishing returns. For an individual firm, the real hourly wage rate is the amount of output that the firm must sell in order to earn the dollars required to pay the nominal wage rate.

Consider the following example of a firm that produces beer: The firm has a total product curve that shows output of beer rising as more hours of labor are employed. All other inputs are held constant, so output rises by a smaller and smaller amount each time an additional hour of labor is hired:

From the firm’s total product curve, we can derive the firm’s MPP L curve:

Now, suppose that the nominal hourly wage rate for brewery workers is $18, and that the price per sixpack of beer is $3. Then the real hourly wage rate for the firm is $18/$3 = 6 sixpacks. Combining the real hourly wage rate with the MPP L, we can determine how many hours of labor the firm will hire in order to maximize profit:

The firm will employ the first hour of labor because it produces 8 sixpacks of beer but costs only 6 sixpacks to hire. The firm will hire the second hour of labor because it contributes 6 additional sixpacks of beer and also costs 6 sixpacks. But the firm will not hire the third hour of labor because it contributes an increase in output of only 4 sixpacks but still costs 6 sixpacks to hire. If the nominal hourly wage rate were now to decrease to $12, assuming the price per sixpack remains at $3, the real hourly wage rate confronted by the firm would decrease to $12/$3 = 4 sixpacks. Now it would be profitable for the firm to hire the third hour of labor, whose MPP is 4 sixpacks.

Therefore, we see that a profit maximizing firm will hire additional hours of labor up to the point where the MPP L = real hourly wage rate. This example also illustrates that, when the real hourly wage rate falls, the firm responds by hiring more hours of labor. Therefore we can conclude that the quantity of labor demanded increases when the real hourly wage rate falls. In a competitive labor market, a firm’s MPP L is in fact the firm’s demand curve for labor in the short run. Since the MPP L decreases as more hours of labor are employed, the firm’s demand curve for labor is downward sloping.

The demand for labor in the whole economy is obtained by adding up all of the individual firms’ labor demand curves. Therefore the economy-wide labor demand curve is also downward sloping: a decrease in the real hourly wage rate causes an increase in the quantity of labor demanded:

The supply of labor The quantity of labor supplied is the number of hours that all households in the economy plan to work during a given time period at a given real wage rate. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate, holding constant all other influences on households’ labor supply decisions.

The quantity of labor supplied increases as the real hourly wage rate rises, i.e., the labor supply curve is upward sloping. For example:

The quantity of labor supplied is determined by the real hourly wage rate, not the nominal hourly wage rate, because what matters to households is not the number of dollars they earn but what those dollars can buy. There are two reasons why the quantity of labor supplied increases when the real wage rate increases: Hours per worker increase Labor force participation increases

Hours per worker Here there are actually two contradictory effects, a substitution effect and an income effect. The substitution effect: The real wage rate is the opportunity cost of not working, e.g., of consuming leisure. If an individual chooses to spend an hour not working, the opportunity cost of doing so is the forgone earnings, which is given by the real hourly wage rate.

The substitution effect means that, as the real hourly wage rate rises, leisure and other non-work activities become relatively more expensive compared to working, therefore individuals substitute the relatively cheaper activity (work) for the relatively expensive activity (leisure). Consequently, according to the substitution effect, the quantity of labor supplied rises as the real hourly wage rate rises.

The income effect: As the real hourly wage rate rises, individuals’ incomes rise, and therefore they consume more of all normal goods, including leisure. Since they are consuming more leisure, they are supplying fewer hours of labor, therefore, according to the income effect, the quantity of labor supplied decreases as the real hourly wage rate rises. For most households, the substitution effect dominates the income effect, so that a rise in the real hourly wage rate, on net, causes an increase in the quantity of labor supplied.

Labor force participation Most individuals have opportunities to engage in non- market production, e.g., child care, household production. They will choose to work in the labor market only if the real wage exceeds the value to them of non-market production. The higher the real wage rate, the more likely it is that individuals will choose to enter the labor force.

Other factors influencing the labor supply decision Income tax rate: An increase in the income tax rate reduces the after-tax wage rate and therefore reduces the quantity of labor that workers offer to supply for any given real hourly wage rate.

These benefits lower the cost of searching for a job and therefore encourage unemployed workers to search longer before accepting a job offer. The more generous the unemployment benefits, the longer the time workers spend searching and the lower the quantity of labor offered at any given real hourly wage rate. Unemployment benefits: Both an increase in the income tax rate and an increase in unemployment benefits causes the quantity of labor supplied to decrease for any given real hourly wage rate. Therefore the labor supply curve shifts to the left:

Labor market equilibrium The labor market works just like any other market for goods or services. The real hourly wage rate is the “price” of labor. When the quantity of labor supplied equals the quantity of labor demanded, the labor market is in equilibrium. Another way of saying that the market is in equilibrium is to say that the market clears. Market clearing means that, for every hour of labor that a worker is offering to supply, there is an hour of labor that an employer wishes to hire. That is, there is a job vacancy for every job seeker. This is what is meant by full employment.

When the labor market is in equilibrium, the economy is at full employment. Adjustment to labor market equilibrium occurs through changes in the real hourly wage rate:

When the real hourly wage rate is above the market clearing equilibrium wage, e.g., at $15, there is an excess supply (surplus) of labor. Competitive forces in the market will cause the real hourly wage rate to fall toward equilibrium, eliminating the excess supply. When the real hourly wage rate is below the market clearing equilibrium wage, e.g., at $5, there is an excess demand for labor (a shortage). Competitive forces in the market will cause the real hourly wage rate to rise toward equilibrium, eliminating the excess demand.

Full employment and potential GDP The aggregate production function tells us how much real GDP any given amount of labor can produce. Labor market equilibrium tells us the full employment quantity of labor. Therefore, we can now determine potential GDP:

The full employment quantity of labor is 150 billion hours per year. If this is the quantity of labor employed, then, from the aggregate production function, we can obtain potential GDP, which is $9 trillion. When the labor market is in equilibrium, the economy is at full employment and real GDP equals potential GDP.

Recall that the natural rate of unemployment is the unemployment rate when the economy is operating at full employment, i.e., when all of the unemployment is frictional, structural and seasonal. Therefore, to explain what determines the natural rate of unemployment, we must explain what determines frictional and structural unemployment. Determinants of the natural rate of unemployment The two fundamental causes of unemployment are: Job search Job rationing

Job search When people enter or re-enter the labor force, or move between jobs, they are normally involved in search activity until they find a suitable job. When industries decline and firms shut down, people are laid off, and they normally take some time to search for new jobs in expanding industries. While they are searching, job seekers are classified as unemployed. The greater the number of people searching or the longer the average duration of search, the higher is the natural rate of unemployment.

The amount of job search depends on: Demographic change Unemployment benefits Structural change Demographic change: An increase in the proportion of the population of working age causes increased entry into the labor force and therefore an increase in search unemployment. Aging of the population causes a decrease in new entrants, and search unemployment decreases.

An increase in the number of households with two incomes causes an increase in search unemployment. With a second income-earner in the household, an unemployed member of the household can take longer searching. Unemployment benefits: The more generous these benefits, the lower is the opportunity cost of job search, therefore the longer the duration of search and the higher the natural rate of unemployment.

Structural change: Technological change can work to either increase or decrease search unemployment. If technological change causes some industries to decline while others are expanding, and the newly created jobs are not a good match for the workers laid off from the older industries, then the duration of job search increases and search unemployment rises. However, if technological change creates many new jobs that are a good match for the workers losing their jobs in older industries, then there is less job search and the natural rate of unemployment falls.

Job rationing In a competitive goods market, adjustments of the market price ration scarce resources, which means that price adjustments ensure that scarce resources are allocated to their highest-valued users. In a competitive labor market, the real hourly wage rate (the “price” of labor) similarly adjusts to ration jobs, i.e., to ensure that the number of job vacancies equals the number of job seekers.

However, in some industries, the real hourly wage rate is set above the full-employment equilibrium wage. In these cases, since the real hourly wage rate is stuck above the market-clearing wage rate and is prevented from adjusting downward, there will be an excess supply (surplus) of labor. In such situations, the real hourly wage rate is no longer performing its rationing function. Some other mechanism, therefore, must be found to ration the number of available jobs. This mechanism is unemployment.

Three reasons why the real hourly wage rate might be set above the full-employment equilibrium wage rate: Efficiency wage Minimum wage Union wage Efficiency wage: An efficiency wage is a real wage rate that is set above the market-clearing equilibrium wage in order to create an incentive for worker effort.

Minimum wage: If a government minimum wage law sets the minimum wage above the market-clearing equilibrium wage rate, then the quantity of labor demanded will decrease, the quantity supplied will increase, and there will be an excess supply of labor, i.e., unemployment. Union wage: A union wage is a wage rate that is negotiated through collective bargaining between a labor union and an employer. Union wages often exceed those that would prevail in a competitive labor market.

Whether because of efficiency wages, a minimum wage law or union wages, if the real hourly wage rate is stuck above the market-clearing equilibrium wage rate, there will be an excess supply of labor, i.e., unemployment. Job rationing causes the level of employment to be below full employment. Therefore the level of real GDP will be below potential GDP: