1 Chap 3: Productivity, Output, and Employment Focus : The Labor Market What factors determine real wage and the employment level? How equilibrium is achieved in the labor market? Types and causes of unemployment.

2 Production function relates the total output to the total amount of inputs used in the production. Two characteristics of the production function: 1) Strictly increasing Marginal product 2) Diminishing Marginal Productivity Marginal product refers to increment in output for a unit increase in an input holding other inputs constant.

3 Supply or Productivity Shocks refer to changes in the production function. Equilibrium in the Labor Market Assumptions: 1) All workers are identical. 2) Individual firms and workers take market wage as given. 3) Firms maximize their profits. 4) Workers maximize their utility.

4 The Demand for Labor While making hiring decision, a firm compares the cost of hiring (wage) with the benefit from hiring (value of extra production). The Marginal Revenue Product of Labor (MRPN) = Marginal Product of Labor (MPN) * Price (P) The demand for workers by a firm is given by the condition that MRPN = MPN * P = Nominal Wage (W) Or, MPN = W/P = w (Real Wage) The labor demand curve is same as the MPN curve.

5 The Supply of Labor While making labor supply decision, a worker compares the cost of working (forgone leisure) with the benefit from working (real wage). The Substitution Effect – Higher real wage by increasing the benefit from working increases the labor supply. The Income Effect - Higher real wage by increasing the wealth of workers reduces the labor supply. The substitution effect has positive and the income effect has negative effect on the labor supply. The longer the higher wage is expected to last, stronger is the income effect and vice versa.

6 The Labor Supply Curve of a worker relates the amount of labor supplied with the current real wage, holding other factors constant. It slopes upwards. The Labor Market Equilibrium The labor market attains equilibrium at the employment level and the real wage at which labor supply equals labor demand. The equilibrium level of employment is called Full Employment Level of Employment and the corresponding output as the Full Employment or Potential Output.

7 Unemployment Frictional Unemployment – Unemployment which arise as workers search for suitable jobs and firms search for suitable workers. Structural or Chronic Unemployment – Long term unemployment. Natural Rate of Unemployment = Frictional Unemployment Rate + Structural Unemployment Rate Cyclical Unemployment Rate = Actual Unemployment Rate - Natural Rate of Unemployment