1. © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez The Economy atFull Employment F ERNANDO Q UIJANO, Y VONN Q UIJANO, K YLE T HIEL & A PARNA S UBRAMANIAN PREPARED BY:

2. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 2 of 22 1 Although we normally think that increased immigration will reduce wages, what factors could cause increased immigration to raise wages? Immigration Affects Both the Demand and Supply for Labor 2 Why are differences in the amount of labor supply across countries an important determinant of economic performance? Labor Supply Varies Across Countries and Time 3 Do differences in taxes and government benefits explain why Europeans work substantially fewer hours per year than do Americans or the Japanese? A Nobel Laureate Explains Why Europeans Work Less Than Americans or the Japanese

3. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 3 of 22 WAGE AND PRICE FLEXIBILITY AND FULL EMPLOYMENT 7.1 classical models Economic models that assume wages and prices adjust freely to changes in demand and supply. Understanding Full Employment

4. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 4 of 22 THE PRODUCTION FUNCTION 7.2 production function The relationship between the level of output of a good and the factors of production that are inputs to production. stock of capital The total of all machines, equipment, and buildings in an entire economy. labor Human effort, including both physical and mental effort, used to produce goods and services.

5. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 5 of 22 THE PRODUCTION FUNCTION 7.2 Y = F(K,L)  FIGURE 7.1 The Relationship Between Labor and Output with Fixed Capital

6. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 6 of 22 THE PRODUCTION FUNCTION 7.2

7. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 7 of 22 THE PRODUCTION FUNCTION 7.2  FIGURE 7.2 An Increase in the Stock of Capital

8. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 8 of 22 WALL STREET BOOSTED BY JOBS DATA Earnings data from several firms also appeared strong and, coupled with wage growth data, fueled some speculation that inflation was still a risk. Bonds yields adjusted accordingly as many bond traders now believe that impending rate cuts are now more unlikely. Stocks opened higher on Wall Street after job market data indicated the economy was still growing and adding jobs. U.S. unemployment rates fell to their lowest level in more than five years as non-farm payrolls increased by 92,000 jobs during October. Prior months’ data was also revised upward and confirmed solid job growth. Adding units of labor while holding capital constant will increase total output. However, note that the returns to adding new labor are not as great at higher levels of output as they are at lower levels of output. This is known as diminishing returns. Extra Application 4

9. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 9 of 22  FIGURE 7.3 The Demand and Supply of Labor WAGES AND THE DEMAND AND SUPPLY FOR LABOR 7.3 real wage The wage rate paid to employees adjusted for changes in the price level. Labor Market Equilibrium

10. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 10 of 22  FIGURE 7.4 Shifts in Labor Demand and Supply WAGES AND THE DEMAND AND SUPPLY FOR LABOR 7.3 Changes in Demand and Supply

11. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 11 of 22 IMMIGRATION AFFECTS BOTH THE DEMAND AND SUPPLY FOR LABOR APPLYING THE CONCEPTS #1: Although we normally think that increased immigration will reduce wages, what factors could cause increased immigration to raise wages? A recent study by Gianmarco Ottaviano of the University of Bologna and Giovanni Peri of the University of California, Davis, estimated that during the 1990s immigration, on average, increased the average wage of American-born workers by 2.7 percent. They took into account that increased immigration led to: Increases in the supply of labor Additional investment Result: Both the demand and the supply for labor shifted, with the shift in demand slightly outpacing the shift in supply. When they looked more closely at wages, they found: The wages of high-school dropouts fell, while wages of workers with at least a high-school education increased. Reason: High-school dropouts compete most directly with the new immigrants, whereas those workers with more education do not.

12. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 12 of 22  FIGURE 7.5 Determining Full-Employment Output LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT 7.4 full-employment output The level of output that results when the labor market is in equilibrium and the economy is producing at full employment.

13. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 13 of 22 LABOR SUPPLY VARIES ACROSS COUNTRIES AND TIME APPLYING THE CONCEPTS #2: Why are differences in the amount of labor supply across countries an important determinant of economic performance? Although work may be universal, the amount of work done varies substantially and consequently affects output. Example: vacation time. A typical worker in the United States has 12 days of vacation. The United Kingdom: 28 vacation days Germany: 35 days Italy: 42 days Per capita output is higher in the United States than in Germany. But if Germans worked as many hours as their U.S. counterparts, per capita output would be similar in both countries. Within the United States, the amount of work we do has changed substantially over time. In the last 50 years: The labor force participation rate has increased from 59 to 67 percent. Labor force participation of women has increased from 34 percent to nearly 60 percent. The labor force participation of men has fallen from 86 to 75 percent.

14. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 14 of 22  FIGURE 7.6 How Employment Taxes Affect Labor Demand and Supply USING THE FULL-EMPLOYMENT MODEL 7.5 Taxes and Potential Output

15. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 15 of 22 A NOBEL LAUREATE EXPLAINS WHY EUROPEANS WORK LESS THAN AMERICANS OR THE JAPANESE APPLYING THE CONCEPTS #3: Do differences in taxes and government benefits explain why Europeans work substantially fewer hours per year than do Americans or the Japanese? Today the French (and other Europeans) work one-third fewer hours than do Americans. In the early 1970s Europeans actually worked slightly more hours than did Americans. What explains this dramatic turnaround in the space of just 20 years? Nobel-laureate Edward Prescott of the Federal Reserve Bank of Minneapolis and Arizona State University attributes the decreases in hours in Europe to: Increases in the tax burden that ultimately falls on workers. Government spending and transfers play a larger role in European economies than in the United States. Prescott notes that as the burdens of Social Security and Medicare increase, the United States may be tempted to increase its tax rates. What will happen if we do not make changes in the underlying programs and allow tax rates to increase?

16. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 16 of 22  FIGURE 7.7 How an Adverse Technology Shock Affects Labor Demand and Supply USING THE FULL-EMPLOYMENT MODEL 7.5 Real Business Cycle Theory real business cycle theory The economic theory that emphasizes how shocks to technology can cause fluctuations in economic activity.

17. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 17 of 22 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT 7.6 International Comparisons

18. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 18 of 22 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT 7.6 Crowding Out in a Closed Economy crowding out The reduction in investment (or other component of GDP) caused by an increase in government spending. closed economy An economy without international trade. output = consumption + investment + government purchases Y = C + I + G

19. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 19 of 22 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT 7.6 Crowding Out in a Closed Economy  FIGURE 7.8 U.S. Consumption and Government Spending During World War II

20. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 20 of 22 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT 7.6 Crowding Out in a Closed Economy  FIGURE 7.9 U.S. Investment and Government Spending During World War II

21. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 21 of 22 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT 7.6 Crowding Out in an Open Economy open economy An economy with international trade. Y = C + I + G + NX Crowding In crowding in The increase of investment (or other component of GDP) caused by a decrease in government spending.

22. chapter © 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan Sheffrin Perez 22 of 22 classical models closed economy crowding in crowding out full-employment output labor open economy production function real business cycle theory real wage stock of capital