Topic 6 (ABC: Chapter 2)

Marginal productivity of labor and labor demand, Labor supply,

Labor market equilibrium, Inequality, Unemployment
 The Economy at a Glance

Private Sector Oversight

Saving (S) Banks / Investment (I)

(Capital) Fed / RBI
Financial Sector

Return Return
to Capital (r) to Capital (r) Money (M)

Labor Foreign Exchange

Households Firms
Wages NFP

Human I
Capital goods
Tuition,
Consumption
health exp. M (Imports) Rest
(C) GDP of the
Education & Health
(Y) World
Systems

Taxes Taxes X (Exports)

G

Govt. services Government Govt. services

} A production function relates the amount of
output that can be produced using the productive
inputs.
} Production function for the economy:
Y = A K0.3L0.7
◦ Productivity shocks: Sudden, unexpected changes in A
} The marginal product of labor or capital (MPK or
MPL) is the extra amount of output which can be
produced with an extra unit of capital or labor.
} MPK = DY / DK = slope of the production function
in the direction of K, for fixed A,L (ceteris
paribus).
} MPL = DY / DL = slope of the production function
in the direction of L, for fixed A,K.
 Y Y
(Total L K
Output)

K L
MPK MPL (Marginal
(Marginal Product of Labor)
Product
of
Capital)
Extra L K
Output
K L
The slope of the total output function is the MPK or MPL. It
is decreasing, due to diminishing returns.
What happens with a productivity shock?

K, A2 Y
Y L, A2
(Total
Output) K, A1 L, A1

L K
III. IV.
MPL MPK (Marginal
(Marginal Product of
Product of Capital)
Labor)
K, A2 L, A2

K, A1 L, A1
L K
A2>A1
} Assume firms are competitive (take wage W,
capital rental price R, and output price P as
given).
} Also assume firms are profit maximizing.
} How much labor does firm hire?
DProfit = DRevenue - DCost
= (P x MPL) - W
◦ If MPL > W/P, firm can ­ profits by ­ L.
◦ If MPL < W/P, firm can ­ profits by ¯ L.
◦ Optimal to hire labor up to the point where MPL=
W/P.
 MPL MPL>W/P MPL= W/P (Optimum Point)
Δ Profits >0 Δ Profits = 0

Similar analysis can W/P

be done for optimal MPL < W/P
capital to rent using Δ Profits < 0
MPK & R.
0 1 2 3 (L*) L

Total Optimum Quantity of Labor to

Profits hire

Total Profits are Maximum at

the Optimum (Δ Profits = 0)

0 3* L
} W/P is called the real wage since it is
measured in units of output as opposed to
Rupees or dollars.
} Since the firm hires up to the point where
MPL equals real wage, the MPL schedule is
the firm’s labor demand curve.
} What is an example of a factor that can
shift the labor demand curve?
MPL Schedule is labor demand for competitive firms (since MPL set
to W/P for any given market wage).

MPL
(W/P)1
W/P
(real wage)
(W/P)2

(W/P)3

L (Quantity of Labor)
L1 L2 L3
} The labor supply decision is made by
households. Aggregate labor supply is sum
of labor supplied by everyone in the
economy.
} Benefit, to an individual, of working: income
earned which can be used for consumption.
Cost of working: Time and effort no longer
available for leisure.
} When current real wage (w = W/P) ­,
opportunity cost of leisure ­. This force tends
to ­ the labor supplied. (A substitution effect.)
} But higher wages imply one can work less to
make the same income as before. This force
tends to ¯ the labor supplied. (An income
effect.)
} We assume substitution effect dominates.
Therefore individual labor supply curve
upward sloping.
} Aggregate labor supply = number of
workers(L) x Hours worked per worker
} Aggregate labor supply curve is also upward
sloping. When w ­, currently employed work
more, and people not in the labor force are
enticed to work.
} Aggregate labor supply shifted by:
◦ Changes in population (due to birth rate changes,
immigration, etc.)
◦ Changes in labor force participation (e.g. entry of
women into labor force, elimination of mandatory
retirement age, etc.)
} In an equilibrium:
◦ Households maximize utility (determines labor
supply, consumption / savings).
◦ Firms maximize profits (determines demand for
labor and capital, and therefore investment).
◦ Prices adjust such that all markets clear (supply =
demand in all markets).
– Labor market equilibrium (labor supplied = labor demanded)
determines wage rate and quantity of labor.
– Capital market equilibrium (savings = investment) determines rental
rate and quantity of capital.
– Goods market equilibrium ensures Goods Production = Goods
Demanded.
} Aggregate the labor supplies of individual
workers and the labor demands of individual
firms.
} Classical (full employment) labor market
equilibrium is given by the intersection of the
labor supply and demand curves.
◦ Real wage adjusts to set labor supply equal to labor
demand.
◦ Otherwise, workers would be willing to work at a
lower wage, or firms would be willing to pay higher
wage.
w Supply (Hh)

w*

Demand (Firms)

L* L
} An example:
◦ Adverse productivity (supply) shock, say unusually
bad weather: MPL ¯ at every level of employment.
Demand curve shifts leftward. Equilibrium w and L
¯.
} Full employment model has zero
unemployment. Classical economists believe
all unemployment is voluntary. Keynesians
believe stickiness (rigidity) of wages causes
involuntary unemployment.
 Note: This is also a
classical position on
unemployment- market
clears at lower wage and
w some people voluntarily “sit
S out” the recession.

w*
wcl = w*’
D
D’
L
L*’ L*
} Short run unemployment at business cycle
frequencies is called cyclical unemployment.
◦ When economy is booming, unemployment is < long run
average and conversely for a recession.
◦ Classical position: Seen that an adverse productivity shock ¯
MPL, shifts down labor demand and ¯ both equilibrium wages
and labor. (People voluntarily substitute labor supply during
bad times for labor during good times.)
◦ Keynesian position: Real wage is slow to adjust. At the going
wage, supply > demand. Leads to job rationing (no point in
searching).
(when there is a negative productivity shock):

w S

Unemployment since S >

D
wk = w*

Wage rigid D
here
D’

L
} Given Y = A K0.3L0.7,
MPL = w = 0.7 A(K/L)0.3
= 0.7 Al
} That is, real wage is proportional to labor
productivity. Intuitive conclusion.
} Countries with higher labor productivity have
higher real wages
} Within a country, periods of high labor
productivity correspond to higher wages
Groth (2008)
} In several countries inequality in the
population increased tremendously
during the 80s and the 90s:
◦ “College premium” increased sharply. For
example, in the US between 1979 and 1994, real
wages of college graduates increased by 5% and
earnings of high school graduates declined by
20%.
} Likewise, the Indian growth led by the
high-tech boom has seen salaries of the
highly educated workers in India skyrocket
◦ Salaries in India expected to increase by 10% in
2019; inflation-adjusted real-wage increases are
expected to be 5% in 2019, up from 4.7% last year;
highest in Asia. China: 3.2% (Korn Ferry)
} Candidate explanation for increasing
inequality starting in the 80s in the
US:
◦ Trade and outsourcing sent lower skilled jobs
abroad (explains 20%)
◦ Skill-biased technological change: Technological
change (growth in A) has ­ MPL of skilled
workers more than unskilled workers.
} Skill-biased technological change can
explain increased Indian inequality as well?
} In the US latest figures show that even
college-educated workers are now falling
behind. Top 1% of the population gaining.
w w
MPL, A2> A1
MPL, A1
MPL, A1 MPL, A2> A1
Ls Lu
Demand Demand
S

S
ws*’ ws*’
ws* ws*

D’ wu*
wu*’ D
D
D’
Ls Lu

Old skill premium: ws*/wu* New skill premium: ws*’/wu*’ >

ws*/wu*
 Composition of Population: A Real Example
Unemployed

Employed Under 16

Not in labor
force

Labor force = Number Employed + Unemployed

Labor force participation rate = Number in Labor force / Population 16 and older

Unemployment rate = Number Unemployed / Number in Labor force

KURDISTAN REGION--
IRAQ (KRI) LABOR
FORCE SURVEY
Have you done any paid work at your own
enterprise or farm?

Have you done any unpaid work in a

family business or farm?

Have you done any unpaid work at another

person’s farm or business?
 Duhok

Erbil

Sulaimaniyah

4.9 million
Total population
of the KRI
 1.1 million (92.6%)

1.2 million (38%)

Employed
3.1 million (63%) In the
labor force
Age 15
or older

Unemployed
Not in the
Under labor force 88,500 (7.4%)
age 15
1.9 million (62%)
1.8 million (37%)
} In the US, each person sixteen and older
assigned to one of three categories (all figures
are for May 2019):
◦ employed: worked full or part time during the past
week (156.8M)
◦ unemployed: did not work the past week, but
looked for work during the past four weeks (5.9M)
◦ not in the labor force: did not work the past week
and did not look for work during the past four
weeks (96.2M)
} Labor force: employed + unemployed workers
(162.7M)
} Participation rate: Labor force as a
percentage of adult population; (162.7 /
(162.7 + 96.2)) = 62.8%
} Unemployment rate: Percentage of labor
force that is unemployed; 5.9 / 162.7 = 3.6%
} Long run unemployment rate (natural rate) is
never zero. Always some frictional
unemployment as matches between firms
and employees form and dissolve.
} “In May, 1.4 million persons were marginally attached to
the labor force, little changed from a year earlier. These
individuals were not in the labor force, wanted and were
available for work, and had looked for a job sometime in
the prior 12 months. They were not counted as
unemployed because they had not searched for work in
the 4 weeks preceding the survey.”
} “Among the marginally attached, there were 338,000
discouraged workers in May, little changed from a year
earlier. Discouraged workers are persons not currently
looking for work because they believe no jobs are available
for them. The remaining 1.1 million persons marginally
attached to the labor force in May had not searched for
work for reasons such as school attendance or family
responsibilities.”
  Bureau of Labor Statistics news release, June 7, 2019
} A large share of the labor force is engaged in
informal unemployment; need to take official rates
with caution
} Unemployment rates (Source: CIA World Factbook)

2013 9.1%
2014 7.3%
2015 8.4%
2016 8.5%
2017 8.5%
 Percent Informal Employment

10
20
30
40
50
60
70
80
90

0
Ar
ge
nt
Ar ina
m
en
i
Bo a
liv
ia
Br
az
i
Ch l
Co in
lo a
m
bi
a
D C o
om sta
in
ic
Ec an
ua
do
r
El Egy
Sa p t

Source: ILO, 2012

lv
Ho ado
nd r
ur
as
I
In nd
do ia
ne
Le s i a
so
th
L o
M ibe
ac ria
M edo
ad n
ag ia
as
ca
r
M
a
M li
ex
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o
 100 6000

GDP (Constant Taka, Billions)

Percent Formal Employment

80 5000

4000
60
3000
40
2000
20
1000

0 0
2002 2005 2010
Formal Employment GDP
Source: Authors’ calculations based on Bangladesh Labour Force
Surveys.
 100 6000

GDP (Constant Taka, Billions)

Percent Formal Employment

80 5000

4000
60
3000
40
2000
20
1000

0 0
2002 2005 2010
Formal Employment GDP

Source: Authors’ calculations based on Bangladesh Labour Force

Surveys.
 } Sample choice:
JOB A JOB B
Written Contract 6 months initially 1 year initially

Termination Notice 15 days 15 days

Working hours 30-45 hours per week 45-60 hours per week
Amount of paid leave (not 10 days 10 days
including major government
holidays / festival leave)
Provident Fund No No
Monthly income 20% higher than your current monthly 10% higher than your current monthly
income from main economic activity income from main economic activity

} Tradeoff in sample choice is between lower wage

and higher stability (contract length).
} We find average worker would be willing to forego
an increase of about 19 percent of monthly income
for a 6-month contract, 27 percent for a 1-year
contract and 44 percent for a long-term contract
(relative to no contract); and to forego an increase
of about 12 percent of monthly income in order to
obtain thirty days of termination notice.
 S
W Unemployment
among young
unskilled labor
Wmin

W*

L* L
The gap (Wmin- W*) determines the severity of distortion.
Draw for yourself: The situation during “good times” (positive ‘A’
shock) that might reduce the impact of minimum wage laws, & bad
times that might worsen it.
} A firm hires labor up to the point where MPL = W/P; the
MPL curve is the labor demand curve
} The individual labor supply curve is upward sloping if
the substitution effect of change in wages dominates;
aggregate curve slopes upward because of an additional
effect – more people enter labor force as wages increase
} Classical view of unemployment: with negative
productivity shock wages adjust downward and people
voluntarily drop out. Keynesian view: wage is sticky
and imbalance between supply and demand
} Wages are related to labor productivity
} If technological change is biased towards skilled labor,
it can increase inequality
} Minimum wage laws can cause unemployment hurting
individuals they seek to protect
Y Total output (connect to GDP)
A Economy-wide productivity
(technology or TFP)
K Physical capital
L Labor
P Output price (General price level)
W Wage rate (nominal)
R Capital rental rate (nominal)
MPK Marginal product of capital
MPL Marginal product of labor
w Real wage = W / P