Productivity, Output, and

Employment
 Outline
• Earlier, we discussed the measurement of several economic variables
used to gauge the economy's health and performance
– such as GDP, labor productivity, unemployment, inflation,
budget/trade deficits, CA, income, savings – private, government,
wealth, investment )
– There are many others such as - consumer spending rate, the
dollar, the stock market, the growth rate of the money supply, etc.
• This understanding is required to fulfill the main objective of
macroeconomics which is to understand how the economy works
• We now shift focus from economic measurement to economic
analysis and analyze the factors that affect the longer-term
performance of the economy, including
– the rate of economic growth
– productivity
– the long-run levels of employment and unemployment
 Goals
• The Production Function
– amount of output an economy produces
– An economy's productivity is basic to determining living standards
• The Demand & Supply of Labor and Labor Market Equilibrium
– the factors that affect the quantity of labor demanded by employers and
supplied by workers and then look at the forces that bring the labor market
into equilibrium
– Equilibrium in the labor market determines wages and level of employment;
– We show how productivity affects people's incomes by helping to determine
how many workers are employed and how much they receive in wages
– The level of employment, together with the quantities of other inputs (such as
capital) and the level of productivity, determines how much output an
economy produces.
– Our basic model of the labor market rests on the assumption that the
quantities of labor supplied and demanded are equal so that all labor
resources are fully utilized.
• Unemployment
– Relating Output and Unemployment: Okun’s Law
– In reality, however, there are always some unemployed workers.
– In the latter part, we introduce unemployment and look at the relationship
between the unemployment rate and the amount of output produced in the
economy.
 The Production Function
• Amongst the many determinants of economic
performance and living standards the most basic is the
economy's physical capacity to produce goods and
services.
• If an economy's factories, farms, and other businesses all
shut down for some reason, other economic factors
wouldn't mean much
• The amount of output an economy produces depends on
the following factors of production
– capital goods, labor, raw materials, land, and energy
• The key factors or factors of production
– Capital (K) - factories and machines
– Labor (N)
– Productivity: For e.g. the same stocks of capital and labor,
effective use with superior technologies and management
practices will produce a greater amount of output
 The Production Function
• The production function
Y = A*F(K, N)
– Y = real output produced in a given period of time;
– A = “total factor productivity” (the effectiveness with
which capital and labor are used)
• an increase in productivity of, say, 10% implies a 10% increase
in the amount of output that can be produced
– K = the capital stock, or quantity of capital used in the
period;
– N = the number of workers employed in the period;
– F = a function relating output Y to capital K and labor N.
• Application: The production function of the U.S. economy
and U.S. productivity growth
– Cobb-Douglas production function works well for U.S.
economy: Y = A K0.3 N0.7
 The Production Function
• Productivity growth calculated using production
function
• Output, capital, and labor in the table are measured directly,
but there is no way to measure productivity directly. Instead,
the productivity index, A, shown in column (4) is measured
indirectly by assigning to A the value necessary to satisfy the
Equation
• Productivity moves sharply from year to year
• Productivity grew rapidly in the second half of
the 1990s, but grew more slowly in the 2000s
• Rate of productivity growth is closely related to
the rate of improvement of living standards.
 The shape of the production function
– The easiest way to graph the production function is to
hold with productivity and employment held constant
and then graph the relationship between output and
the other factor
– Suppose that we use the U.S. production function for
the year 2007 and hold labor N at its actual 2007 value
of 146.05 million workers (see Table 3.1). We also use
the actual 2007 value of 21.103 for A. The production
function (Eq. 3.2) becomes

– Two main properties of production functions

• Slopes upward: more of any input produces more output
• Slope becomes flatter as input rises: diminishing marginal
product as input increases (more capital always leads to more
output, it does so at a decreasing rate)
The Production Function Relating Output and Capital
 Marginal product of capital
MPK (Marginal product of capital) = Y/K
– Equal to slope of production function graph (Y vs. K)
– MPK always positive
– The tendency for MPK to declines as K rises is called
Diminishing marginal productivity of capital
– The economic reason for diminishing marginal
productivity of capital is as follows:
• When the capital stock is low, there are many workers for
each machine, and the benefits of increasing capital further
are great; but when the capital stock is high, workers already
have plenty of capital to work with, and little benefit is to be
gained from expanding capital further
The marginal product of capital
 Marginal product of labor
MPN (Marginal product of labor) = Y/N
– Equal to slope of production function graph (Y vs.
N)
– MPN always positive
– Diminishing marginal productivity of labor
• the greater the number of workers already using a fixed
amount of capital and other inputs, the smaller the
benefit (in terms of increased output) of adding even
more workers
The production function relating output and labor
 Supply shocks
– Supply shock = productivity shock = a change in an
economy’s production function
– Supply shocks affect the amount of output that
can be produced for a given amount of inputs
– Shocks may be positive (increasing output) or
negative (decreasing output)
– Examples: weather, inventions and innovations,
government regulations, oil prices
 The Production Function
Supply shocks (a.k.a. productivity shocks)
• Supply shocks shift graph of production function
• Negative (adverse) shock: Usually slope (MPN or MPK) of production
function decreases at each level of input
• Positive shock: Usually slope of production function (MPN or MPK)
increases at each level of output
• A shift of the production function like that shown would occur if
there were a decline in total factor productivity, A
• Real-world examples of supply shocks include
– changes in the weather, such as a drought or an unusually cold
winter;
– inventions or innovations in management techniques
– changes in government regulations, such as antipollution laws,
that affect the technologies or production methods used
– changes in the supplies of factors of production other than capital
and labor that affect the amount that can be produced
An adverse supply shock that lowers the MPN
 The Demand for Labor
• The capital stock in an economy changes over time as a result of
investment by firms and the scrapping of worn-out or obsolete
capital
• However, because the capital stock is long lived, new investment
and the scrapping of old capital happens only slowly
• Thus, for analyses spanning only a few quarters or years,
economists often treat the economy's capital stock as fixed
• For now we follow this practice and assume a fixed capital stock
• Later in taking up long-term economic growth we drop this
assumption and examine how the capital stock evolves over
time
• In contrast to the amount of capital, the amount of labor
employed in the economy can change fairly quickly
– For e.g. firms may lay off workers or ask them to work
overtime without much notice. Workers may quit or decide
to enter the work force quickly
 The Demand for Labor
• How much labor do firms want to use?
– Assumptions
• Hold capital stock fixed—short-run analysis
• Workers are all alike
• Labor market is competitive – wages are set in
competitive labor markets and not set by the firms
themselves
• In making decisions about how much labor to employ,
firms goal is to maximize profits
 The marginal product of labor and labor
demand
The firm will continue to hire additional labor until
the benefit of an extra worker (the value of extra
goods or services produced) equals the cost (the
wage)
– Setting the nominal wage equal to the marginal
revenue product of labor
MRPN = P  MPN
W = MRPN
The Clip Joint’s Production Function
initial w = 240; how many workers
later w = 180; how many workers
The determination of labor demand
 The Marginal Product of Labor and the Labor
Demand Curve
• The MPN and the real wage, both of which are measured in
goods per unit of labor are on the vertical axis
• The MPN curve slopes downward because of the diminishing
marginal productivity of labor.
• The horizontal line represents the real wage firms face in the
labor market, which the firms take as given. Here, the real
wage is w*.
• Why is N* a firm's profit-maximizing level of labor input?
– At employment levels less than N*, the marginal product of labor
exceeds the real wage (the MPN curve lies above the real-wage
line); thus, if the firm's employment is initially less than N*, it can
increase its profit by expanding the amount of labor it uses.
– Similarly, if the firm's employment is initially greater than N*, the
marginal product of labor is less than the real wage (MPN < w*) and
the firm can raise profits by reducing employment.
– Only when employment equals N* will the firm be satisfied with
the number of workers it has
Summary
 A change in the wage
• The marginal product of labor and labor demand:
an example
• Begin at equilibrium where W = MRPN
• A rise in the wage rate means W  MRPN, unless N is
reduced so the MRPN rises
• A decline in the wage rate means W  MRPN, unless N rises
so the MRPN falls
• How much labor do firms want to use?
– Analysis at the margin: costs and benefits of hiring
one extra worker
• If real wage (w)  marginal product of labor (MPN), profit
rises if number of workers declines
• If w  MPN, profit rises if number of workers increases
• Firms’ profits are highest when w = MPN
 Factors that shift the labor demand curve

• A change in the wage causes a movement along

the labor demand curve, not a shift of the curve
• The labor demand curve shifts in response to
factors that change the amount of labor that
firms want to employ at any given level of the
real wage.
– Supply shocks: Beneficial supply shock raises MPN at
all levels so shifts labor demand curve upward and to
the right; opposite for adverse supply shock
– Size of capital stock: Higher capital stock raises MPN,
so shifts labor demand curve to the right; opposite for
lower capital stock
The Clip Joint’s Production Function After a Beneficial Productivity
Shock
The Clip Joint discovers that playing music soothes the dogs. It makes them more
cooperative and doubles the number of grooming per day that the same number
of workers can produce
The effect of a beneficial supply shock on labor
demand
Summary
 Aggregate labor demand
• Aggregate labor demand is the sum of all
firms’ (in the economy) labor demand
• Same factors (supply shocks, size of capital
stock) that shift firms’ labor demand cause
shifts in aggregate labor demand
 The Supply of Labor
• The demand for labor is determined by firms;
supply of labor is determined by individuals
– Aggregate supply of labor is the sum of individuals’
labor supply
– The Labor supply decision of individuals results
from a trade-off of leisure against income
• Weigh the benefit of working an extra hour (the utility
gained from extra income) with the cost (the utility lost
by reducing leisure)
• Level of happiness, or utility, depends on the amount of
goods and services one consumes and on the amount of
leisure time
 The income-leisure trade-off
• Utility depends on consumption and leisure
• Need to compare costs and benefits of
working another day
– Costs: Loss of leisure time
– Benefits: More consumption, since income is
higher
• If benefits of working another day exceed
costs, work another day
• Keep working additional days until benefits
equal costs
 Real wages and labor supply
• An increase in the real wage has offsetting
income and substitution effects
– Substitution effect: The tendency of workers to
supply more labor as higher real wage encourages
work, since reward for working is higher
– Income effect: Higher real wage increases income
for same amount of work time, so person can
afford more leisure, so will supply less labor
– The substitution and income effects of a higher
real wage operate in opposite directions
 Real wages and labor supply
• A pure substitution effect: a one-day rise in the real
wage
– A temporary real wage increase has just a pure
substitution effect, since the effect on wealth is
negligible
• A pure income effect: winning the lottery
– Winning the lottery doesn’t have a substitution effect,
because it doesn’t affect the reward for working
– But winning the lottery makes a person wealthier, so a
person will both consume more goods and take more
leisure; this is a pure income effect
• A pure income effect: increase in the future real wage
– the increase in the future real wage has an income effect
that leads one to reduce their current labor supply
 Real wages and labor supply
• The substitution effect and the income effect together:
a long-term increase in the real wage
– The reward to working is greater: a substitution effect
toward more work
– But with higher wage, a person doesn’t need to work as
much: an income effect toward less work
– The longer the high wage is expected to last, the stronger
the income effect
• Empirical evidence on real wages and labor supply
– Overall result: Labor supply increases with a temporary
rise in the real wage
– Labor supply falls with a permanent increase in the real
wage
 The labor supply curve
• Labor supply curve relates quantity of labor
supplied to real wage
• Increase in the current real wage should raise
quantity of labor supplied
• Labor supply curve slopes upward because
higher wage encourages people to work more
The labor supply curve of an individual worker
 The Supply of Labor
• Factors that shift the labor supply curve
– Any factor that changes the amount of labor
supplied at a given level of the current real wage
shifts the labor supply curve
– Wealth: Higher wealth reduces labor supply (shifts
labor supply curve to the left)(income effect
discussed previously)
– Expected future real wage: Higher expected future
real wage is like an increase in wealth, so reduces
labor supply (shifts labor supply curve to the left)
The effect on labor supply of an increase in wealth
 Aggregate labor supply
• Aggregate labor supply rises when current real
wage rises
– Some people work more hours
– Other people enter labor force
– Result: Aggregate labor supply curve slopes upward
 Factors Increasing Labor Supply
• wealth
• expected future real wage
• working-age population (higher birth rate,
immigration)
• labor force participation (increased female
labor participation, elimination of mandatory
retirement)
Summary
 Labor Market Equilibrium
• Equilibrium: Labor supply equals labor demand
• Classical model of the labor market—real wage
adjusts reasonably quickly to equate labor supply
and labor demand
• The equilibrium level of employment, achieved
after the complete adjustment of wages and
prices, is known as the full-employment level of
employment
• Problem with classical model: can’t study
unemployment
– Because it assumes that any worker who wants to work
at the equilibrium real wage can find a job, the model
implies zero unemployment, which never occurs
Labor market equilibrium
 Labor Market Equilibrium
• Factors that shift either the aggregate labor demand curve or
the aggregate labor supply curve affect both the equilibrium
real wage and the full-employment level of employment.
• Example - A temporary adverse supply shock because of, say,
a spell of unusually bad weather decreases the marginal
product of labor at every level of employment. This decrease
causes the labor demand curve to shift to the left, from ND1
to ND2.
• Because the supply shock is temporary, however, it is not
expected to affect future marginal products or the future real
wage, so the labor supply curve doesn't shift.
• Equilibrium in the labor market moves from point A to point
B. Thus the model predicts that a temporary supply shock will
lower both the current real wage (from w1 to w2) and the
full-employment level of employment (from N1 to N2).
Effects of a temporary adverse supply shock on the
labor market
 Full-employment output
• Full-employment output = potential output = level of output
when labor market is in equilibrium
Y  AF ( K , N )
• affected by changes in full employment level of employment or
production function
• For example, an adverse supply shock that reduces the MPN
works in two distinct ways to lower full-employment output:
– The adverse supply shock lowers output directly, by reducing the quantity
of output that can be produced with any fixed amounts of capital and
labor. This direct effect can be thought of as a reduction in the
productivity measure A in Equation .
– The adverse supply shock reduces the demand for labor and thus lowers
the full-employment level of employment N, as in Fig. shows. A reduction
in N also reduces full-employment output, Y, as Equation confirms
 Unemployment
• Classical model of the labor market, relies on supply-demand
analysis, for studying the wage rate and the level of employment
in an economy and showing how these variables are linked to
output and productivity.
• This model of the labor market is based on the strong
assumption that, when the labor market is in equilibrium, all
workers who are willing to work at the prevailing wage are able
to find jobs.
• In reality, there is always some unemployment
• Government agencies measure unemployment using surveys
– Categories: employed, unemployed, not in the labor force
– Labor Force = Employed + Unemployed
– Unemployment Rate = Unemployed/Labor Force
– Participation Rate = Labor Force/Adult Population
– Employment Ratio = Employed/Adult Population
 Unemployment
Why there are always unemployed people
• Even when the economy is growing vigorously and many new jobs are being
created, some people remain unemployed
• Two types of unemployment that always exist in the labor market and thus
prevent the unemployment rate from ever reaching zero
• Frictional unemployment
– Search activity of firms and workers due to heterogeneity (neither jobs
nor workers are identical)
– Workers vary in their talents, skills, experience, goals, geographic location
(and willingness to move), jobs vary in the skills and experience required,
working conditions, location, hours, and pay
– Matching process takes time
• Structural unemployment
– Chronically unemployed: workers who are unemployed a large part of the
time - don't seem to search for work very intensively and don't generally
find stable employment
– Structural unemployment: the long-term and chronic unemployment that
exists even when the economy is not in a recession. Causes -
• Lack of skills prevents some workers from finding long-term
employment
• Reallocation of workers out of shrinking industries or depressed
regions; matching takes a long time
 Unemployment
• Because of the combination of frictional and
structural unemployment, an economy's
unemployment rate is never zero, evenuwhen the
economy is at its full-employment level.

• The rate of unemployment that prevails when output

and employment are at the full-employment level is
called the natural rate of unemployment