Productivity, Output, and Employment

Chapter 3
Productivity,
Output, and
Employment
Chapter Outline
• The Production Function

• The Demand for Labor
• The Supply of Labor
• Labor Market Equilibrium
• Unemployment
Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-2

The Production Function
• Factors of production
– Capital (K)
– Labor (N)
– Others (raw materials, land, energy)
– Productivity of factors depends on technology
and management

• The production function

Y = AF(K, N) (3.1)
– Parameter A is “total factor productivity” (the
effectiveness with which capital and labor are
used)

• The shape of the production function

– 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


– Graph production function (Y vs. one input; hold
other input and A fixed)
– Cobb-Douglas production function works well for
U.S. economy:
Y = A K0.3 N0.7
– Figure 3.1

Figure 3.1: The production function
relating output and capital


– Marginal product of capital: Increase in
output produced that results from a one-unit
increase in the capital stock, holding other
factors constant
MPK = Y/K
• Equal to slope of production function graph (Y vs. K)


– Marginal product of capital:
MPK = Y/K
• In the figure
– Moving from B to C, K=1000, Y=828
 MPK = 828/1000 = 0.828
– Moving from C to D, K=1000, Y=652
 MPK = 652/1000 = 0.652


– Marginal product of capital:
MPK = Y/K
• Two properties:
– MPK always positive
– Diminishing marginal productivity of capital
MPK declines as K rises

Figure 3.2: The marginal product of
capital


– Marginal product of labor: Increase in output
produced that results from a one-unit increase
in labor, holding other factors constant
MPN = Y/N
• Equal to slope of production function graph (Y vs. N)
• Two properties:
– MPN always positive
– Diminishing marginal productivity of labor
MPN declines as N rises

Figure 3.1: The production function
relating output and labor

• Supply shocks
– Supply shock (productivity shock): a change
in parameter A in the 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 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
• Firms maximize profits


– Analysis at the margin: compare the cost and
the benefit of hiring one extra worker
• Continue hiring workers as long as the benefit is higher
than the cost

• Benefit of an extra worker:

– MPN (marginal product of labor): The amount of
additional output produced with each additional
worker (in units of output)
– MRPN (marginal revenue product of labor): The
amount of additional revenue generated with each
additional worker (in TL, $, €, etc. units)
MRPN = P  MPN (3.3)

• Cost of an extra worker:

– Nominal wage (W): in TL, $, €, etc. units
– Real wage (w) : in units of output
Real wage = Nominal wage/Price
w = W/P (3.4)
• Compare the nominal wage (W) with MRPN

• Compare the real wage (w) with MPN

Table 3.2: The Clip Joint’s Production
Function

• Clip Joint Example

– W = $240, P = $30
– w = $240/$30 = 8 units of output
1st worker: MRPN=$330 > W=$240 MPN=11 > w=8
2nd worker: MRPN=$270 > W=$240 MPN=9 > w=8
3rd worker: MRPN=$210 < W=$240 MPN=7 < w=8
=> The amount of labor demanded by Clip Joint is 2 workers


– Analysis at the margin: costs and benefits of
hiring one extra worker (Fig. 3.5)
• If marginal product of labor (MPN) > real wage (w),
profit rises if number of workers increases
• If MPN  w, profit rises if number of workers declines
• Firms’ profits are highest when w = MPN
=> The amount of labor demanded is given by
w = MPN

Figure 3.5: The determination of labor
demand

• A change in the wage

Summary 2: Comparing the Benefits and
Costs of Changing the Amount of Labor

• The marginal product of labor and the labor

demand curve
– Labor demand curve shows relationship
between the real wage rate and the quantity of
labor demanded
– It is the same as the MPN curve, since w =
MPN at equilibrium
– So the labor demand curve is downward sloping;
firms want to hire less labor, the higher the real
wage

Figure 3.5: The determination of labor
demand

• Factors that shift the labor demand

curve
– Any factor that changes the amount of labor
demand at any given level of the real wage
shifts the labor demand curve
Labor demand increases => ND shifts right
Labor demand decreases => ND shifts left
– Note: A change in the wage causes a movement

along the labor demand curve, not a shift of the
curve

• Factors that shift the labor demand

curve
– Supply shocks: Beneficial supply shock raises
MPN, so shifts labor demand curve 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

Figure 3.6: The effect of a beneficial
supply shock on labor demand

Summary 3: Factors That Shift the
Aggregate Labor Demand Curve

• Aggregate labor demand

– Aggregate labor demand is the sum of all firms’
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
• Supply of labor is determined by individuals

– Aggregate supply of labor is the sum of
individuals’ labor supply
– Labor supply of individuals depends on labor-
leisure choice
• Leisure: All off-the-job activities (eating, sleeping,
spending time with family and friends, etc.)

The Supply of Labor
• 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

The Supply of Labor
• If benefits of working another day exceed costs,

work another day
• Keep working additional days until benefits equal
costs
– As you work more, leisure time that you are
giving up will be more valuable, i.e. cost of
working increases
– When the cost of working equals the benefit of
working, you stop working => this gives the
amount of labor supplied by an individual

The Supply of Labor
• Real wages and labor supply

– An increase in the real wage has offsetting
income and substitution effects
• Substitution effect: 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 Supply of Labor

– 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

The Supply of Labor

– 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

The Supply of Labor

– 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; thus labor supply will
increase by less or decrease by more than for a
temporary reduction in the real wage

The Supply of Labor

– 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 Supply of Labor

– The labor supply curve (Fig. 3.7)
• Labor supply curve relates quantity of labor supplied to
the current real wage, holding other factors constant
• 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

Figure 3.7: 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 any given level of the current real
wage shifts the labor supply curve
Labor supply increases => NS shifts right
Labor supply decreases => NS shifts left

The Supply of Labor
• Factors that shift the labor supply curve of

an individual
– Wealth: Higher wealth reduces labor supply
(shifts labor supply curve to the left, as in
Fig. 3.8)
– 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)

Figure 3.8: The effect on labor supply
of an increase in wealth

The Supply of Labor
• 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

The Supply of Labor
• Factors that shift the aggregate labor

supply curve
– Factors increasing labor supply (NS shifts right)
• Decrease in wealth
• Decrease in expected future real wage
• Increase in working-age population (higher birth rate,
immigration)
• Increase in labor force participation (increased female
labor participation, elimination of mandatory
retirement)

Summary 4: Factors That Shift the
Aggregate Labor Supply Curve

Labor Market Equilibrium
• Equilibrium: Labor supply equals labor

demand
• Real wage adjusts to equate labor supply
and labor demand

Figure 3.9: Labor market equilibrium

• Determines
: Full-employment level of employment
(equilibrium level of employment)
: Market-clearing real wage (equilibrium real
wage)
• Classical model of the labor market—real
wage adjusts quickly
• Problem with classical model: can’t study
unemployment

Figure 3.10: Effects of a temporary
adverse supply shock on the labor
market

Figure 3.11: Effects of an increase in the
labor force participation rate

• Full-employment output
• Full-employment output = potential output
= level of output when labor market is in
equilibrium
Y  AF ( K , N ) (3.4)
• Affected by changes in A, K and

Unemployment
• Measuring unemployment
– 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

– Frictional unemployment
• Search activity of firms and workers due to
heterogeneity
• Matching process takes time

Unemployment
• Why there are always unemployed people

– Structural unemployment
• Chronically unemployed: workers who are unemployed
a large part of the time
• Structural unemployment: the long-term and chronic
unemployment that exists even when the economy is
not in a recession
• One cause: Lack of skills prevents some workers from
finding long-term employment
• Another cause: Reallocation of workers out of shrinking
industries or depressed regions; matching takes a long
time

Unemployment
• The natural rate of unemployment (u)

– natural rate of unemployment; when output and
employment are at full-employment levels
= frictional + structural unemployment
– Cyclical unemployment: difference between actual
unemployment rate and natural rate of unemployment
u u

Productivity, Output, and Employment

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Chapter 3

• The Production Function

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-2

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-3

• The production function

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-4

• The shape of the production function

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-5

• The shape of the production function

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-6

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-7

• The shape of the production function

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-8

• The shape of the production function

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• The shape of the production function

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-10

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-11

• The shape of the production function

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Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-13

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-14

• How much labor do firms want to use?

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• How much labor do firms want to use?

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• Benefit of an extra worker:

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• Cost of an extra worker:

• Compare the nominal wage (W) with MRPN

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• Clip Joint Example

1st worker: MRPN=$330 > W=$240 MPN=11 > w=8

2nd worker: MRPN=$270 > W=$240 MPN=9 > w=8

3rd worker: MRPN=$210 < W=$240 MPN=7 < w=8

=> The amount of labor demanded by Clip Joint is 2 workers

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• How much labor do firms want to use?

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• A change in the wage

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• The marginal product of labor and the labor

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Copyright ©2017 Pearson Education, Ltd. All rights reserved. 3-26

• Factors that shift the labor demand

– Note: A change in the wage causes a movement

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• Factors that shift the labor demand

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• Aggregate labor demand

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• Supply of labor is determined by individuals

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• The income-leisure trade-off