ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The Classical Model (I): The Labor Market

Real output Peak Long-run trend: growth in potential GDP

Peak

Trough

Trough Expansion Recession Expansion Time

1. The Classical Model In this and the next topics, we will consider the long-run behavior of the economy and focus on the determination of potential GDP (i.e. the long-run trend). The Classical model o Assumes wages and prices adjust rapidly enough to maintain equilibrium in all markets, i.e. market-clearing. o Argue that government should have, at most, a limited role in the economy. In order to fully understand how the macroeconomy works in the long run, we have to explore the following markets: o Labor Market The supply side o Goods Market The demand side o Loanable Funds Market (The In this topic, we focus on the supply side, i.e. the amount of output an economy produces. It depends on two factors: o The amounts of inputs (such as labor and capital) utilized in the production. o The production technology to transform inputs into outputs. Note that in the classical model, we focus on the real variables, which are measured in terms of real purchasing power.

2. The Production Function The production technology is summarized by the production function. o It shows the relationship between maximum amount of output produced and the amount of inputs (such as labor and capital) utilized.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

For now, we focus on just one input, labor. The following production function shows the relationship between output and the amount of labor used, keeping the amount of other inputs constant. Two important assumptions about a typical production function: o Marginal product is positive. o Law of diminishing marginal returns: as more of any variable input is added, holding other inputs constant, its marginal product will eventually decline (why?)
Real Output (Y)

Production Function Y2

Y1

L1 Real Output (Y)

L2

Labor (L)

New Production Function positive supply shock

Old Production Function

L1

L2

Labor (L)

The factors affecting the production function is called a supply shock (or productivity shock) o A positive (or beneficial) supply shock raises the amount of output that can be produced for given quantities of labor. It shifts the production function upward More output can be produced for a given amount of labor.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

It also increases the slope of the production function, i.e. the MPL increases. A negative (or adverse) supply shock lowers the amount of output that can be produced for given quantities of labor.

Examples of supply shocks: o Technological change o Increase in other inputs (e.g. capital stock) o Other factors such as weather and natural disasters

3. The Labor Market: Labor Demand To understand the labor demand, we need to understand individual firms employment decision, which is simply a marginal benefit and marginal cost comparison: o Marginal Revenue Product of Labor (MRPL) Suppose a firm considers employing an additional labor. If this worker can produce an additional output of 10 units per day and each unit of output can be sold at $10 (suppose other inputs remain fixed). What is the additional benefit of employing this additional worker? The MRPL measures the marginal benefit of employing an additional labor in terms of the extra revenue produced:
MRP P MPL L

Nominal wage (W) Suppose the market wage of each labor is $80 per day, should the firm employ this additional labor? Firms will increase employment as long as MRPL W. Firms will decrease employment as long as MRPL < W.

In general, firms will demand the amount of labors until

MRPL W

In terms of real wage, the labor demand can be expressed as:

P MPL W

MPL

W P

Labor demand curve shows the total amount of labor demanded at each real wage. o It is downward sloping because of diminishing marginal returns to labor. o Therefore, at a lower real wage, more labors are profitable to be employed, other things constant.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Real wage (W/P)

Labor Demand (LD) Labor (L)

Factors affecting labor demand: o Any factor affecting the marginal product of labor (MPL) o Supply shocks (i.e. technological change; increase in other inputs (e.g. capital stock), etc.)

4. The Labor Market: Labor Supply In deciding how much to work, individuals weigh the benefits against the costs of working, i.e. the income-leisure tradeoff.
Real wage (W/P) Labor Supply (LS)

Labor (L)

How would an increase in real wage affect the amount of labor supplied? o Substitution effect: An increase in real wage raises the cost of leisure, inducing households to supply more labor units. o Income (or wealth) effect:

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

An increase in real wage makes workers effectively wealthier because for the same amount of work they now earn a higher real income, inducing households to consume more leisure (hence supply less labor units).

It is generally assumed that the substitution effect outweighs the wealth effect and the labor supplied would increase with real wage. The labor supply curve, which shows the total amount of labor supplied at each real wage, is upward sloping.

Factors affecting labor supply: o Wealth o Expected future real wage o Working-age population o Labor-force participation rate

5. The Labor Market Equilibrium Based on the assumption that the real wage is flexible, the classical economists assumed the labor market clears, i.e. labor demand equals labor supply. o It ensures full employment (no cyclical unemployment) in the economy. o Note that small amount of frictional unemployment and structural unemployment still exists.

Real wage (W/P) Labor Supply (LS)

(W/P)

Labor Demand (LD) LF (full employment) Labor (L)

6. The Labor Market and Real Output Recall that the amount of output an economy produces depends on: o The amounts of inputs (such as labor and capital) utilized in the production. The amount of labor employed determined by the labor market equilibrium. o The production technology to transform inputs into outputs. The production function

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The following diagram shows the relationship between the labors employed and real output: o In the classical model, the economy reaches its potential output or GDP in the long run.

Real wage (W/P) Labor Supply (LS)

(W/P)

Labor Demand (LD)

Labor (L) Output (Y)

Production Function YF

LF

Labor (L)

7. The Supply Side Economics: Taxes and Labor Supply In 1980s, a group of supply-side economists1 stress that fiscal policy can affect economic growth.

This group mainly consisted of political commentators, mainly supporters of Ronald Reagan. In the 1980s, the nonpartisan American Economics Association recorded only 12 of approximately 18,000 members who called themselves supply-side economists.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The central idea is that tax cuts cause economic growth by increasing the rewards for effort and stimulating people to work harder and save more. o A major emphasis is on the impact of a change in tax, in particular a change in marginal tax rate, e.g. tax rates on labor income. They believe that a change in tax rates on labor income has the following impacts: Lower tax rates on labor income increases after-tax wage rate and make leisure more expensive, which will induce workers to work more. Therefore, it increases the labor supply. While a main concern of lowering tax rate is that it may lower government tax revenues, the major proposition of behind the supply-side economics is that lowering tax rate may have no impact on or even increase tax revenues. o Laffer curve2 depicts the relationship between tax rates and tax revenues.
Tax revenues (T)

T*

T1

t1

t*

t2

100

Tax rate (t)

While all economists would recognize that people may work less if taxes rise, Laffer curve is controversial because where the economy is actually located on the curve is difficult to determine.

Readings: Chapter 20 (p.598 606)

The Laffer curve is an idea developed in a series of dinner conversations in a New York restaurant between the economist Arthur Laffer and Robert Bartley, a journalist with the Wall Street Journal.