1
C h a p t e r
07
THE ECONOMY AT
FULL EMPLOYMENT
O u t l i n e
Production and Jobs
A. In 2001, each hour of work produced twice as much output
as in 1961. Why? And how can output per hour increase
even during a recession, as in 2001?
B. What are the connections between capital accumulation,
education, and technical change with employment,
earnings, and potential GDP?
C. What determines the level of unemployment at full
employment?
I.
Real GDP and Employment
A. Production Possibilities
1. The production possibility frontier (PPF) is the
boundary between those combinations of goods and
services that can be produced and those that cannot.
2. Figure 22.1(a) (page 505/159) illustrates a production
possibility frontier between leisure time and real
GDP.
3. The more leisure time foregone, the greater is the
quantity of labor employed and the greater is the real
GDP.
4. The PPF showing the relationship between leisure time
and real GDP is bowed-out, which indicates an
increasing opportunity cost.
5. Opportunity cost is increasing because the most
productive labor is used first and as more labor is
used it is increasingly less productive.
B. The Production Function
1. The production function is the relationship between real
GDP and the quantity of labor employed, other things
remaining the same.
2. One more hour of labor employed means one less hour of
leisure, therefore the production function is the
mirror image of the leisure time-real GDP PPF.
3. Figure 22.1(b) (page 505/159) illustrates the
production function that corresponds to the PPF shown
in Figure 22.1(a).
C. Changes in Productivity
1. Labor productivity is real GDP per hour of labor.
2. Three factors influence labor productivity.
a) Physical capital: the more physical capital, the
more productive is labor, other things remaining
the same.
b) Human capital: the more human capital, the more
productive is labor, other things remaining the
same.
i) Human capital is the knowledge and skill that has
been acquired from education and on-the-job
training.
ii)
Learning-by-doing is the activity of on-the-job
education that can greatly increase labor
productivity.
c) Technology: the more technological advances, the
greater labor productivity, other things remaining
the same.
D. Shifts in the Production Function
1. Any influence that increases labor productivity
increases real GDP at each level of labor hours and
shifts the production function upward.
2. Figure 22.2(a) (page 506/160) illustrates in increase
in labor productivity. The production function shifts
upward from PF0 to PF1. This shift could result from an
increase in physical and/or human capital and/or
technological change.
3. Figure 22.2(b) (page 160) illustrates the increase in
U.S. labor productivity and the associated shift in
the production function between 1981 and 2001.
II. The Labor Market and Aggregate Supply
A. The Demand for Labor
1. The quantity of labor demanded is the labor hours hired by
all firms in the economy.
2. The demand for labor, Figure 22.3 (page 507/161) is the
relationship between the quantity of labor demanded
and the real wage rate, other things remaining the
same.
3. The real wage rate is the quantity of good and services
that an hour of labor earns.
a) The money wage rate is the number of dollars an hour
of labor earns.
b) The average real wage rate is the average money
wage rate divided by the price level multiplied by
100.
c) It is the real wage rate, not the money wage rate,
that determines the quantity of labor demanded.
4. The demand for labor depends on the marginal product of
labor, which is the additional real GDP produced by an
additional hour of labor, all other things remaining
the same.
a) The marginal product of labor is calculated as the
change in real GDP divided by the change in the
quantity of labor employed. The marginal product of
labor is the slope of the PF curve.
b) The marginal product of labor diminishes as the
quantity of labor employed increases. Diminishing
marginal product occurs because all the labor
employed works with the same fixed capital and
technology, and is an example of the law of diminishing
returns.
c) The diminishing marginal product of labor limits
the demand for labor.
5. The demand for labor is the marginal product of labor.
Figure 22.4 (page 508/162) shows the PF in part (a).
The production function determines the marginal
product of labor, which is the slope of the PF curve.
And the marginal product of labor curve is the demand
for labor curve in part (b).
a) Firms hire more labor as long as the marginal
product of labor exceeds the real wage rate.
b) Eventually, with the diminishing marginal product
of labor, the extra output from an extra hour of
labor is exactly what the extra hour of labor
costs, i.e. the real wage rate. At this point, the
profit-maximizing firm hires no more labor.
c)
When the marginal product of labor changes, the
demand for labor changes. If the marginal product
of labor increases, the demand for labor shifts
rightward.
B. The Supply of Labor
1. The quantity of labor supplied is the number of labor hours
that all the households in the economy plan to work at
a given real wage rate.
2. The supply of labor is the relationship between the
quantity of labor supplied and the real wage rate, all
other things remaining the same.
3. The quantity of labor supplied increases as the real
wage rate increases for two reasons:
a) Hours per person increase because the higher the
real wage rate, the higher the opportunity cost of
not working. There is an opposing income effect.
The higher real wage rates increase household
income, which increases the demand for all normal
goods, including leisure. An increase in the
quantity of leisure demanded is the same thing as a
decrease in the quantity of labor supplied. The
opportunity cost effect is usually greater than the
income effect over the relevant range for most U.S.
workers, so a rise in the real wage rate brings an
increase in the quantity of labor supplied.
b) Labor force participation increases because higher
real wage rates induce some people who choose not
to work at lower real wage rates to enter the labor
force.
4. The labor supply response to an increase in the real
wage rate is positive but small. A large percentage
increase in the real wage rate brings a small
percentage increase in the quantity of labor supplied.
The labor supply curve is relatively steep. Figure
22.5 (page 509/163) illustrates a labor supply curve.
C. Labor Market Equilibrium and Potential GDP
1. Labor market equilibrium is the real wage rate where the
quantity of labor demanded is equal to the quantity of
labor supplied. Figure 22.6(a), (page 511/165)
illustrates labor market equilibrium.
2. Labor market equilibrium is full-employment
equilibrium.
3. The level of real GDP at full employment is potential
GDP. Note that in Figure 22.6(a), labor market
equilibrium occurs at 200 billion labor hours.
Referring back to the production function in Figure
22.2 repeated as Figure 22.6(b) (page 511/165) 200
billion labor hours would indicate that potential GDP
is 10 trillion dollars.
D. Aggregate Supply
1. The long-run aggregate supply curve is the relationship
between the quantity of real GDP supplied and the
price level when real GDP equals potential GDP.
2. Figure 22.7 (page 511/165) illustrates the long-run
and short-run aggregate supply curves (LAS and SAS).
LAS is a vertical line at potential GDP.
a) As the price level changes, the money wage also
changes to keep the real wage rate at the fullemployment equilibrium level.
b) With no change in the real wage rate, there is no
change in real GDP.
3. The short-run aggregate supply curve is the relationship
between the quantity of real GDP supplied and the
price level when the money wage rate and potential GDP
remain constant.
a) Along the SAS curve, as the price level increases,
the money wage remains the same, so the real wage
rate falls. As the real wage rate falls the
quantity of labor demanded increases and real GDP
increases.
i) When the economy is above potential GDP, the
real wage rate is lower than the equilibrium
real wage rate.
ii)
When the economy is below potential GDP, the
real wage rate is greater than the equilibrium
real wage rate.
4. Production is efficient in the sense that the economy
is on its PPF, but is inefficient in the sense that
the economy is not at a sustainable point on the PPF.
5. The sustainable point on the PPF is at the fullemployment equilibrium, which is illustrated in Figure
22.1 by point A.
III. Changes in Potential GDP
A. Real GDP increases if the economy recovers from a
recession or if potential GDP increases. Two factors that
increase potential GDP are an increase in population and
an increase in labor productivity.
B. An Increase in Population
1. An increase in population increases the supply of
labor, as illustrated in Figure 22.8 (page 513/167).
2. An increase in the supply of labor shifts the labor
supply curve rightward creating a surplus of labor
that results in a decrease in the equilibrium real
wage rate and an increase in the equilibrium quantity
of labor.
3. As the full-employment quantity of labor increases,
the level of potential GDP increases.
4. The potential GDP per hour of work decreases.
a) Potential GDP is increasing but at a decreasing
rate due to diminishing returns. Potential GDP per
hour of work decreases.
C. An Increase in labor Productivity
1. Three factors increase labor productivity. The effects
of an increase in labor productivity are illustrated
in Figure 22.9 (page 515/169).
2. An increase in physical capital increases labor
productivity.
a) Additional capital increases the real GDP that each
quantity of labor can produce.
b) Additional capital increases the marginal product
of labor, so the demand for labor increases.
c) Some capital replaces labor, so the demand for that
type of labor replaced decreases.
d) Increases in the demand for labor exceed the
decreases in the demand for labor, so there is a
net increase in the demand for labor and the
equilibrium real wage rate increases as does the
equilibrium quantity of labor supplied.
e) Potential GDP increases because a given level of
employment produces more and because the
equilibrium level of employment has increased.
3. An increase in human capital also increases labor
productivity.
a) The results are similar to that of an increase in
physical capital. There is an increase in the real
wage rate, employment, and potential GDP.
4. An advance in technology also increases labor
productivity.
a) The results are similar to that of an increase in
physical capital. There is an increase in the real
wage rate, employment and potential GDP.
D. Population and Productivity in the United States
1. Population and productivity in the United States have
increased over time. We compare 1981 with 2001, both
times of close to full employment, in Figure 22.10
(page 516/170).
2. The working age population in the United States
increased by 25 percent, from 170 million to 212
million.
a) Labor hours increased by more than 25 percent, from
159 billion to 231 billion, during the same period,
because increases in capital and technological
advances increased labor productivity and thus real
wage rates, which increased the labor force
participation rate.
3. The capital stock increased from $15 trillion (1996
dollars) to $25 trillion. This increase in the capital
stock increased labor productivity.
4. Technological advances have occurred from 1981 to
2001. Most notably the information revolution and the
widespread computerization of production processes
have increased labor productivity.
5. The effects have been an increase in the real wage
rate from $18 to $24 per hour and an increase in the
number of hours employed from 159 billion hours per
year to 231 billion hours per year.
IV. Unemployment at Full Employment
A. Unemployment always is present.
1. The unemployment rate at full employment is called the
natural rate of unemployment.
2. The natural unemployment rate is always positive; that
is, there is always some unemployment because of job
search and job rationing.
B. Job Search
1. Job search is the activity of workers looking for an
acceptable vacant job.
2. All unemployed workers—frictionally, structurally, and
cyclically unemployed — search for new jobs, and while
they search many are unemployed. Job search
unemployment, and how it is consistent with our notion
of the natural unemployment rate, is illustrated in
Figure 22.11 (page 517/171).
3. Job search can be affected by:
a) Demographic change. As more young workers entered
the labor force in the 1970s, the amount of
frictional unemployment increased as they searched
for jobs. It may have fallen in the 1980s as those
workers aged. Two-earner households may increase
search, because one member can afford to search
longer if the other still has income.
b) Unemployment benefits. The more generous
unemployment benefit payments become, the lower the
opportunity cost of unemployment, so the longer
workers search for better employment rather than
any job. More workers are covered now by
unemployment insurance than before, and the
payments are relatively more generous.
c) Structural change. An increase in the pace of
technological change that reallocates jobs between
industries or regions increases the amount of
search.
C. Job Rationing
1. Job rationing occurs when employed workers are paid a
wage that creates an excess supply of labor.
2. Job rationing can occur for two reasons:
a) A firm pays an efficiency wage, or above-equilibrium
wage, in order to boost its workers’ productivity.
b) The minimum wage is set above the equilibrium wage
rate.
D. Job Rationing and Unemployment
1. If the real wage rate is above the equilibrium wage,
regardless of the reason, there is a surplus of labor
that adds to unemployment and increases the natural
unemployment rate.
2. Most economists agree that efficiency wages and
minimum wages increase the natural unemployment rate.
a) Card and Krueger have challenged this view and
argue that an increase in the minimum wage works
like an efficiency wage, making workers more
productive and less likely to quit.
b) Hamermesh argues that firms anticipate increases in
the minimum wage and cut employment before they
occur. Therefore, looking at the effects of minimum
wage changes after the change occurs misses the
effects.
c) Welch and Murphy say regional differences in
economic growth, not changes in the minimum wage,
explain the Card and Krueger theory.