The Labor Market and Potential
GDP
• The Supply of Labor
– 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.
– The supply of labor is the relationship
between the quantity of labor supplied and the
real wage rate, all other things remaining the
same.
The Labor Market and Potential GDP
Figure 8.4 illustrates a
labor supply curve.
The higher the real wage
rate, the greater is the
quantity of labor supplied.
The Labor Market and Potential
GDP
– The quantity of labor supplied increases as
the real wage rate increases for two reasons:
– Hours per person increase
– Labor force participation increases
The Labor Market and Potential
GDP
– Hours per person increase because the real
wage rate is the opportunity cost of not
working.
– But a higher real wage rates increase income,
which increases the demand for normal
goods, including leisure.
– An increase in the quantity of leisure
demanded means a decrease in the quantity
of labor supplied.
– The opportunity cost effect is usually greater
than the income effect, so a rise in the real
The Labor Market and Potential
GDP
– 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.
– 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.
Shape of Labor Supply Curve
– 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.
The Labor Market and Potential
GDP
– The labor market is in equilibrium at the real
wage rate at which the quantity of labor
demanded equals the quantity of labor
supplied.
– Labor market equilibrium is full-employment
equilibrium.
– The level of real GDP at full employment is
potential GDP.
The Labor Market and Potential GDP
Figure 8.5(a) illustrates
labor market equilibrium.
Labor market equilibrium
occurs at a real wage rate
of $35 and an employment
of 200 billion labor hours.
The Labor Market and Potential GDP
Potential GDP
At a full employment level
of 200 billion hours,
potential GDP is 10 trillion
dollars.
Unemployment at Full
Employment
– The unemployment rate at full employment is
called the natural rate of unemployment.
– Unemployment always is present for two
broad reasons
– Job search (Frictional and Structural
Unemployment)
– Job rationing
Unemployment at Full Employment
Figure 8.6 illustrates the
relationship between the
amount of job search
unemployment and the
real wage rate.
Unemployment at Full
Employment
– The amount of job search unemployment
changes over time and some of the sources
of these changes are
– Demographic change
– Unemployment compensation
– Structural change
Unemployment at Full
Employment
– Demographic change
– As more young workers entered the labor
force in the 1970s, the amount of frictional
unemployment increased as they searched
for jobs. Frictional unemployment 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 has an income.
Unemployment at Full
Employment
– Unemployment compensation
– 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.
Unemployment at Full
Employment
– Structural change
– An increase in the pace of technological
change that reallocates jobs between
industries or regions increases the amount of
search.
Unemployment at Full
Employment
• Job Rationing
– Job rationing occurs when employed
workers are paid a wage that creates an
excess supply of labor.
– Job rationing can occur for two reasons
– Efficiency wage
– Minimum wage
Unemployment at Full
Employment
– An efficiency wage is a real wage rate that is
set above the full-employment equilibrium
wage that balances the costs and benefits of
this higher wage rate to maximize the firm’s
profit.
– The cost of a higher wage is direct.
– The benefit of a higher wage is indirect: it
enables a firm to attract high-productivity
workers, stimulates greater work effort, lowers
the quit rate, and lowers recruiting costs.
Unemployment at Full
Employment
– A minimum wage is the lowest wage rate at
which a firm may legally hire labor.
– If the minimum wage is set below the
equilibrium wage rate, it has no effect.
– If the minimum wage is set above the
equilibrium wage rate, it does affect the labor
market.
Unemployment at Full
Employment
• Job Rationing and Unemployment
– 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.
– Most economists agree that efficiency wages
and minimum wages increase the natural
unemployment rate.