Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment

THE LABOR MARKET

3.1 The Production Function

The effectiveness with which capital and labor are used may be summarized by a relationship called the
production function. The production function is a mathematical expression relating the amount of
output produced to quantities of capital and labor utilized. A convenient way to write the production
function is

Y = AF (K, N), (1)

Where

Y = real output produced in a given period of time;

A = a number measuring overall productivity;

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.

The production function in Eq. (1) applies both to an economy as a whole (where Y, K, and N refer to the
economy's output, capital stock, and number of workers, respectively) and to an individual firm, in which
case Y, K, and N refer to the firm's output, capital, and number of workers, respectively.

The shape of the production function

The production function in Eq. (1) can be shown graphically. The easiest way to graph it is to
hold one of the two factors of production, either capital or labor, constant and then graph the
relationship between output and the other factor.

The production function relating output and capital

The production function relating output

and capital this production function
shows how much output the U.S.
economy could produce for each level of
U.S. capital stock, holding U.S. labor and
productivity at 2010 levels. Point A
corresponds to the actual 2010 output
and capital stock. The production
function has diminishing marginal
productivity of capital: Raising the capital
stock by $1000 billion to move from
point B to point C raises output by $927
billion, but adding another $1000 billion
in capital togo from point C to point D
increases output by only $730 billion.
Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment
THE LABOR MARKET
The production function graphed in Fig. 1 shares two properties with most production
functions:

1. The production function slopes upward from left to right. The slope of the production
function reveals that, as the capital stock increases, more output can be produced. 2. The
slope of the production function becomes flatter from left to right. This property
implies that although more capital always leads to more output, it does so at a
decreasing rate.

The marginal product of capital

The marginal product of capital, or MPK, is the increase in output produced that results from a
one-unit increase in the capital stock. Because ΔK additional units of capital permit the
production of ΔY additional units of output, the amount of additional output produced per
additional unit of capital is ΔY/ΔK. Thus the marginal product of capital is ΔY/ΔK.

The marginal product of capital is positive. Whenever the capital stock is increased, more output
can be produced. Because the marginal product of capital is positive, the production function
slopes upward from left to right.

The marginal product of capital declines as the capital stock is increased. Because the marginal
product of capital is the slope of the production function, the slope of the production function
decreases as the capital stock is increased. As Fig. 1 shows, the slope of the production function
at point D, where the capital stock is 4000, is smaller than the slope at point B, where the capital
stock is 2000. Thus the production function becomes flatter from left to right.

The marginal product of labor

The production function relating output

and labor This production function
shows how much output the U.S.
economy could produce at each level of
employment (labor input), holding
productivity and the capital stock
constant at 2010 levels. Point A
corresponds to actual 2010 output and
employment. The marginal product of
labor (MPN) at any point is measured as
the slope of the line tangent to the
production function at that point. The
MPN is lower at higher levels of
employment, reflecting diminishing
marginal productivity of labor.
Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment
THE LABOR MARKET
Supply shock

The production function of an economy doesn’t usually remain fixed over time. Economists use
the term supply shock—or, sometimes, productivity shock—to refer to a change in an
economy’s production function. A positive, or beneficial, supply shock raises the amount of
output that can be produced for given quantities of capital and labor. A negative, or adverse,
supply shock lowers the amount of output that can be produced for each capital-labor
combination.

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 that improve
efficiency, such as computerized inventory control or statistical analysis in quality control; and
changes in government regulations, such as antipollution laws, that affect the technologies or
production methods used. Also included in the category of supply shocks are changes in the
supplies of factors of production other than capital and labor that affect the amount that can be
produced.

Figure shows the effects of an adverse supply shock on the production function relating output
and labor. The negative supply shock shifts the production function downward so that less
output can be produced for specific quantities of labor and capital. In addition, the supply shock
shown reduces the slope of the production function so that the output gains from adding a
worker (the marginal product of labor) are lower at every level of employment. Conversely, a
beneficial supply shock makes possible the production of more output with given quantities of
capital and labor and thus shifts the production function upward.

An adverse supply shock

that lowers the MPN

An adverse supply shock is

a downward shift of the
production function. For
any level of labor, the
amount of output that can
be produced is now less
than before. The adverse
shock reduces the slope of
the production function at
every level of
employment.
Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment
THE LABOR MARKET
3.2 Demand for Labor

As a step toward understanding the overall demand for labor in the economy, we consider how
an individual firm decides how many workers to employ. To keep things simple for the time
being, we make the following assumptions:

a) Workers are all alike. We ignore differences in workers’ aptitudes, skills, ambitions, and
so on.
b) Firms view the wages of the workers they hire as being determined in a competitive labor
market and not set by the firms themselves. For example, a competitive firm in
Cleveland that wants to hire machinists knows that it must pay the going local wage for
machinists if it wants to attract qualified workers. The firm then decides how many
machinists to employ.
c) In making the decision about how many workers to employ, a firm’s goal is to earn the
highest possible level of profit (the value of its output minus its costs of production,
including taxes). The firm will demand the amount of labor that maximizes its profit.

A Change in Wage

All else being equal, a decrease in the real wage raises the amount of labor demanded.
Similarly, an increase in the real wage decreases the amount of labor demanded.
Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment
THE LABOR MARKET
MPN and labor demand curve
The determination of labor
demand mount of labor
demanded is determined by
locating the point on the MPN
curve at which the MPN equals
the real wage rate; the amount of
labor corresponding to that point
is the amount of labor
demanded. For example, when
the real wage is w*, the MPN
equals the real wage at point A
and the quantity of labor
demanded is N*. The labor
demand curve, ND, shows the
amount of labor demanded at
each level of the real wage. The
labor demand curve is identical to
the MPN curve.

Factors That Shift Labor Demand Curve

The effect of a beneficial supply

shock on labor demand a beneficial
supply shock that raises the MPN at
every level of labor shifts the MPN
curve upward and to the right.
Because the labor demand curve is
identical to the MPN curve, the labor
demand curve shifts upward and to
the right from ND1 to ND2. For any
real wage, firms demand more labor
after a beneficial supply shock.
Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment
THE LABOR MARKET

Aggregate Demand for Labor

So far we have focused on the demand for labor by an individual firm, such as The Clip Joint. For
macroeconomic analysis, however, we usually work with the concept of the aggregate demand
for labor, or the sum of the labor demands of all the firms in an economy. Because the
aggregate demand for labor is the sum of firms’ labor demands, the factors that determine the
aggregate demand for labor are the same as those for an individual firm. Thus the aggregate
labor demand curve looks the same as the labor demand curve for an individual firm Like the
firm’s labor demand curve, the aggregate labor demand curve slopes downward, showing that
an increase in the economy wide real wage reduces the total amount of labor that firms want
to use. Similarly, a beneficial supply shock or an increase in the aggregate capital stock shifts
the aggregate labor demand curve upward and to the right; an adverse supply shock or a drop
in the aggregate capital stock shifts it downward and to the left.

3.3 Supply of Labor.

The aggregate supply of labor is the sum of the labor supplied by everyone in the economy.
Recall that, in determining how much labor to demand, firms compare the costs and benefits of
hiring additional workers. Similarly, in deciding how much to work, an individual should weigh
the benefits against the costs of working.

Trade-Off between Income and Leisure

Labor should continue to increase his time at work until the utility he receives from the
additional income just equals the loss of utility associated with missing an hour of leisure.

Real Wage

Generally, an increase in the real wage affects the labor supply decision in two ways. First, an
increase in the real wage raises the benefit (in terms of additional real income) of working an
additional hour and thus tends to make the worker want to supply more labor. The tendency of
workers to supply more labor in response to a higher reward for working is called the
substitution effect of a higher real wage on the quantity of labor supplied.

Second, an increase in the real wage makes workers effectively wealthier because for the same
amount of work they now earn a higher real income. Someone who is wealthier will be better
able to afford additional leisure and, as a result, will supply less labor. The tendency of workers
to supply less labor in response to becoming wealthier is called the income effect of a higher
real wage on the quantity of labor supplied
Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment
THE LABOR MARKET
Note that the substitution and income
effects of a higher real wage operate in
opposite directions, with the substitution
effect tending to raise the quantity of labor
supplied and the income effect tending to
reduce it.

The labor supply curve of an individual

worker the horizontal axis shows the
amount of labor that a worker will supply
for any given current real wage on the
vertical axis. The labor supply curve slopes
upward, indicating that—with other
factors, including the expected future real
wage, held constant—an increase in the
current real wage raises the amount of
labor supplied.

3.4 Labor Market Equilibrium.

The quantity of labor demanded equals
the quantity of labor supplied at point
E. The equilibrium real wage is
w, and the corresponding equilibrium
level of employment is N, the
Full-employment level of employment.
Macroeconomics Long Run Economic Performance BBA-II Productivity, Output and Employment
THE LABOR MARKET
Effects of a temporary adverse supply shock on the labor market.

An adverse supply shock

that lowers the marginal
product of labor (see
Fig. 3.4) reduces the
quantity of labor demanded
at any real wage
level. Thus the labor
demand curve shifts left,
from ND1 to ND2, and
the labor market equilibrium
moves from point
A to point B. The adverse
supply shock causes the
real wage to fall from w1
to w2 and reduces the
full-employment level
of employment from N1
to N2.

Full-employment

By combining labor market equilibrium and the production function, we can determine the
amount of output that firms want to supply. Full-employment output, Y, sometimes called
potential output, is the level of output that firms in the economy supply when wages and prices
have fully adjusted. Equivalently, full-employment output is the level of output supplied when
aggregate employment equals its full-employment level, N. Algebraically, we define full
employment output, Y, by using the production function.

Y = AF(K, N). …………….. (3.4)

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 Eq. (3.4).

The adverse supply shock reduces the demand for labor and thus lowers the full-employment
level of employment N. A reduction in N also reduces full-employment output, Y, as Eq. (3.4)
confirms.