Productivity, Output, and Employment: Objectives

Chapter 3
Productivity, Output, and Employment
 Learning Objectives
I. Goals of Part 2: The Macroeconomics of Full Employment
A. Analyze factors that affect the longer-term performance of the economy
B. Develop a theoretical model of the macroeconomy
1. Three markets
a. Labor market (this chapter)
b. Goods market (Ch. 4)
c. Asset market (Ch. 7)
II. Goals of Chapter 3

A. Discuss production function properties and changes (Section 3.1)
B. Discuss factors that affect the demand for labor (Section 3.2)
C. Discuss the factors that affect the supply of labor (Section 3.3)
D. Identify factors that affect labor market equilibrium (Section 3.4)
E. Explain how the unemployment rate is measured and describe changes in employment status
(Section 3.5)
F. Explain the significance of Okun’s law (Section 3.6)
III. Notes to Eighth Edition Users

A. We added a new box on alternative measures of the unemployment rate
B. We have also made the Working with Macroeconomic Data questions align more closely
between the textbook and MyEconLab
©2017 Pearson Education, Inc.

Chapter 3 Productivity, Output, and Employment 35
 Teaching Notes
I. How Much Does the Economy Produce? The Production Function (Sec. 3.1)
A. Factors of production
1. Capital (K)
2. Labor (N)
3. Others (raw materials, land, energy)
4. Productivity of factors depends on technology and management
B. The production function
1. Y  AF(K, N) (3.1)
2. Parameter A is “total factor productivity” (the effectiveness with which capital and labor
are used)
C. Application: The production function of the U.S. economy and U.S. productivity growth
1. Cobb-Douglas production function works well for U.S. economy:
Y  A K 0.3 N 0.7 (3.2)
2. Data for U.S. economy—text Table 3.1
Numerical Problem 1 gives students practice working with a production function.
3. Productivity growth calculated using production function

a. Productivity moves sharply from year to year
Data Application
An example of the sharp movements in productivity that are possible can be seen by comparing
data on productivity for 2003 to data for 2004. Employment grew about the same amount in both
years, but in 2003 productivity grew 1.6%, while in 2004 it grew 2.4%. Economists generally
believe that it is measurement error, rather than true changes in productivity, that is responsible
for these swings during a given phase of the business cycle. As the business cycle changes
phases, for example from recession to expansion, there may be large, true swings in productivity.
For example, in 2009, productivity fell 0.2%, and in 2010 it rose 2.8%.
Roy H. Webb addresses the pitfalls in using productivity statistics in his article “National
Productivity Statistics,” Federal Reserve Bank of Richmond Economic Quarterly, Winter 1998,
pp. 45–64.
b. Productivity grew rapidly in the second half of the 1990s, but grew much more slowly in
the 2000s
Policy Application
Perhaps the greatest source of uncertainty facing policymakers in the 1990s and early 2000s was
trying to figure out the underlying trend in productivity. For a discussion of this issue, see the
article “How Fast Can the New Economy Grow?” by Glenn Rudebusch, Federal Reserve Bank of
San Francisco Economic Letter, February 25, 2000.

36 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
D. The shape of the production function

1. Two main properties of production functions
a. Slopes upward: more of any input produces more output
b. Slope becomes flatter as input rises: diminishing marginal product as input increases
2. Graph production function (Y vs. one input; hold other input and A fixed)
a. Marginal product of capital, MPK  Y/K (Figure 3.1; Key Diagram 1; like text
Figure 3.2)
Figure 3.1
(1) Equal to slope of production function graph (Y vs. K)

(2) MPK always positive
(3) Diminishing marginal productivity of capital—MPK—declines as K rises
b. Marginal product of labor, MPN  Y/N (Figure 3.2; like text Figure 3.3)
Figure 3.2
(1) Equal to slope of production function graph (Y vs. N)

(2) MPN always positive
(3) Diminishing marginal productivity of labor
Numerical Problem 2 gives students practice calculating the MPK and MPN.

E. Supply shocks
1. Supply shock  productivity shock  a change in an economy’s production function
2. Supply shocks affect the amount of output that can be produced for a given amount of inputs
3. Shocks may be positive (increasing output) or negative (decreasing output)
4. Examples: weather, inventions and innovations, government regulations, oil prices
5. Supply shocks shift graph of production function (Figure 3.3; like text Figure 3.4)
Figure 3.3
a. Negative (adverse) shock: Usually slope of production function decreases at each level of
input (e.g., if shock causes parameter A to decline)
b. Positive shock: Usually slope of production function increases at each level of output
(e.g., if parameter A increases)
Analytical Problem 1 asks students to draw production functions and show how they change
when there are supply shocks.
Theoretical Application
At this point, the instructor may wish to introduce the idea of real business cycle analysis
(discussed in greater detail in Chapter 10). The basic point to get across is that many business
cycle fluctuations may be caused by outside events (supply shocks) over which policy has no
control.
II. The Demand for Labor (Sec. 3.2)

A. How much labor do firms want to use?
1. Assumptions
a. Hold capital stock fixed—short-run analysis
b. Workers are all alike
c. Labor market is competitive
d. Firms maximize profits

2. Analysis at the margin: costs and benefits of hiring one extra worker (Figure 3.4; like text
Figure 3.5)
Figure 3.4
a. If real wage (w)  marginal product of labor (MPN), the firm is paying the marginal
worker more than the worker produces, so the firm should reduce the number of workers
to increase profits
b. If w  MPN, the marginal worker produces more than he or she is being paid, so the firm
should increase the number of workers to increase profits
c. Firms’ profits are highest when w  MPN
B. The marginal product of labor and labor demand: an example
1. Example: The Clip Joint—setting the nominal wage equal to the marginal revenue product
of labor
MRPN  P  MPN (3.3)
2. W  MRPN is the same condition as w  MPN, since W  P  w and MRPN  P  MPN
3. A change in the wage
a. Begin at equilibrium where W  MRPN
b. A rise in the wage rate means W  MRPN, unless N is reduced so the MRPN rises
c. A decline in the wage rate means W  MRPN, unless N rises so the MRPN falls
Numerical Problem 3 sets up an example in which students calculate MPN and see what happens
when the wage rate or price of the product changes.
C. The marginal product of labor and the labor demand curve

1. Labor demand curve shows relationship between the real wage rate and the quantity of labor
demanded

2. It is the same as the MPN curve, since w  MPN at equilibrium

3. So the labor demand curve is downward sloping; the higher the real wage, the less labor
firms want to hire
D. Factors that shift the labor demand curve
1. Note: A change in the wage causes a movement along the labor demand curve, not a shift of
the curve
2. Supply shocks: Beneficial supply shock raises MPN, so shifts labor demand curve to the
right; opposite for adverse supply shock
3. Size of capital stock: Higher capital stock raises MPN, so shifts labor demand curve to the
right; opposite for lower capital stock
E. Aggregate labor demand (Figure 3.5)
Figure 3.5
1. Aggregate labor demand is the sum

of all firms’ labor demand
2. Same factors (supply shocks, size
of capital stock) that shift firms’ labor demand
cause shifts in aggregate labor demand
III. The Supply of Labor (Sec. 3.3)

A. Supply of labor is determined by
individuals
1. Aggregate supply of labor is sum
of individuals’ labor supply
2. Labor supply of individuals
depends on labor-leisure choice
B. The income-leisure trade-off
1. Utility depends on consumption and leisure
2. Need to compare costs and benefits of working another day
a. Costs: Loss of leisure time
b. Benefits: More consumption, since income is higher
3. If benefits of working another day exceed costs, work another day
4. Keep working additional days until benefits equal costs
C. Real wages and labor supply
1. An increase in the real wage has offsetting income and substitution effects
a. Substitution effect of a higher real wage: Higher real wage encourages work, since the
reward for working is higher
b. Income effect of a higher real wage: Higher real wage increases income for the same
amount of work time, and with higher income, the person can afford more leisure, so will
supply less labor
2. A pure substitution effect: a one-day rise in the real wage
a. A temporary real wage increase has just a pure substitution effect, since the effect on
wealth is negligible
3. A pure income effect: winning the lottery

a. Winning the lottery doesn’t have a substitution effect, because it doesn’t affect the reward
for working
b. 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
4. The substitution effect and the income effect together: a long-term increase in the real wage
a. The reward to working is greater: a substitution effect toward more work
b. But with a higher wage, a person doesn’t need to work as much: an income effect toward
less work
c. 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
5. Empirical evidence on real wages and labor supply
a. Overall result: Labor supply increases with a temporary rise in the real wage
b. Labor supply falls with a permanent increase in the real wage
The results of changes in labor supply due to changes in the wage rate play a major role in the
real business cycle (RBC) model of the economy that we will examine in Chapter 10.
Analytical Problem 7 examines how workers might change their labor supply if there are changes
in Social Security taxes.
D. The labor supply curve (Figure 3.6; like text Figure 3.7)
1. Increase in the current real wage should raise quantity of labor supplied
2. Labor supply curve relates quantity of labor supplied to real wage
Figure 3.6

The field of labor economics studies the determinants of labor supply. One of the major issues in
the 1970s and early 1980s had to do with the increased participation rates of women in the labor
force. Research on both the causes and consequences of this change occupied many economists
and yielded many interesting research results, such as explaining why there is a negative
relationship between family income and labor force participation across families, but over time
there is a positive relationship. Now, in the 2010s, we are working on research to explain the
significant decline in labor force participation that has occurred in recent years, especially since
the recession of 2007–2009.
3. Labor supply curve slopes upward because higher wage encourages people to work more
E. Factors that shift the labor supply curve
1. Wealth: Higher wealth reduces labor supply (shifts labor supply curve to the left; text
Fig. 3.8)
2. 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)
Analytical problem 4 asks students to think about factors that shift an individual’s labor supply
curve.
F. Aggregate labor supply

1. Aggregate labor supply rises when current real wage rises
a. Some people work more hours
b. Other people enter labor force
c. Result: Aggregate labor supply curve slopes upward
2. Factors increasing labor supply
a. Decrease in wealth
b. Decrease in expected future real wage
c. Increase in working-age population (higher birth rate, immigration)
d. Increase in labor force participation (increased female labor participation, elimination of
mandatory retirement)
Data Application
A broad characterization of labor force participation rates (LFPR) is that men’s LFPR had
declined fairly steadily from the 1960s to the 1980s, while the LFPR of women was rising. But
in the 1990s, women’s LFPR growth slowed, probably due to both economic (a discouraged
worker effect) and social considerations (an increased fertility rate). These factors continued in
the 2000s, and women’s LFPR actually declined from about 60% in 2000 to about 57% in 2015.
IV. Labor Market Equilibrium (Sec. 3.4)

A. Equilibrium: Labor supply equals labor demand (Figure 3.7; Key Diagram 2; like text
Figure 3.9)

Figure 3.7
1. Classical model of the labor market—real wage adjusts quickly (later, in Chapter 11, look at
other models of labor market in which real wage does not adjust quickly)
2. Determines full-employment level of employment N and market-clearing real wage w
3. Factors that shift labor supply or labor demand affect N and w
4. Problem with classical model: can’t study unemployment
Numerical Problems 4, 5, and 6 are exercises in which students are given algebraic labor demand
and supply curves and are asked to find the equilibrium. Analytical Problems 3 and 5 are
comparative static exercises dealing with labor market equilibrium.

Data Application
There are, of course, many different wages in the economy; our model with just one wage is a
simplification. When economists look at real data to see how wages are changing over time, they
control for the fact that the mix of jobs changes over time. The employment cost index (ECI)
provides a measure of the change in the wage rate that controls for changes in the mix of jobs;
economists use changes in the ECI to see how wages change relative to inflation.
Data Application
Real wage growth changes substantially over time. In the 1960s, real wages grew 26%, but wage
growth slowed considerably after that. The slowest wage growth occurred in the 1980s, as this
table shows. (Source: Bureau of Labor Statistics, downloaded from FRED database, Federal
Reserve Bank of St. Louis, variable COMPRNFB.)
Real Wage Growth by Decade (percent per decade)

1960s 26%
1970s 13%
1980s 7%
1990s 13%
2000s 13%
B. Full-employment output
1. Full-employment output  potential output  Y level of output when labor market is in
equilibrium
2. Y  AF(K, N ) (3.4)
3. Y affected by changes in N or production function (example: supply shock, text Fig. 3.10)
Analytical Problem 2 asks students to show how different shocks to the economy affect full-
employment output.
Data Application
What is full-employment output? For many of our theories about macroeconomics, we need a
measure of full-employment output, but it is not clear where to get such a measure. In practice,
economists make some assumptions about the structure of the economy, including the production
function or the relationship between unemployment and output (see Section 3.6 on Okun’s law),
apply these assumptions to the data, and thus estimate what they think is the full-employment
level of output.
C. Application: output, employment, and the real wage during oil price shocks
1. Sharp oil price increases in 1973–1974, 1979–1980, 2003–2008 (text Fig. 3.11)
2. Adverse supply shock—lowers labor demand, employment, the real wage, and the full-
employment level of output
3. First two cases: U.S. economy entered recessions

4. Research result: 10% increase in price of oil reduces GDP by 0.4 percentage points
V. Unemployment (Sec. 3.5)

A. Measuring unemployment
1. Categories: employed, unemployed, not in the labor force
2. Labor Force  Employed  Unemployed
3. Unemployment Rate  Unemployed/Labor Force
4. Table 3.4 shows current data
Data Application
The unemployment rate jumped up sharply in January 1994, not because of any true change in
the labor market, but merely because the Bureau of Labor Statistics changed the survey with
which it calculates the unemployment statistics. The older survey didn’t properly distinguish
between the classifications of unemployed and not in the labor force. In addition, introducing
laptop computers on which to perform the survey eliminated a number of errors in the way
people answered questions. The result was a small increase in the measured unemployment rate,
but no change in the underlying amount of unemployment.
4. Participation Rate  Labor Force/Adult Population

5. Employment Ratio  Employed/Adult Population
Analytical Problem 6 tests students’ ability to use these different measures.
B. Changes in employment status

1. Flows between categories (text Fig. 3.12)
2. Discouraged workers: people who have become so discouraged by lack of success at finding
a job that they stop searching
Data Application
For an in-depth look at job creation and destruction, see the book by Steven J. Davis, John C.
Haltiwanger, and Scott Schuh, Job Creation and Destruction, Cambridge, Mass.: MIT Press,
1996.
Numerical Problems 7 and 8 are quantitative exercises using the unemployment and employment
concepts.
C. How long are people unemployed?

1. Most unemployment spells are of short duration
a. Unemployment spell  period of time an individual is continuously unemployed
b. Duration  length of unemployment spell
2. Most unemployed people on a given date are experiencing unemployment spells of long
duration

3. Reconciling 1 and 2—numerical example:

a. Labor force  100; on the first day of every month, two workers become unemployed for
one month each; on the first day of every year, four workers become unemployed for one
year each
b. Result: 28 spells of unemployment during year; 24 short (one month), four long (one
year); so most spells are short
c. At any date, unemployment  six; four have long spells (one year), two have short spells
(one month); so most unemployed people on a given date have long spells
D. Application: Unemployment Duration and the 2007–2009 Recession
1. The mean duration of unemployment always rises in recessions but in the 2007–2009 the rise
was larger than ever before (text Fig. 3.13)
2. Four possible explanations for the increase include measurement issues, the extension of
unemployment benefits, very large job losses, and a weak economic recovery
E. Why there are always unemployed people
1. Frictional unemployment
a. Search activity of firms and workers due to heterogeneity
b. Matching process takes time
Policy Application
Because the matching process in labor markets takes time, government policy often provides
income support for people without jobs in the form of unemployment insurance. But this has
disincentive effects—people may prefer to prolong their job searches so they may receive
unemployment benefits for a longer time, thus getting income without working. Indeed, some
economists believe that the high average rates of unemployment in Europe in the 1980s were in
part a consequence of generous unemployment insurance.
2. Structural unemployment
a. Chronically unemployed: workers who are unemployed a large part of the time
b. Structural unemployment: the long-term and chronic unemployment that exists even
when the economy is not in a recession
c. One cause: Lack of skills prevents some workers from finding long-term employment
d. Another cause: Reallocation of workers out of shrinking industries or depressed regions;
matching takes a long time
3. The natural rate of unemployment
a. u natural rate of unemployment; when output and employment are at full-employment
levels
b. u  frictional  structural unemployment
Data Application
There is much controversy about how to measure the natural rate of unemployment, as we will
discuss in greater detail in Chapter 12. The problem is that the natural rate is simply not observable
directly, so we must use the data we have to try to estimate what the natural rate is based on some
model of the labor market. Doing so is quite difficult, and there is much debate among empirical
macroeconomists as to the size of the natural rate at any date.

c. Cyclical unemployment: difference between actual unemployment rate and natural rate
of unemployment (u  u )
4. In touch with data and research: labor market data
a. BLS employment report
(1) Household survey: unemployment, employment
(2) Establishment survey: jobs
5. In touch with data and research: alternative measures of the unemployment rate
a. U-1: unemployed 15 weeks or more
b. U-2: counts job losers or persons who completed temporary jobs, so it does not
count people who have quit their jobs
c. U-3: the official rate, as defined in textbook
d. U-4: like U-3 but adds discouraged workers (those not looking for work because
they do not think they can find a job)
e. U-5: like U-4 but adds marginally attached workers (those who say they are not
looking for work but indicate that they want and are available for a job and have
looked for work sometime in the past 12 months)
f. U-6: like U-5 but adds persons who are employed part time for economic reasons
(those who want and are available for full-time work but have had to settle for a
part-time schedule)
g. Graph (text Fig. 3.14) shows that all measures move similarly over time; however, U-6
measure in 2015 is quite elevated relative to its past level, while U-3 has returned to a
normal level by 2015
Data Application
The household and establishment surveys often give conflicting results. In September 2012, the
household survey showed a rise in employment of 873,000 people, while the establishment survey
showed an increase of 114,000 jobs. Part of the difference is that the establishment survey doesn’t
count the self-employed, and seems to miss much hiring in small firms.
VI. Relating Output and Unemployment: Okun’s Law (Sec. 3.6)

A. Relationship between output (relative to full-employment output) and cyclical unemployment
Data Application
What’s more closely related to output? Employment growth (from the establishment survey) or
the unemployment rate? Business economists usually focus on employment growth (or the
average number of hours worked) rather than the unemployment rate, in part because changes in
the labor force participation rate lead to fluctuations in the unemployment rate that are not
correlated with output.
B. ( Y  Y)/ Y  2 (u  u ) (3.5)
C. Why is the Okun’s Law coefficient 2, and not 1?
1. Other things happen when cyclical unemployment rises: Labor force falls, hours of work per
worker decline, average productivity of labor declines

2. Result is 2% reduction in output associated with 1 percentage point increase in

unemployment rate
Numerical Problems 9 and 10 are exercises dealing with Okun’s Law.
D. Alternative formulation if average growth rate of full-employment output is 3%:

1. Y/Y  3  2 u (3.6)
2. Text Fig. 3.15 shows U.S. data
Data Application
In 2009, the unemployment rate increased far more than expected (or, output did not decline as
much as expected) under Okun’s law. The reason was remarkably strong growth in productivity
in the midst of a bad recession. For an analysis, see Mary Daly and Bart Hobijn, “Okun’s Law
and the Unemployment Surprise of 2009,” Federal Reserve Bank of San Francisco Economic
Letter, 2010-07, March 8, 2010; available at:
www.frbsf.org/publications/economics/letter/el2010-07.pdf.

 Additional Issues for Classroom Discussion

1. Is the Unemployment Rate a Good Measure of Economic Distress?
Macroeconomists often treat the unemployment rate as the key indicator of the business cycle. But terms
like “discouraged worker” and “underemployed” suggest that the unemployment rate by itself doesn’t
reveal the whole picture. A useful topic for classroom discussion is to have students suggest ways in which
the unemployment rate doesn’t reveal fully the economic distress of people in the economy.
2. What Else Is Important for Production?

To ensure that your students haven’t forgotten what they learned in their principles course, you may want
to ask them to discuss some of the factors besides capital and labor that are factors of production.
Typically, they’ll bring up things like land, entrepreneurial ability, and natural resources. When we write
the equation for the production function Y  A F(K, N ), all these other things are lumped together in total
factor productivity (A).
3. As Your Wage Rises, Do You Supply More Labor? Or Less?

The textbook discusses the offsetting income and substitution effects on labor supply of an increase in the
wage rate in the Appendix to Chapter 4. Since this chapter uses the basic ideas that an increase in wealth
reduces labor supply, while an increase in the reward to working increases labor supply, you can combine
these effects and enter a discussion of the overall effect. You could start by asking students if they’d work
more if they received a higher wage. Would someone who’s wealthy make the same decision? Then you
might point out that some firms offer employees the chance to “purchase” additional vacation time, based
on their wage. Some people buy a lot of extra vacation time when their wage is low, but don’t buy as much
when their wage rises because the value of their time has increased.
4. Why Do Oil Price Shocks Hurt the Economy So Much?

The textbook points out that many recessions are associated with increases in oil prices. The reasons that
increases in oil prices cause such great economic distress are interesting to discuss with your students. See
if your students can relate such shocks to their impact on the production function and whether they
recognize the very different sectoral implications of the shocks.

 Answers to Textbook Problems

Review Questions
1. A production function shows how much output can be produced with a given amount of capital and
labor. The production function can shift due to supply shocks, which affect overall productivity.
Examples include changes in energy supplies, technological breakthroughs, and management practices.
Besides knowing the production function, you must also know the quantities of capital and labor the
economy has.
2. The upward slope of the production function means that any additional inputs of capital or labor
produce more output. The fact that the slope declines as we move from left to right illustrates the idea
of diminishing marginal productivity. For a fixed amount of capital, additional workers each add less
additional output as the number of workers increases. For a fixed number of workers, additional
capital adds less additional output as the amount of capital increases.
3. The marginal product of capital (MPK ) is the output produced per unit of additional capital. The
MPK can be shown graphically using the production function. For a fixed level of labor, plot the
output provided by different levels of capital; this is the production function. The MPK is just the
slope of the production function.
4. The marginal revenue product of labor represents the benefit to a firm of hiring an additional worker,
while the nominal wage is the cost. Comparing the benefit to the cost, the firm will hire additional
workers as long as the marginal revenue product of labor exceeds the nominal wage, since doing so
increases profits. Profits will be at their highest when the marginal revenue product of labor just
equals the nominal wage.
The same condition can be expressed in real terms by dividing through by the price of the good. The
marginal revenue product of labor equals the marginal product of labor times the price of the good.
The nominal wage equals the real wage times the price of the good. Dividing each of these through
by the price of the good yields an equivalent profit-maximizing condition: the marginal product of
labor equals the real wage.
5. The MPN curve shows the marginal product of labor at each level of employment. It is related to the
production function because the marginal product of labor is equal to the slope of the production
function (where output is plotted against employment). The MPN curve is related to labor demand,
because firms hire workers up to the point at which the real wage equals the marginal product of
labor. So the labor demand curve is identical to the MPN curve, except that the vertical axis is the
real wage instead of the marginal product of labor.
6. A temporary increase in the real wage increases the amount of labor supplied because the substitution
effect is larger than the income effect. The substitution effect arises because a higher real wage raises
the benefit of additional work for a worker. The income effect is small because the increase in the real
wage is temporary, so it doesn’t change the worker’s income very much, thus the worker won’t reduce
time spent working very much.
A permanent increase in the real wage, however, has a much larger income effect, since a worker’s
lifetime income is changed significantly. The income effect may be so large that it exceeds the
substitution effect, causing the worker to reduce time spent working.

7. The aggregate labor supply curve relates labor supply and the real wage. The principal factors shifting
the aggregate labor supply curve are wealth, the expected future real wage, the country’s working-age
population, or changes in the social or legal environment that lead to changes in labor force
participation. Increases in wealth or the expected future real wage shift the aggregate labor supply
curve to the left. Increases in the working-age population or in labor-force participation shift the
aggregate labor supply curve to the right.
8. Full-employment output is the level of output that firms supply when wages and prices in the economy
have fully adjusted; in the classical model of the labor market, this occurs when the labor market is in
equilibrium. When labor supply increases, full-employment output increases, as there is now more
labor available to produce output. When a beneficial supply shock occurs, then the same quantities of
labor and capital produce more output, so full-employment output rises. Furthermore, a beneficial
supply shock increases the demand for labor at each real wage and leads to an increase in the
equilibrium level of employment, which also increases output.
9. The classical model of the labor market assumes that any worker who wants to work at the
equilibrium real wage can find a job, so it is not very useful for studying unemployment.
10. The labor force consists of all employed and unemployed workers. The unemployment rate is the
fraction of the labor force that is unemployed. The participation rate is the fraction of the adult
population that is in the labor force. The employment ratio is the fraction of the adult population
that is employed.
11. An unemployment spell is a period of time that a person is continuously unemployed. Duration is
the length of time of an unemployment spell. Two seemingly contradictory facts are that most
unemployment spells have a short duration and that most people who are unemployed at a particular
time are experiencing spells with long durations. These can be reconciled by realizing that there may
be a lot of people with short spells and a few people with long spells. On any given date, a survey
finds a fairly long average duration for the unemployed, because of the people with long spells. For
example, suppose that each week one person becomes unemployed for one week, so there are fifty-
two such short unemployment spells during the year. And suppose that there are four people who are
unemployed all year, so there are four long unemployment spells during the year. In any given week
five people are unemployed: one unemployed person has a spell of one week, while four have spells
of a year. So most spells have a short duration (fifty-two short spells compared to four long spells),
but most people who are unemployed at a given time are experiencing spells with long duration (one
short spell compared to four long spells).
12. Frictional unemployment arises as workers and firms search to find matches. A certain amount of
frictional unemployment is necessary, because it is not always possible to find the right match right
away. For example, an unemployed banker may not want to take a job flipping hamburgers if he or
she cannot find another banking job right away, because the match would be very poor. By remaining
unemployed and continuing to search for a more suitable job, the banker is likely to make a better
match. That will be better both for the banker (since the salary is likely to be higher) and for society
as a whole (since the better match means greater productivity in the economy).
13. Structural unemployment occurs when people suffer long spells of unemployment or are chronically
unemployed (with many spells of unemployment). Structural unemployment arises when the number
of potential workers with low skill levels exceeds the number of jobs requiring low skill levels, or
when the economy undergoes structural change, when workers who lose their jobs in shrinking
industries may have difficulty finding new jobs.

14. The natural rate of unemployment is the rate of unemployment that prevails when output and
employment are at their full-employment levels. The natural rate of unemployment is equal to the
amount of frictional unemployment plus structural unemployment. Cyclical unemployment is the
difference between the actual rate of unemployment and the natural rate of unemployment. When
cyclical unemployment is negative, output and employment exceed their full-employment levels.
15. Okun’s Law is a rule of thumb that tells how much output falls when the unemployment rate rises. It
is written either in terms of the levels of output and unemployment, as in Eq. (3.5), ( Y  Y)/ Y  2
(u  u ), or in terms of changes in output and unemployment, as in Eq. (3.6), Y/Y  3  2 u. Since
the Okun’s law coefficient is 2, a 2 percentage point increase in the unemployment rate causes output
to decline by 4%.

Numerical Problems
1. (a) To find the growth of total factor productivity, you must first calculate the value of A in the
production function. This is given by A  Y/(K.3N.7). The growth rate of A can then be
calculated as
[(Ayear 2  Ayear 1)/Ayear 1]  100%. The result is:
A % Increase in A
1960 13.903 —
1970 16.463 18.4%
1980 17.136 4.1%
1990 19.140 11.7%
2000 22.245 16.2%
2010 24.503 10.2%
(b) Calculate the marginal product of labor by seeing what happens to output when you add 1.0 to N;
call this Y2, and the original level of output Y1. [A more precise method is to take the derivative of
output with respect to N; dY/dN  0.7A(K/N).3. The result is the same (rounded).]
Y1 Y2 MPN
1960 3109 3142 33
1970 4722 4764 42
1980 6450 6495 45
1990 8955 9008 53
2000 12,560 12,624 64
2007 14,784 14,858 74
2. (a) The MPK is 0.2, because for each additional unit of capital, output increases by 0.2 units. The
slope of the production function line is 0.2. There is no diminishing marginal productivity of
capital in this case, because the MPK is the same regardless of the level of K. This can be seen
in Figure 3.8 because the production function is a straight line.
Figure 3.8
(b) When N is 100, output is Y  0.2(100  100.5)  22. When N is 110, Y is 22.0976. So the MPN for
raising N from 100 to 110 is (22.0976  22)/10  0.00976. When N is 120, Y is 22.1909. So the

MPN for raising N from 110 to 120 is (22.1909  22.0976)/10  0.00933. This shows diminishing
marginal productivity of labor because the MPN is falling as N increases. In Figure 3.9 this is
shown as a decline in the slope of the production function as N increases.
Figure 3.9
3. (a)
N Y MPN MRPN (P 5) MRPN (P 10)
1 8 8 40 80
2 15 7 35 70
3 21 6 30 60
4 26 5 25 50
5 30 4 20 40
6 33 3 15 30
(b) P  $5.
(1) W  $38. Hire one worker, since MRPN ($40) is greater than W ($38) at N  1. Do not hire
two workers, since MRPN ($35) is less than W ($38) at N  2.
(2) W  $27. Hire three workers, since MRPN ($30) is greater than W ($27) at N  3. Do not hire
four workers, since MRPN ($25) is less than W ($27) at N  4.
(3) W  $22. Hire four workers, since MRPN ($25) is greater than W ($22) at N  4. Do not hire
five workers, since MRPN ($20) is less than W ($22) at N  5.
(c) Figure 3.10 plots the relationship between labor demand and the nominal wage. This graph is
different from a labor demand curve because a labor demand curve shows the relationship
between labor demand and the real wage. Figure 3.11 shows the labor demand curve.

Figure 3.10 Figure 3.11
(d) P  $10. The table in part (a) shows the MRPN for each N. At W  $38, the firm should hire five
workers. MRPN ($40) is greater than W ($38) at N  5. The firm shouldn’t hire six workers, since
MRPN ($30) is less than W ($38) at N  6. With five workers, output is 30 widgets, compared to
8 widgets in part (a) when the firm hired only one worker. So the increase in the price of the
product increases the firm’s labor demand and output.
(e) If output doubles, MPN doubles, so MRPN doubles. The MRPN is the same as it was in part (d)
when the price doubled. So labor demand is the same as it was in part (d). But the output
produced by five workers now doubles to 60 widgets.
(f) Since MRPN  P  MPN, then a doubling of either P or MPN leads to a doubling of MRPN.
Since labor demand is chosen by setting MRPN equal to W, the choice is the same, whether
P doubles or MPN doubles.
4. MPN  A(100  N )
(a) A  1. MPN  100  N.
(1) W  $10. w  W/P  $10/$2  5. Setting w  MPN, 5  100  N, so N  95.
(2) W  $20. w  W/P  $20/$2  10. Setting w  MPN, 10  100  N, so N  90.
These two points are plotted as line NDa in Figure 3.12. If labor supply  95, then the
equilibrium real wage is 5.

Figure 3.12
(b) A  2. MPN  2(100  N ).

(1) W  $10. w  W/P  $10/$2  5. Setting w  MPN, 5  2(100  N ), so 2N  195, so N  97.5.
(2) W  $20. w  W/P  $20/$2  10. Setting w  MPN, 10  2(100  N), so 2N  190, so N  95.
These two points are plotted as line NDb in Figure 3.12. If labor supply  95, then the
equilibrium real wage is 10.
5. (a) If the lump-sum tax is increased, there’s an income effect on labor supply, not a substitution
effect (since the real wage isn’t changed). An increase in the lump-sum tax reduces a worker’s
wealth, so labor supply increases.
(b) If T  35, then NS  22  12w  (2  35)  92  12 w. Labor demand is given by
w  MPN  309  2N, or 2N  309  w, so N  154.5  w/2. Setting labor supply equal to
labor demand gives 154.5  w/2  92  12w, so 62.5  12.5w, thus w  62.5/12.5  5.
With w  5, N  92  (12  5)  152.
(c) Since the equilibrium real wage is below the minimum wage, the minimum wage is binding.
With w  7, N  154.5  7/2  151.0. Note that NS  92  (12  7)  176, so NS  N and there is
unemployment.
6. Since w  4.5 K 0.5 N 0.5, N 0.5  4.5 K 0.5/w, so N  20.25 K/w 2. When K  25, N  506.25/w 2.
(a) If t  0.0, then NS  100w 2. Setting labor demand equal to labor supply gives 506.25/w 2  100w 2,
so w 4  5.0625, or w  1.5. Then NS  100 (1.5)2  225. [Check: N  506.25/1.52  225.] Y 
45N0.5  45(225)0.5  675. The total after-tax wage income of workers is (1  t) w NS  1.5  225 
337.5.
(b) If t  0.6, then NS  100 [(1  0.6) w] 2  16w 2. The marginal product of labor is MPN 
22.5/N 0.5, so N  100 [(1  0.6)  22.5/N 0.5] 2, so N 2  8100, so N  90. Then Y  45N 0.5 
45(90) 0.5  426.91. Then w  22.5/900.5  2.37. The total after-tax wage income of workers is (1 
t) w NS  0.4  2.37  90  85.38. Note that there’s a big decline in output and income, although
the wage is higher.
(c) A minimum wage of 2 is binding if the tax rate is zero. Then N  506.25/22  126.6, NS  100 
22  400. Unemployment is 273.4. Income of workers is wN  2  126.6  253.2, which is lower
than without a minimum wage, because employment has declined so much.

7. (a) At any date, 25 people are unemployed: 5 have lost their jobs at the start of the month and 20
have lost their jobs either on January 1 or July 1. The unemployment rate is 25/500  5%.
(b) Each month, 5 people have one-month spells. Every six months, 20 people have six-month spells.
The total number of spells during the year is (5  12)  (20  2)  100. Sixty of the spells (60%
of all spells) last one month, while 40 of the spells (40% of all spells) last six months.
(c) The average duration of a spell is (0.60  1 month)  (0.40  6 months)  3 months.
(d) On any given date, there are 25 people unemployed. Twenty of them (80%) have long spells of
unemployment, while 5 of them (20%) have short spells.
8. Number who become unemployed:

From not in the labor force: 2% of 93.0 million  1.860 million
From employed: 1% of 148.8 million  1.488 million
Total  3.348 million
Number who become employed:

From unemployed: 23% of 8.7 million  2.001 million
From not in the labor force: 5% of 93.0 million  4.650 million
Number who become not in the labor force:

From employed: 3% of 148.8 million  4.464 million
From unemployed: 23% of 8.7 million  2.001 million
9. Since ( Y  Y) /Y  2(u  u ), this can be rewritten as Y  Y  2(u  u ) Y or Y  [1  2(u  u )] Y , or

Y  Y/[1  2(u  u )].
(a) Using the formula above, this table shows the value of Y , given values for u and Y.
Year u Y Y
1 0.08 950 989.6
2 0.06 1030 1030.0
3 0.07 1033.5 1054.6
4 0.05 1127.5 1105.4
b. The first calculation of  Y/Y comes from calculating the percent change in Y from part a.
The second calculation of Δ Y/Y comes from using Eq. (3.6): Y/Y   Y/Y  2 u, so  Y/Y 
Y/Y 2 u.
Year Y  Y/Y  Y Y  u  Y/Y

1 989.6 — — — —
2 1030.0 0.041 0.084 0.02 0.044
3 1054.6 0.024 0.003 0.01 0.023
4 1105.4 0.048 0.091 0.02 0.051

The two methods give fairly close answers.
10. (a) Total hours worked per week  1900 workers  40 hours per worker  76,000 hours per week.
Total output per week  76,000 total hours per week  10 units of output per hour  760,000
units of output. The unemployment rate is 100 unemployed/2000 labor supply  0.05, or 5%.
(b) Employment falls 4% from 1900 to: (1  0.04)  1900  1824. The labor force falls 0.2% from
2000 to: (1  0.002)  2000  1996. With a labor force of 1996 and employment of 1824,
unemployment is 1996  1824  172. The unemployment rate is 172/1996  0.086, or 8.6%.
Hours worked per employed worker falls 2.5% from 40 to: (1  0.025)  40  39. Total hours per
week  39 hours per worker  1824 workers  71,136. So total hours per week falls by (76,000 
71,136)/76,000  0.064  6.4%. Total output per week falls 1.4% for every 1% drop in hours, so
output falls by 6.4%  1.4  8.96%. Since output was 760,000, it now falls to 760,000  (1 
0.0896)  691,904. The Okun’s Law coefficient is the percent change in output divided by the
increase in the unemployment rate  0.0896/(0.086  0.05)  2.49.

Analytical Problems
1. (a) See Figures 3.13 and 3.14.
Figure 3.13 Figure 3.14
(b) In the initial situation, capital K1 and labor N1 produce output Y1; when productivity rises they
produce output 1.1 Y1. Suppose that a small increase in capital to K2 with labor left at N1 produces
output Y2 in the initial situation. Then it produces 1.1 Y2 when productivity rises by 10%. The
marginal product of capital (MPK ) in the initial situation is (Y2  Y1)/(K2  K1); when
productivity rises the new MPK is (1.1 Y2  1.1 Y1)/(K2  K1)  1.1 (Y2  Y1)/(K2  K1). So the
new MPK is 10% higher than the old MPK.
This argument is completely symmetric, so it holds for MPN as well. If you substitute N for K
everywhere and follow the same steps, you will show that the new MPN is 10% higher than the
old MPN.
(c) Yes, it is possible for a beneficial productivity shock to leave the MPK and MPN unchanged.
This could happen only if the shock was additive—that is, if it shifted the whole production
function upward, but did not affect its slope at any point. In Figures 3.15 and 3.16 this is shown
as a shift up in the production function, leaving the slope unchanged.

Figure 3.15
Figure 3.16
2. (a) An increase in the number of immigrants increases the labor force, increasing employment and
increasing full-employment output.
(b) If energy supplies become depleted, this is likely to reduce productivity, because energy is a
factor of production. So the reduction in energy supplies reduces full-employment output.
(c) Better education raises future productivity and output, but has no effect on current full-
employment output.
(d) This reduction in the capital stock reduces full-employment output (although it may very well
increase welfare).
3. (a) As shown in Figure 3.17, when the real wage (w) is above its market-clearing level, labor supply
(NS) exceeds labor demand (ND). The difference is the amount of unemployment (U ).

Figure 3.17
(b) Output is lower because of the real wage rigidity. With the real wage higher than the wage that
clears the market at full employment, labor demand must be lower than it is at full employment,
so employment and output are lower as well.
4. (a) The increased value of Helena’s home increases her wealth. The rise in wealth leads to an income
effect that leads Helena to reduce her labor supply.
(b) The permanent rise in Helena’s real wage gives rise to offsetting income and substitution effects.
The income effect of the higher wage reduces Helena’s labor supply, but the substitution effect
increases it. So the result is theoretically ambiguous.
Empirically, women tend to increase labor supply in response to a permanent increase in the real
wage, and men tend to reduce labor supply in response to a permanent increase in the real wage.
(c) The temporary income tax surcharge is equivalent to a temporary reduction in the real wage,
which reduces current labor supply, assuming that the income effect is smaller than the
substitution effect.
5. The tax reduces the marginal product of labor by 6%, since that portion of output goes to the
government rather than to the firm. Thus labor demand is reduced. With labor supply unchanged, the
downward shift in labor demand reduces the real wage and employment, as shown in Figure 3.18.

Figure 3.18
6. Yes, it is possible for the unemployment rate and the employment ratio to rise during the same
month. For example, suppose the population falls, the labor force is constant, the number of
unemployed rises, and the number of employed falls (but by less than the decline in population).
Then the unemployment rate rises, since there are more unemployed but the same labor force, but
the employment ratio rises, since population declines more than employment does.
Yes, it is possible for the participation rate to fall at the same time that the employment ratio is rising.
For example, suppose that population is constant, the labor force declines, employment rises, and
unemployment falls. The participation rate falls, since there are fewer people in the labor force from
the same population. The employment ratio is rising, since employment rises while population is
constant.
7. (a) Since Sally earns $150,000 per year, she is above the cap, so the Social Security tax doesn’t affect
her after-tax wage (so there’s no substitution effect)—the higher tax only affects her income—and
thus has only an income effect. Since both proposals reduce Sally’s income by the same amount,
she’ll increase her labor supply by the same amount under both proposals.
(b) Under proposal A, Fred’s labor supply doesn’t change because his tax rate stays the same and he
remains below the cap. So there’s neither an income effect nor a substitution effect. Under proposal
B, the Social Security tax rate Fred faces would rise to 15% from 12.4%, so Fred’s after-tax wage
rate declines and there’s both an income effect and a substitution effect. The income effect leads Fred
to work more, since the higher tax leads to a reduction in Fred’s income. The substitution effect leads
Fred to reduce his supply of labor, since the after-tax wage is lower, so there’s less reward to
working. Whether Fred will supply more labor or less labor under proposal B thus depends on
whether the substitution effect is stronger or weaker than the income effect.

Working with Macroeconomic Data

1. Total factor productivity is generally rising over time. The growth rate of total factor productivity
is usually positive, but sometimes negative around the times of recessions. TFP growth generally
declines during oil-price shocks.
2. Both the overall trend in the ratio of employment to the working-age population and the ratio of
the labor force to the working-age population generally increased from 1960 to 2000. Both the
overall trend in the ratio of employment to the working-age population and the ratio of the labor
force to the working-age population generally decreased from 2000 to 2014. The ratio of
employment to the working-age population is more volatile than the ratio of the labor force to the
working-age population. The labor force participation rate of men generally decreased and the
labor force participation rate of women generally increased from 1960 to 2000.
3. Real full-employment GDP is smoother because it continues to grow during recessions, whereas
real GDP usually declines in recessions. Real GDP was more volatile before 1980 than after 1980.
Real full-employment GDP growth generally trended down from 1950 to 2010.

Productivity, Output, and Employment: Objectives

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Productivity, Output, and Employment: Objectives

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Chapter 3

Productivity, Output, and Employment

II. Goals of Chapter 3

III. Notes to Eighth Edition Users

©2017 Pearson Education, Inc.

Numerical Problem 1 gives students practice working with a production function.

3. Productivity growth calculated using production function

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D. The shape of the production function

(1) Equal to slope of production function graph (Y vs. K)

(1) Equal to slope of production function graph (Y vs. N)

©2017 Pearson Education, Inc.

II. The Demand for Labor (Sec. 3.2)

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C. The marginal product of labor and the labor demand curve

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2. It is the same as the MPN curve, since w  MPN at equilibrium

1. Aggregate labor demand is the sum

III. The Supply of Labor (Sec. 3.3)

©2017 Pearson Education, Inc.

©2017 Pearson Education, Inc.

F. Aggregate labor supply

IV. Labor Market Equilibrium (Sec. 3.4)

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Real Wage Growth by Decade (percent per decade)

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V. Unemployment (Sec. 3.5)

4. Participation Rate  Labor Force/Adult Population

Analytical Problem 6 tests students’ ability to use these different measures.

B. Changes in employment status

C. How long are people unemployed?

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3. Reconciling 1 and 2—numerical example:

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VI. Relating Output and Unemployment: Okun’s Law (Sec. 3.6)

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2. Result is 2% reduction in output associated with 1 percentage point increase in

Numerical Problems 9 and 10 are exercises dealing with Okun’s Law.

D. Alternative formulation if average growth rate of full-employment output is 3%:

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 Additional Issues for Classroom Discussion

2. What Else Is Important for Production?

3. As Your Wage Rises, Do You Supply More Labor? Or Less?

4. Why Do Oil Price Shocks Hurt the Economy So Much?

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 Answers to Textbook Problems

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Figure 3.10 Figure 3.11

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(b) A  2. MPN  2(100  N ).

©2017 Pearson Education, Inc.

8. Number who become unemployed:

Number who become employed:

Number who become not in the labor force:

9. Since ( Y  Y) /Y  2(u  u ), this can be rewritten as Y  Y  2(u  u ) Y or Y  [1  2(u  u )] Y , or

Year Y  Y/Y  Y Y  u  Y/Y

©2017 Pearson Education, Inc.

The two methods give fairly close answers.