Foundations of Macroeconomics, 7e (Bade/Parkin)

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Study Plan Problems and Applications

Use the following list of events, which occur in the United States one at a
time, to work Problems 1 to 4.
 Dell introduces a new supercomputer that everyone can afford.
 A major hurricane hits Florida.
 More high school graduates go to college.
 The CPI rises.
 An economic slump in the rest of the world decreases U.S. exports.
1. Sort the items into four groups: those that change the production
function, those that change the demand for labor, those that change the
supply of labor, and those that do not change the production function,
the demand for labor, or the supply of labor. Say in which direction any
changes occur.
 The new supercomputers change the production function by shifting it
upward. The hurricane changes the production function by shifting it
(at least in Florida) downward.
 The hurricane decreases the capital stock and thereby decreases the
demand for labor.
 If the new supercomputers increase workers’ productivity, the
demand for labor increases.

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84 Part 3 . THE REAL ECONOMY

 The increased number of teenagers going to college has the immediate

effect of changing the supply of labor by decreasing the supply of
labor.
 The CPI rising does not change the production function, the supply of
labor, or the demand for labor. Similarly, the economic slump in the
rest of the world does not change the production function, the supply
of labor, or the demand for labor.
2. Which of the events increase the equilibrium quantity of labor and which
decrease it?
If the new supercomputers increase the demand for labor, the equilibrium
quantity of labor increases. The increased number of teenagers in college
has the immediate effect of decreasing the equilibrium quantity of labor.
When a major hurricane hits Florida, the destruction of the capital stock
decreases the demand for labor and decreases the equilibrium quantity of
employment.
3. Which of the events raise the real wage rate and which lower it?
If the new supercomputers increase the demand for labor, the equilibrium
real wage rate rises. The increased number of teenagers in college has the
immediate effect of increasing the equilibrium real wage rate. The
hurricane decreases the demand for labor and thereby lowers the real
wage rate.
4. Which of the events increase potential GDP and which decrease it?
The new supercomputers increase potential GDP. The hurricane and the
direct impact of more teenagers attending college decrease potential GDP.

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 Chapter 8 . Potential GDP and the Natural Unemployment Rate 85

Production function Labor market

Labor Real GDP Real
hours (millions of wage rate Quantity of Quantity of
(millions) 2009 dollars) (dollars per labor labor supplied
hour) demanded
0 0 (millions of hours per year)
1 10 10 1 5
2 19 9 2 4
3 27 8 3 3
4 34 7 4 2
5 40 6 5 1

Use the information set out in the tables above about the economy of
Athabasca to work Problems 5 and 6.
5. Calculate the quantity of labor employed, the real wage rate, and
potential GDP.
The real wage rate is $8 per hour, because that is the real wage that sets
the quantity of labor demanded equal to the quantity of labor supplied.
The equilibrium quantity of labor is 3 million hours per year. The
production function shows that the potential GDP is $27 million.
6. If the labor force participation increases, explain how employment, the
real wage rate, and potential GDP change.
If the labor force participation increases, the supply of labor increases. The
increase in the supply of labor lowers the real wage and increases
employment. The increase in employment increases potential GDP.
Use the following information to work Problems 7 and 8.
Suppose that the United States cracks down on illegal immigrants and
returns millions of workers to their home countries.
7. Explain how the U.S. real wage rate, U.S. employment, and U.S. potential
GDP would change.
The supply of labor in the United States decreases, which decreases
equilibrium U.S. employment and raises the U.S. real wage rate. U.S.
potential GDP decreases. The U.S. production function is unchanged, but
equilibrium employment decreases in the United States so that U.S.
potential GDP decreases.
8. In the countries to which the immigrants return, explain how
employment, the real wage rate, and potential GDP would change.
In the countries to which the immigrants return, the supply of labor
increases, which increases equilibrium employment. The supply of labor
increases, which lowers the equilibrium real wage rate. Potential GDP

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86 Part 3 . THE REAL ECONOMY

increases. The production function is unaffected, but equilibrium

employment increases in those countries so that potential GDP increases.
9. Two island economies, Cocoa Island and Plantation Island, are identical
in every respect except one. A survey tells us that at full employment,
people on Cocoa Island spend 1,000 hours a day on job search, while the
people on Plantation Island spend 2,000 hours a day on job search. Which
economy has the greater level of potential GDP? Which has the higher
real wage rate? And which has the higher natural unemployment rate?
Cocoa Island has the greater level of potential GDP because its labor force
spends less time searching and more time employed.
Plantation Island has the higher real wage rate. We know that Plantation
Island has the higher real wage rate because the supply of labor is less on
Plantation Island since workers spend more time searching for jobs. As
the supply of labor decreases, the real wage rate rises.
10. Decoding ‘natural’ rate of unemployment slumps in July
Unemployment is a normal feature of our economy and the
Congressional Budget Office believes the “natural” unemployment rate
increased from 5 percent in 2007 to 6 percent in 2012.
Source: The Wall Street Journal, September 7, 2012
Provide some reasons why the natural unemployment rate might have
increased.
There are several possible reasons why the natural unemployment rate
increased. First, the severe recession that occurred after 2007 has lead the
government to increase the length of time that unemployed workers can
collect unemployment benefits. These more generous unemployment
benefits increased the natural unemployment rate. Second, the real
minimum wage was higher in 2012 than in 2007. The higher real
minimum wage increases job rationing, which also leads to an increase in
the natural unemployment rate..
11. Read Eye on U.S. Potential GDP on p. 200 and then explain why U.S.
potential GDP per worker per week is greater than that in Europe. What
could induce Europeans to work the same hours as Americans and would
that close the gap between potential GPD per worker in the two
economies?
U.S. potential GDP is higher than European potential GDP for two
reasons: First, U.S. capital per worker and U.S. technology exceed those in
Europe. Consequently, the U.S. production function lies above the
European production function. Second, U.S. workers work more hours
than do European workers. Both these differences mean that U.S.
potential GDP exceeds European potential GDP.

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 Chapter 8 . Potential GDP and the Natural Unemployment Rate 87

European workers would work more hours if taxes and unemployment

benefits were lower in Europe. These changes would help close the gap
between U.S. potential GDP and European potential GDP but would not
eliminate it.

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 Instructor Assignable Problems and Applications

Use the following information to work Problems 1 and 2.
In Korea, real GDP per hour of labor is $22, the real wage rate is $15 per hour,
and people work an average of 46 hours per week.
1. Draw a graph of the demand for and supply of labor in Korea and the
United States. Mark a point at the equilibrium quantity of labor per
person per week and the real wage rate in each economy. Explain the
difference in the two labor markets.
Figure 8.1 shows the labor market in Korea
and also, based on data from page 620 of the
text, in the United States. The demand for
labor in the United States exceeds the
demand for labor in Korea because the
quantity of capital per worker in the United
States exceeds that in Korea and U.S.
technology is generally more productive
than Korean technology. The U.S. supply of
labor is less than the Korean supply of labor
because of the income effect: U.S. income is
higher than income in Korea, which
increases the demand for leisure in the
United States and thereby decreases the
supply of labor in the United States.
2. Draw a graph of the production functions in
Korea and the United States. Mark a point
on each production function that shows
potential GDP per hour of work in each
economy. Explain the difference in the two
production functions.
Figure 8.2 shows the two production
functions. The information used for the U.S.
production function is based on the data
from page 620 of the text. The U.S.
production function is higher than the
production function in Korea because the
United States has more capital per worker
than Korea and because U.S. technology is
generally more advanced that Korean
technology.

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 Chapter 8 . Potential GDP and the Natural Unemployment Rate 89

Use the following list of events that occur one at a time to work Problems 3 to
6.
 The Middle East cuts supplies of oil to the United States.
 The New York Yankees win the World Series.
 U.S. labor unions negotiate wage hikes that affect all workers.
 A huge scientific breakthrough doubles the output that an additional
hour of U.S. labor can produce.
 Migration to the United States increases the working-age population.
3. Sort the items into four groups: those that change the production
function, those that change the demand for labor, those that change the
supply of labor, and those that do not change the production function,
the demand for labor, or the supply of labor. Say in which direction each
change occurs.
The decrease in the supply of oil changes the production function by
shifting it downward. The scientific breakthrough changes the production
function by shifting it upward.
The decrease in the supply of oil decreases the demand for labor. The
scientific breakthrough increase workers’ productivity so the demand for
labor increases.
The increased migration increases the supply of labor.
The New York Yankees winning the World Series has no effect on the
production function, the supply of labor, or the demand for labor. The
union negotiation has no effect on the production function, the supply of
labor, or the demand for labor. However it does increase the quantity of
labor supplied and decrease the quantity of labor demanded. But these
are movements along the curves and not shifts in the curves.
4. Which of the events increase the equilibrium quantity of labor and which
decrease the equilibrium quantity of labor?
The scientific breakthrough and the increased migration increase the
equilibrium quantity of labor. The union negotiated higher wage rate
decreases the equilibrium quantity of labor.
5. Which of the events raise the real wage rate and which of the events
lower the real wage rate?
The scientific breakthrough and the union negotiated wage hike increase
the equilibrium real wage rate. The increased migration decreases the
equilibrium real wage rate.
6. Which of the events increase potential GDP and which decrease potential
GDP?
The scientific breakthrough and the increased migration increase
potential GDP. The cut in the supply of oil and the union negotiated wage
hike decrease potential GDP.

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90 Part 3 . THE REAL ECONOMY

Production function Labor market

Labor Real GDP Real
hours (2009 dollars wage rate Quantity of Quantity of
(per day) per year) (dollars per labor labor supplied
hour) demanded
0 0 (hours per day)
10 100 1.00 10 50
20 180 0.80 20 40
30 240 0.60 30 30
40 280 0.40 40 20

The two tables set out information about the economy of Nautica. Use this
information to work Problems 7 and 8.
7. What is the quantity of labor employed, potential GDP, the real wage
rate, and total labor income?
The real wage rate is $0.60 per hour, because that is the real wage that sets
the quantity of labor demanded equal to the quantity of labor supplied.
The equilibrium quantity of labor is 30 hours per day. The production
function shows that the potential GDP with this amount of employment is
$240 per year. Total labor income is $0.60 × 30 hours = $18 per week.
8. Suppose that the government introduces a minimum wage of $0.80 an
hour. What is the real wage rate, the quantity of labor employed,
potential GDP, and unemployment? Does the unemployment arise from
job search or job rationing? Is the unemployment cyclical? Explain.
The minimum wage of $0.80 an hour is greater than the equilibrium real
wage rate, so the real wage rate equals the minimum wage, $0.80 an hour.
At this wage rate the quantity of labor supplied is 40 hours per day but
the quantity of labor demanded is 20 hours per day. Hence employment
is 20 hours per day. At this level of employment, potential GDP is $180
per year. Unemployment equals the difference between the quantity of
hours supplied, 40 per day, and the quantity of hours demanded, 20 per
day, or 20 hours per day of unemployment. This unemployment reflects
job rationing from the minimum wage. It is not cyclical.

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 Chapter 8 . Potential GDP and the Natural Unemployment Rate 91

9. Fixing up for the fall show

Businesses damaged by flooding from Tropical Storm Irene are under
pressure to rebuild and reopen this week as Vermont’s peak leaf-peeping
season begins. Not everyone is cheering. Vermont’s recovery hasn’t
reached every road, and the rebuilding work will persist long after the
maple leaves fall.
Source: The Wall Street Journal, September 21, 2011
Explain the effect of Tropical Storm Irene on employment across
Vermont. Did Vermont move along its production function or did its
production function shift? How did Vermont’s potential GDP change?
The most immediate effect of Irene was to decrease employment followed
by a rapid increase in employment to rebuild. Some of Vermont’s capital
was destroyed. Vermont’s production function shifted downward—
reflecting the destruction of capital—and there was an initial movement
downward along the production function followed by an upward
movement—reflecting the initial fall and then rise in employment.
Vermont’s potential GDP decreased.

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 Multiple Choice Quiz

1. U.S. potential GDP is the value of the goods and services produced in the
United States ________.
A. in the reference base year
B. when the U.S. unemployment rate is zero
C. when the U.S. economy is at full employment
D. when the U.S. inflation rate is zero
Answer: C Answer C is correct because it is the definition of potential
GDP.

2. The demand for labor curve shows the relationship between _________.
A. the quantity of labor employed and firms’ profits
B. all households’ willingness to work and the real wage rate
C. the quantity of labor businesses are willing to hire and the real wage
rate
D. the labor force and the real wage rate
Answer: C Answer C is the definition of the demand for labor curve.

3. The supply of labor is the relationship between __________.

A. the quantity of labor supplied and leisure time forgone
B. the real wage rate and the quantity of labor supplied
C. firms’ willingness to supply jobs and the real wage rate
D. the labor force participation rate and the real wage rate
Answer: B Answer B defines the supply of labor.

4. Households’ labor supply decisions are influenced by all of the

following except _______.
A. the opportunity cost of taking leisure and not working
B. the after-tax wage rate
C. unemployment benefits
D. the number of full-time jobs available
Answer: D The number of full-time jobs available reflects firms’ demand
for labor not households’ supply of labor.

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 Chapter 8 . Potential GDP and the Natural Unemployment Rate 93

5. The full-employment quantity of labor _______.

A. increases if labor becomes more productive
B. cannot increase because everyone who wants a job has one
C. increases as the economy moves along its production function
D. decreases if the income tax rates decrease
Answer: A The increase in the productivity of labor increases the
demand for labor, thereby raising the full-employment
quantity of labor.

6. The natural unemployment rate _______.

A. increases if unemployment benefits become more generous
B. increases in a recession
C. increases as the average age of the labor force rises
D. decreases as firms outsource manufacturing jobs
Answer: A More generous unemployment benefits decrease the cost of
searching for a job and thereby increase the amount of job
search.

7. Job rationing ________.

A. increases the natural unemployment rate
B. has no effect on the natural unemployment rate
C. increases labor turnover as firms compete for high quality labor
D. decreases the demand for labor, which lowers the real wage rate
Answer: A Job rationing decreases the quantity of labor demanded and
thereby raises the natural unemployment rate.

8. An efficiency wage results in all of the following except _________.

A. a decrease in the rate of labor turnover
B. an increase in the full-employment quantity of labor
C. greater work effort
D. an increase in the cost of monitoring work effort
Answer: B An efficiency wage decreases employment.

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