lOMoARcPSD|5248020

<The master-economist must possess a rare

combination of gifts .... He must be mathematician,
historian, statesman, philosopher4in some degree.
He must understand symbols and speak in words.
He must contemplate the particular, in terms of the
general, and touch abstract and concrete in the same
flight of thought. He must study the present in the
light of the past for the purposes of the future. No
part of man9s nature or his institutions must be
entirely outside his regard. He must be purposeful
and disinterested in a simultaneous mood, as aloof
and incorruptible as an artist, yet sometimes as near
to earth as a politician.=
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The Labor Market

Wong Wei Kang
Do not distribute without permission
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The Big Picture

Goods Mkt
Equil. Expectations-aug.
Sd=Id IS IS-LM Phillips Curve
Ch 4 curve model
Ch 9
Asset Mkt LM Explanation
Equil. curve of short-run
L(Y,i)=M/P fluctuations
Agg.
Ch 7
demand
curve Business
Labor Cycle
FE Agg. Theories
Mkt
line supply
Equil. Ch 10-11
curve
Ch 3

3
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Outline
" The Production Function
" The Demand for Labor
" The Supply of Labor
" Labor Market Equilibrium
" Employment Status and Unemployment

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Motivation
" We first turn to output Y in
Y=C+I+G
" What are the determinants of Y?
3 How does a profit-maximizing firm determine the level of
output it will produce?
3 What is the full-employment output?
3 What is the level of output that firms supply when wages
and prices in the economy have fully adjusted to their
equilibrium levels?

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Outline
" The Production Function
" The Demand for Labor
" The Supply of Labor
" Labor Market Equilibrium
" Employment Status and Unemployment

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The Production Function

" Real output Y = AF(K, N)
" Factors of production
" Capital K; Labor N
3 Capital good:

" Total factor productivity A

" The effectiveness with which capital and labor are used
" Technology and management
" Others (raw materials, land, energy)
" E.g., Cobb-Douglas production function
0.3 0.7
Y = AK N 7
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Figure 3.1 The production function relating Y and K

A and N : means holding A and N constant
Y
output As more capital is
added, MPK ¯
AF (K , N )
MPK
1
MPK
1

MPK Slope = MPK

1
K
capital
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Production Function: the Shape

" Y vs. K, holding constant the rest
" Two properties
3 It slopes upward
3 Its slope becomes flatter as input rises

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Marginal Product of Capital

MPK = DY / DK
" The symbol — (called delta) denotes the change in a
variable
" The slope of production function (Y vs. K)
" MPK > 0
" MPK falls as K rises
3 Diminishing marginal product of capital

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Figure 3.2 The production function relating Y and K

Y
output As more capital is
added, MPK ¯
AF (K , N )

Slope = MPK

K1 K2
K
capital
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Marginal Product of Labor

MPN = DY / DN
" The slope of production function (Y vs. N)
" MPN > 0
" MPN falls as N rises
3 Diminishing marginal product of labor

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Figure 3.3 The production function relating Y and N

A and K : means holding A and K constant
Y
output As more labor is
added, MPN ¯
AF (K , N )
MPN
1
MPN
1

MPN Slope = MPN

1
N
labor
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Figure 3.2B The production function relating Y and N

Y
output As more labor is
added, MPN ¯
AF (K , N )

Slope = MPN

N1 N2
N
labor
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Supply Shocks or Productivity Shocks

" Affect the amount of output that can be produced
for a given amount of inputs
" E.g., weather, inventions and innovations, oil prices
" A negative / adverse shock
" Shifts production function ____
" Slope _______ at each level of input (A ³)
" A positive / beneficial shock
" Shifts production function ____
" Slope _______ at each level of input (A ±)
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Figure 3.4 A positive supply shock that raises the MPN

K : means holding K constant
Y
output
A2 F (K , N )

A1F (K , N )

A2 > A1

N
N1 labor
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Returns to Scale
Initially Y1 = AF (K1 ,L1 )
Scale all inputs by the same factor z:
K2 = zK1 and L2 = zL1
(If z = 2, then all inputs double. Does output double?)
What happens to output, Y2 = AF (K2 ,L2 ) ?
" If constant returns to scale, Y2 = zY1
" If increasing returns to scale, Y2 > zY1
" If decreasing returns to scale, Y2 < zY1
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Outline
" The Production Function
" The Demand for Labor
" The Supply of Labor
" Labor Market Equilibrium
" Employment Status and Unemployment

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The Demand for Labor

" Assumptions
3 Hold total capital stock fixed 3 short-run
3 Workers are all alike
3 Labor market is competitive
3 Firms maximize profits
" Begin with a simple one-period or static model. Therefore,
we treat K as fixed (i.e., not a choice variable)
3 In the short run, firms cannot vary the quantity of plant and
equipment they have, but have flexibility in hiring and laying
off workers
3 Will turn to investment and capital later
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The Firm9s Profit Maximization Problem

" The firm maximizes its profit, by choosing labor to employ N
at real wage w (with fixed K in the short run):
max à (K, N ) = AF(K, N ) 2 wN
N

" First order condition for N: "F (K, N )

A 2w=0
"N
"F (K, N )
" Rewriting: A =w
!#" "N#$
MPN

" The firm9s labor demand: how many units of labor the firm
would employ for different levels of real wage

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The Demand for Labor

" A firm hires each unit of labor if the marginal benefit
exceeds the marginal cost
marginal benefit = marginal product of labor (MPN)
marginal cost = real wage (w = W/P)
" To maximize profits
3 MPN > w ³ ± N
3 MPN < w ³ ³ N
3 MPN = w ³ maximum profits
" Labor demand curve given by w = MPN
3 downward sloping
3 Real wage = the wage measured in terms of units of output = w
3 Nominal wage = the wage measured in today9s dollars = W
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Figure 3.5 The determination of labor demand

Real
Wage w
(units of Each firm hires labor
output) until MPN = W/P
Real
wage
w1
w2

MPN = w

N1 N2 Units of labor, N

Note that both MPN and w are measured in real terms

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Figure 3.6 The effect of a beneficial or

positive supply shock on labor demand
±A ² ±MPN at every N
Real
Wage w ² ND shifts upward
(units of
output)

ND2

ND1

N1 N2 Units of labor, N

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Factors That Shift Labor Demand Curve

" Productivity shocks (A)
3 Beneficial shock ³ ± A ³ ± MPN
³
" The size of the capital stock (K)
3 Higher capital stock ³ ± K ³ ± MPN
³
" What about a change in the wage?

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Outline
" The Production Function
" The Demand for Labor
" The Supply of Labor
" Labor Market Equilibrium
" Employment Status and Unemployment

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The Supply of Labor

" Relates quantity of labor supplied to real wage
" Aggregate supply of labor
3 The sum of the labor supplied by everyone in the
economy

" Determined by individuals

" The income-leisure trade-off
" Let9s start with a simple one-period or static model of
consumer/worker9s income-leisure tradeoff
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The Consumer/Worker9s
Income-Leisure Trade-off: Notations

" h = Units of time available

" l = Time spent in leisure (a choice variable)
" h 3 l = Time spent working (or labor supply ns)
" c = Consumption (a choice variable)
" u = Utility function
" w = Real wage

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The Consumer/Worker9s
Income-Leisure Trade-off
" The consumer/worker maximizes her utility, by choosing
consumption and leisure, i.e., c and l:
max u(c,l)
c,l

" Consumption is financed by labor income, from time spent

working (h 3 l) c = w(h 2 l)
3 Consumption is a function of leisure (negatively related)

" Substituting, we get the following utility maximization

problem involving only one choice variable l
max u(w(h 2 l),l)
l
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Notations: What the Subscript Means when

Differentiating a multivariate function

Suppose : f (x, y)
"f (x, y)
f 1 (x, y) =
"x
"f (x, y)
f 2 (x, y) =
"y

"f "f
f1= ; f2 =
"x "y

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Calculus Review: Chain Rule

Suppose : f (x(z), z)

Differentiating f (x(z), z) with respect to z

df (x(z), z) "f (x(z), z) dx "f (x(z), z)
= +
!#" dz #$ !## "x"## dz
$ !#" "z #$
Total effect due to —z Indirect effect due to —z (through —x ) Direct effect due to —z

df (x(z), z)
= f1 (x(z), z)x '(z) + f 2 (x(z), z)
dz !##"##$ !#"#$
Differentiate f wrt z through x Differentiate f wrt z directly

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The Consumer/Worker9s
Income-Leisure Trade-off
" The consumer/worker maximizes her utility function, by choosing leisure l:

max u(w(h 2 l),l) c = w(h 2 l)

l

" First order condition: "u(c,l) "c "u(c,l)

+ =0
"c "l "l
( )
u1 (c,l) 2w + u2 (c,l) = 0
u2 (c,l)
=w
u1 (c,l)

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The Consumer/Worker9s
Income-Leisure Trade-off
" The consumer/worker maximizes her utility function, by choosing
leisure l:
max u(w(h 2 l),l)
l

u2 (c,l)
" First order condition: =w
u1 (c,l)

" The marginal rate of substitution of leisure for consumption = real

wage (relative price of l in terms of c) at the optimum
" This gives a labor supply curve, relating the choice of leisure (hence
labor supply because ns = h 3 l) to the real wage, i.e., the relative
price of leisure in terms of output or consumption goods
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Consumer Preferences
Higher IC ³
c
Higher levels of
An indifference happiness
curve (IC) shows all
combinations of l
and c that make the
consumer
IC2
equally happy IC1

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Consumer Preferences
Marginal rate of c
substitution (MRS):
the amount of c
the consumer The slope of an
would be willing to
IC = MRS
substitute for 1
one unit of l -MRS

—c MU l
MRSlc = 2 = IC1
—l U =U MU c
l

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Budget Constraint
c
c = w(h 2 l)

wh

The slope of
budget line
= -w
w
-1
l

h
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Consumer maximizes utility

subject to the budget constraint
c
The optimal (l*,c*) is
where the budget line
is tangent to the IC

At the tangency, the

marginal rate of
substitution of leisure O
c*
for consumption
equals the relative
price of leisure in IC
terms of consumption l
l*
MRSlc = w
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The Supply of Labor

" The income-leisure trade-off
" The benefits (the wage) and the costs of working (leisure
forgone)
" An increase in the real wage has two opposite effects
3 Substitution effect (SE)
" ± w = W/P ³ ± price of leisure relative to consumption ³ ³ leisure
³ ± NS
3 Income Effect (IE)
" ± w = W/P ³ ± workers9 wealth ³ ± leisure ³ ³ NS
" For the same amount of work they now earn a higher real income
" Leisure is a normal good (± wealth ³ ± demand for leisure)
" Empirically, labor supply curve slopes upward (SE dominates)
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An Increase in w: 2 opposing effects

For the decomposition, draw
BLint parallel to the new c
An increase in w = W/P
budget line, but tangent to
and makes it steeper
the original IC
D to P: Substitution Effect
(keep utility constant)
Q
P to Q: Income Effect
(keep prices constant) P
As depicted: D
Substitution Effect > Income
Effect
³ D to Q: Net effect l
³± w ³ ³ l ³ ± ns = h - l
³ Upward sloping labor 38
supply
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Aggregate Labor Supply

" tends to be upward sloping because at higher
real wage
3 Existing workers work more hours
3 Other people enter the labor force

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Figure 3.7 The labor supply curve of an individual worker

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Factors that Shifts Labor Supply Curve

" Wealth
" ± wealth ²

" Expected future real wage

" ± expected future real wage ²

" The size of the working age population

" Higher birth rate, immigration
" Labor force participation rate
" Increase in the female labor force participation rate
" Change in retirement age
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Figure 3.8 The effect on labor supply of an increase in wealth

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Figure 2.05M Rise in Female Labor Force Participation Rate (U.S.)

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Figure: Rise in Female Labor Force Participation Rate (Singapore)

Female: 28.2% (1970); 44.3% (1980); 48.8% (1990); &; 58.6% (2014)
Male: 81.2% (1970); 81.5% (1980); 77.5% (1990); &; 75.9% (2014)
90.0

80.0

70.0

60.0

50.0

40.0

30.0

20.0

10.0

0.0
1990 1995 2000 2005 2010

Male Female

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Outline
" The Production Function
" The Demand for Labor
" The Supply of Labor
" Labor Market Equilibrium
" Employment Status and Unemployment

45

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Labor Market Equilibrium

" Equilibrium
" Supply = Demand
" Full-employment level
" Market-clearing real wage
" Classical model
" Real wage adjusts quickly
" There cannot be involuntary unemployment
" New Keynesian model
" There are various reasons why rational, profit-maximizing
firms may not adjust real wage quickly when labor demand is
not equal to labor supply
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Figure 3.9 Labor market equilibrium

N or N *: Full employment level of employment (where ND = NS)

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Figure 3.9 Labor market equilibrium

Labor Supply NS
Real
Wage w
(units of
output)

w*

Labor Demand ND

N* Units of labor, N

N* : Full employment level of employment (where ND = NS)

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Full-Employment / Potential Output

* *
Y = AF (K, N )
Here, Abel, Bernanke and Croushore write Y = AF (K, N )

" The level of output that firms supply when wages and
prices have fully adjusted
Y * or Y : Full employment output (aka potential output)
N * or N : Full employment level of employment

" Affected by changes in equilibrium employment or the

production function
3 E.g., a negative supply shock - increases in energy prices
3 Figure 3.10 and 3.11
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A Negative Supply Shock

" Increases in energy prices, e.g., due to the oil crisis,
cause firms to cut back on energy use
" ³ A in the production function
Þ ³ MPN for any N
Þ ND shifts down, where ND is given by MPN = W/P
Þ ³ W/P and ³ N in equilibrium [Fig 3.10]

" Both ³ A and ³ full employment level of employment

Þ ³ Full employment output (³ Y*)

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Figure 3.10 Effects of a temporary adverse supply shock on the labor market

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Figure 3.11 Relative price of energy, 1960-2017

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Outline
" The Production Function
" The Demand for Labor
" The Supply of Labor
" Labor Market Equilibrium
" Employment Status and Unemployment

53
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Employment Status
" Bureau of Labor Statistics (BLS) monthly survey
" Three categories (adult population aged 16 and above)
3 Employed
" Those who worked part-time or full-time during the past week (or
was on sick leave or vacation from a job)
3 Unemployed
" Those who were not employed during the past week but actively
searched for work at some time during the last four weeks

3 Not in the labor force

" Those who are neither employed nor unemployed (e.g., full-time
students, homemakers, and retirees)
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Useful Labor Market Measures

" Labor force = employed + unemployed
" Unemployment rate = unemployed / labor force
" Participation rate = labor force / adult population
" Employment ratio = employed / adult population
" Discouraged workers
3 Workers who stop searching for jobs because they have
become discouraged by lack of success at finding a job 4
but they will take it if they find a job
3 Not included in the unemployment rate
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Table 3.4 Employment Status of the U.S. Adult

Population, March 2018

Number Share of labor force Share of adult

Category
(millions) (percent) population (percent)
Employed workers 155.2 95.9 60.4
(employment ratio)
Unemployed workers 6.6 4.1 2.6
(unemployment rate)
Labor force (employed + 161.8 100.0 62.9
unemployed workers) (participation rate)
Not in labor force 95.3 37.1
Adult population (labor 257.1 100.0
force + not in labor force)

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Figure 3.13 Changes in employment status in a

typical month, March 2018

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Zero Unemployment Rate?

" Impossible to achieve
" Two types of unemployment always exist
3 Frictional unemployment
" Workers search for suitable jobs and firms search for suitable
workers
3 Structural unemployment
" Long term and chronic unemployment even when the
economy is not in a recession
3 Low-skilled workers
3 Reallocation of labor from shrinking industries or declining
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The Natural Rate of Unemployment

" The rate that prevails when output and employment
are at the full-employment level
" Frictional and structural unemployment
" Cyclical unemployment = Actual unemployment rate
3 Natural rate of unemployment

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