Ch.

1 Final
Supply and demand for labor
Supply and demand approach is useful for studying labor market conditions.
Firms and employers represent the demanders in the labor market. They demand labor to produce
goods and services.
All of us represent the suppliers in the labor market. We supply labor during some phase of our lives.
The price of labor is the “real wage” paid to workers in exchange for their services.
The quantity of labor is the amount of labor that firms use measured by number of workers.
Marginal Product of each worker: it is the extra production that is gained by adding one more worker.
Diminishing returns to labor: it is the tendency for marginal product to decline as more and more
workers are added.
Demand for labor
Demand curve for labor is downward sloping, meaning that the higher the wage “price”, the fewer
workers that employer will hire.
Factors that shifts labor demand curve:
 The price of workers’ output: any increase in the price of workers’ output increase the value
of the marginal product of labor, causing a right shift of the labor demand curve.
 The productivity of labor: any increase in labor productivity raises workers’ marginal product
causing a right shift of the labor demand curve.
Increase in trade lead to:
- Demand for workers in importing industry declines, lowering real wage and employment.
- Demand for workers in exporting industry increases, raising real wage and employment.
Supply of labor:
The supply of labor is the total number of people who are willing to work at each real wage.
Labor suppliers are workers and potential workers.
The labor supply curve is upward sloping, meaning that the higher the wage “price”, the more
people are willing to work.
Factors that shifts labor supply curve:
 Domestic birth rates.
 Immigration and emigration rates.
 The age at which people normally first enter the work force and retire, increase in size of the
working age population, shifts the supply curve to right.
Unemployment
Labor force: it is the total number of employed and unemployed people in the economy.
Unemployment rate: it is the number of unemployed people divided by the labor force.
The natural unemployment rate: it is the unemployment rate at equilibrium.
Participation rate: it is the percentage of the working age population in the labor force either
employed or looking for work.
Voluntarily unemployed workers: at the given level of real wages, he/she wishes to be in the labor
force but does not yet wish to accept a job.

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 Ch.1 Final
Involuntarily unemployed workers: individual would accept a job offered at the going wage rate.
Discouraged workers: people who say they would like to have a job but have not made an effort to
find one in the past four weeks.
Labor unions: organizations that negotiate with employers on behalf of workers.
Costs of unemployment:
 Economic cost: it is the output that is lost because the labor force is not fully utilized.
 Psychological cost: unemployment can lead to a loss of self-esteem, feelings of loss control
over one’s life, depression, and even suicidal behavior.
 Social cost: facing financial difficulties with feeling anger, frustration, and despair lead to an
increase in crime, violence, alcoholism, drug abuse, and other social problems.
Types of unemployment:
 Frictional unemployment: it is a short-term unemployment associated with the process of
matching workers with jobs.
 Structural unemployment: it is a long-term and chronic unemployment that exists even when
the economy is producing at a normal rate.
 Cyclical unemployment: it is the extra unemployment that occurs during periods of recession.
Inflation
Inflation: it is a rise in the price level.
Pure inflation: where the prices of goods (output) and inputs rise at the same rate.
Consumer Price Index (CPI): it measures the cost in that period of a standard set, or basket, of
goods and services relative to the cost of the same basket of goods and services in a fixed year,
called base year. This index represents the basic tool for measuring inflation. CPI is a measure of the
cost of living during a particular period.
The CPI is not itself the price of a specific good or service as it has no units of measurement at all.
It is a measure of the average price of a given class of goods and services relative to the price of
the same goods and services in a base year.
While the CPI provides a measure of the average level of prices relative to prices in the base year,
inflation is a measure of how fast the average price level is changing over time.
The rate of inflation (inflation rate): the annual percentage rate of change in the price level.
Inflation rate = nominal money growth – money demand growth
The negative inflation rate: it is called deflation where the prices of most goods and services are
falling over time.
Nominal quantity: a quantity that is measured in terms of its current dollar value.
Real quantity: a quantity that is measured in physical terms (in terms of quantities of goods and
services).
Adjusting for inflation: the deflating process is used by dividing a nominal quantity by a price index
to express the quantity in real terms.
Real wage: it is the wage paid to workers measured in terms of purchasing power.

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 Ch.1 Final
Real wage = nominal wage/CPI
Price level: it is a measure of the overall level of prices at a particular point in time as measured by a
price index such as the CPI.
Relative price: it is the price of a specific good or service in comparison to the prices of other goods
and services.
Note that: the changes in the price level and changes in relative prices of specific goods are two
quite different issues.
The true costs of inflation include “noise” in the price system; distortions of the tax system; “shoe
leather” costs, which are the real resources that are wasted as people try to economize on cash
holdings; unexpected redistribution of wealth; and interference with long-run planning.
Hyperinflation: it is a situation in which the inflation rate is extremely high.
For example, inflation was 102,000,000 percent in Germany in 1923.
Economic theory suggests that high inflation rates, especially those associated with hyperinflation,
reduce economic efficiency and growth.
Real interest rate: it is the annual percentage increase in the purchasing power of a financial asset.
r = i – π
Note that: the real interest rate is not equal to the nominal interest rate divided by the price level
as the nominal rate is a rate of return which is measured in percent, or a nominal quantity measured
in dollars.
Nominal interest rate (market interest rate): it is the annual percentage increase in the nominal
value of a financial asset.
Inflation protected bonds: are bonds that pay a nominal interest rate each year equal to a fixed real
rate plus the actual rate of inflation during that year. They pay a fixed real interest rate.
Fisher effect: it is the tendency for nominal interest rates to be high when inflation is high and vice
versa.
i.e. higher inflation leads to similarly higher nominal interest rates.

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