Macroeconomic Analysis I

Topic 3

Productivity, Output and Employment

(Abel, Bernanke & Croushore: Chapter 3)

1
 Learning Objectives

• Discuss the properties of the production function

• Describe factors which affect the demand for labour

• Describe factors which affect the supply of labour

• Identify factors which affect the labour market

equilibrium

• Explain how unemployment is measured

• Explain the significance of Okun’s Law

2
 The Production Function
Factors of production
– Capital (K)
– Labour (N)
– Others (raw materials, land, energy)
1

– Productivity of factors depends on technology and

2 management

3
 The Production Function
expression the
a mathematical relating amount

The production function Of of and labor

Output produced to quantities Capital utilized .

sh¥#lputcanb
Y = AF(K, N) of
(3.1)
produced
capital
With

and
a

labor
given
.
amount

– Parameter A is “total factor productivity” (the

effectiveness with which capital and labor are used)

production
→ -
output
L
function
LY )

,
other

factors
inputs
into outputs
translates

4
 The Production Function
Application: The Production Function and Changes of
Productivity in the European Union
– Cobb-Douglas production function works well for EU economy:
Y = A K0.33 N0.67 (3.2)
– Data for EU economy—Table 3.1

5
Table 3.1: The Production Function of the EU-28,
2005–2014

←
global
financial
crisis

←
European

debt

CRBB

6
 The Production Function
Productivity growth calculated using production function
– Productivity can vary substantially over different
periods

– Productivity fell sharply in 2008 due to the global

financial crisis but rebounded significantly in 2009

– The European Debt Crisis caused productivity to

decline in 2014

7
 The Production Function
The shape of the production function
– Two main properties of production functions
• Slopes upward: more of any input produces more
output

• Slope becomes flatter as input rises: diminishing

marginal product as input increases

8
 The Production Function
The shape of the production function
– Graph production function (Y vs. one input; hold
other input and A fixed)
– Figure 3.1 shows the shape of the production
function

9
Figure 3.1 The Production Function Relating
Output and Capital

10
 The Production Function
The shape of the production function
– Marginal product of capital, MPK = Y/ K
• Equal to slope of production function graph (Y vs. K)
• MPK always positive
• Diminishing marginal productivity of capital

✓
Whenever
c
→ MPK declines as K rises

stock
-

t
the capital is increased
more output can be produced .

capital -

When the
capital
stock is low , there are
many Workers for each machine
,

And the benefits of capital further are

increasing great ;

when the stock is workers have plenty of

capital high , already capital to

work with ,
and little benefit is to be
gained
from
expanding Capital further .

labor -
the
greater the number of workers
already using a fixed amount of

Capital and other of

inputs , the smaller the benefit C in terms increased

output ) of adding even more workers .

11
Figure 3.2 The marginal product of capital

Oko
→
Dko

) 040
oyo
>
04 '

12
 The Production Function
Supply shocks
– Supply shock = productivity shock = a change in an
economy’s production function

– Supply shocks affect the amount of output that can

be produced for a given amount of inputs

– Shocks may be positive (increasing output) or

negative (decreasing output)

– Examples: weather, inventions and innovations,

government regulations, oil prices

13
 The Production Function
Supply shocks
Supply shocks shift graph of production function (Fig. 3.4)
• Negative (adverse) shock: Usually slope of
1
bad
production function decreases at each level of input
weather (for example, if shock causes parameter A to decline)

• Positive shock: Usually slope of production function

increases at each level of output (for example, if
✓e¥
in
parameter A increases)
or

innovation

14
Figure 3.4 An adverse supply shock that lowers the MPN
of
( A)of
B)
§
ope
< slop

:
3

15
 The Demand for Labour
How much labour do firms want to use?
– Assumptions
• Hold capital stock fixed—short-run analysis

• Workers are all alike

taker ;

price
=

worker the
over

• Labour market is competitive influence

-

has
no market .

the labor
in
rate
wage
the market
and goods

• Firms maximize profits

16
 :
The Demand for Labour
The marginal product of labour and labour demand: an
example
– Example: The Clip Joint—setting the nominal wage
equal to the marginal revenue product of labor
additional
.

with 1
associated

MRPN = P MPN (3.3) revenue

produced
additional
by
product
1- add .

WASE
.

labour

constant wage
revenue
marginal the real
nominal of labour in Market
t product pricegoods
v 7
– W = MRPN is the same condition
/ as w = MPN, since
W = P w and MRPN = P MPN t
'

.
product
Marginal
of labour

)
condition
Optimal

marginal

Mprfftdditional
marginal firm
benefits
costs
(
production )
( MRPN )
( nominal wage CW ) ]
Additional revenue
( W= ( P ) ( W ) )
derived from

(
T
MPRN
Real Variable
-

NINE real wage Output

)
mice

w=(¥ , apdnddiffondaibuusnifnofiabour 17
C w
W Cp ) )
-
Table 3.2 The Clip Joint’s Production Function
(Assume nominal wage = $240 per worker)

additional
output

) ( 11×5130 )
=

2
(-9×5130)
j
O.mu#nnEuunnEgEy0nws
Constant p .

'

MRPNIV

0=2
diminishing . .

NF
-

as

workers
2
hire

the Optimal
Condition for the firm
cost
help find
N
.

£ N MRPN W
At =3 <
MRPN $270 >
=
$240 : hire 2nd worker $240
At
=

but
18
$210
.

in pay
/
bring
,

3rd Work →
add
,

profit :
270-240=5130 if
should not hire
Iv by $30 i.
profits ,
 The Demand for Labour
The marginal product of labour and labor demand: an
example
– A change in the wage
• Begin at equilibrium where W = MRPN

• A rise in the wage rate means W MRPN, unless

N is reduced so the MRPN rises → reduce # workers

"
XP
MPN

( MPN

':
• A decline in the wage rate means W MRPN,
unless N rises so the MRPN falls
workers
.

more t
MPPN hire
MPRN
in
t
MPN

in
$EioiiiIy
.

$200
-

- -
.

, /

1 1

:
>
N 19
2
1 3
 The Demand for Labour
How much labour do firms want to use?
– Analysis at the margin: costs and benefits of hiring
one extra worker (Fig. 3.5)
• If real wage (w) marginal product of labor (MPN),
profit rises if number of workers declines

• If w MPN, profit rises if number of workers

increases

• Firms’ profits are highest when w = MPN

20
Figure 3.5 The determination of labour demand
w
^
dimmishjnefurn A
Wo
.
.
- .
- -

WY
¥¥pBmpn
labotnand

•"
. -

,
.

i
=L

>
No N , N

GM$
less
-

pay
- -
-

-
•

more labour
* .
.

.
demand
MPN > W

(:
1

W
'
MPN <

$ :
/

1
D l

1
i

! 1

a
,

Nl Nz

21
Summary 2

22
 The Demand for Labour
The marginal product of labour and the labour demand curve
– Labour demand curve shows relationship between the
real wage rate and the quantity of labour demanded

– It is the same as the MPN curve, since w = MPN at

equilibrium

– So the labour demand curve is downward sloping; firms

want to hire less labour, the higher the real wage

23
 The Demand for Labour
Factors that shift the labour demand curve
– Note: A change in the wage causes a movement
along the labour demand curve, not a shift of the curve
(
level ?
at any
Of labor

– Supply shocks: Beneficial supply shock raises MPN, input

so shifts labour demand curve to the right; opposite for

adverse supply shock

– Size of capital stock: Higher capital stock raises MPN,

so shifts labour demand curve to the right; opposite for

!
lower capital stock
each
giving equipments
'

K -

by 1
machines
'

more
Worker workers
raises
with any
to
Work ,

at
the MPN
&
productivity Of labor
. 24
level
Table 3.3 The Clip Joint’s Production Function After a )
rate

Beneficial Productivity Shock ( unchanged wage

remains

(Assume nominal wage = $240 per worker)

g.
'

arranged

|
} C=
30×22 )
.
.
. . .
. -
. . .
-
. -

30×18 )
}
(
=
- - - . .
-
- .
-
-
. -
- . .
.

workers
;] 0<2/(0

25
Figure 3.6 The effect of a beneficial supply shock on
labour demand

-
.
-

.
IN
I

I
1

/
,

o* jet
26
 The Demand for Labour
Aggregate labor demand
– Aggregate labour demand is the sum of all firms’
labor demand

– Same factors (supply shocks, size of capital stock)

that shift firms’ labour demand cause shifts in
aggregate labour demand

27
Summary 3

28
 The Supply of Labour
Supply of labour is determined by individuals
– Aggregate supply of labor is the sum of individuals’
labour supply

– Labour supply of individuals depends on labour-leisure

choice

29
 The Supply of Labour
The income-leisure trade-off
– Utility depends on consumption and leisure
.

– Need to compare costs and benefits of working

another day
• Costs: Loss of leisure time
• Benefits: More consumption, since income is
higher
– If benefits of working another day exceed costs,
work another day
– Keep working additional days until benefits equal
costs

30
 The Supply of Labour
Real wages and labour supply
– An increase in the real wage has offsetting income
and substitution effects leisure
Makes
expensive
, more

s • Substitution effect: Higher real wage encourages

work, since reward for working is higher
;¥ (
hours )

|
longer

• Income effect: Higher real wage increases

income for same amount of work time, so person
can afford more leisure, so will supply less labor

31
 The Supply of Labour
Real wages and labour supply
– The substitution effect and the income effect
together: a long-term increase in the real wage
• The reward to working is greater: a substitution
effect toward more work

• But with higher wage, a person doesn’t need to

work as much: an income effect toward less work

• The longer the increase in real wage is expected

to last, the larger will be the income effect and
more likely that the quantity of labour will be
reduced.
32
 The Supply of Labor
Real wages and labor supply
– The labour supply curve (Fig. 3.7)
• Increase in the current real wage should raise
quantity of labour supplied

• Labour supply curve relates quantity of labor

supplied to real wage

• Labour supply curve slopes upward because

higher wage encourages people to work more

33
Figure 3.7 The labour supply curve of an individual worker
-

Backward
Bending
-

\
about
\
Supply

#
:
cinema
:)
suggestions >

hours
working
more
-
-

⇒
- -
-
- -
.

)
term .

short

...
-

e-
.

in real
increase wage
permanent
the amount of
1
I lowers
aggregate
1
labor Supplied
, .

1 1

34
 The Supply of Labour
Factors that shift the labour supply curve
– Wealth: Higher wealth reduces labour supply (shifts
labour supply curve to the left, as in Fig. 3.8)

– Expected future real wage: Higher expected future

real wage is like an increase in wealth, so reduces
labour supply (shifts labour supply curve to the left)

Changes in real wage only cause an movement along the labour supply curve.

(Graph on previous slide)

35
Figure 3.8 The effect on labour supply of an increase in wealth

36
 The Supply of Labour
Aggregate labour supply
– Aggregate labour supply rises when current real
wage rises
• Some people work more hours
• Other people enter labor force
0
• Result: Aggregate labor supply curve slopes
upward
o

37
 The Supply of Labour
Aggregate labour supply
– Factors increasing labor supply
• Decrease in wealth
• Decrease in expected future real wage
• Increase in working-age population (higher birth
rate, immigration)
• Increase in labour force participation (increased
female labor participation, elimination of
mandatory retirement)

38
Summary 4

39
Figure 3.9 Labour market equilibrium
The labor demand curve is dependent on technology and demand for capital. During recession, firm does not
need to produce so much - output falls - do not need as many machinaries, or operate less hours on the
machinaries - demand for machinaries falls - need less workers - labor demand falls.

Labour
←
force
memo

¥
o#m¥mf * namreunmetmepnofment
NRU -7

.am
unemployment (a)
Actual

Difference bewteen u and u-bar = cyclical

unemployment

(
% recession )

market
When
's
at
is

equilibrium
full employment 40
 Labour Market Equilibrium
• Classical model of the labour market—real wage
adjusts quickly

• Determines full-employment level of employment and

market-clearing real wage

• Problem with classical model: unable to study

unemployment

41
 Labor Market Equilibrium
Full-employment output
Full-employment output = potential output = level of
output when labor market is in equilibrium
Y AF ( K , N ) employment (3.4)
full
employment
output
* my

output
Of

employment

42
 Unemployment
Measuring unemployment
– Categories: employed, unemployed, not in the labor
force

– Labor Force = Employed + Unemployed

– Unemployment Rate = Unemployed/Labor Force

– Participation Rate = Labor Force/Adult Population

– Employment Ratio = Employed/Adult Population

(a) without a Job
unemployed :

for a Job
(b) actively looking
take the job when
C C ) Available to Up
made to him
Offer is

43
.
 Unemployment
Changes in employment status
– Flows between categories (Fig. 3.12)

– Discouraged workers: people who have become so

discouraged by lack of success at finding a job that
they stop searching

44
 Figure 3.12 Changes in employment status in a
typical month (May 2015)

G) discouraged

b) students

homemakers
c)

Labour
force

45
 Unemployment
Why there are always unemployed people needed
time
search

– Frictional unemployment
-
to find jobs

component • Search activity of firms and workers due to

One

)
NRU ( 40
Of
heterogeneity

• Matching process takes time

46
 Unemployment
Why there are always unemployed people
between worker skills
mismatch

Of
– Structural unemployment
-
→
and
job requirements

component

NRU
1-• Chronically unemployed: workers who are
unemployed a large part of the time
• Structural unemployment: the long-term and
chronic unemployment that exists even when the
economy is not in a recession
• One cause: Lack of skills prevents some workers
from finding long-term employment
• Another cause: Reallocation of workers out of
shrinking industries or depressed regions;
matching takes a long time

47
 Unemployment
The natural rate of unemployment ( u )
– natural rate of unemployment; when output and
employment are at full-employment levels
= frictional + structural unemployment
1 2

– Cyclical unemployment: difference between actual

unemployment rate and natural rate of
unemployment ( u u )

48
 Relating Output and Unemployment: Okun’s Law
Relationship between output (relative to full-employment
output) and cyclical unemployment
Gap blw potential Output CI )

and
Of
#
Y Y (3.5)
2(u u )
Y Cyclical
-
Unemployment

blw change in output

and unemployment
negative relationship

( 4¥ ) a)
-
= zcu -

49
 Relating Output and Unemployment: Okun’s Law
Why is the Okun’s Law coefficient 2, and not 1?
– Other things happen when cyclical unemployment
rises: Labor force falls, hours of work per worker

=¥
decline, average productivity of labor declines which
magnifies the effect of the increase in unemployment

– Result is 2% reduction in output associated with 1

percentage point increase in unemployment rate
magnified

50
 Figure 3.14 Okun’s Law in the United States: 1951-2014

+1%
→
Y
production
.

used in
- . .

÷
.

labour

¥a
, less

!
less
output

Sources: Real
No
GDP growth rate from the Federal Reserve Bank of St. Louis FRED database,
i ←

research.stlouisfed.org/ fred2/series/GDPCA. Civilian unemployment rate for all civilian workers from
Bureau of Labor Statistics Web site, data.bls.gov.
51