CHAPTER The Economy at Full Employment Copyright © 2012 Pearson Prentice Hall All rights reserved Copyright © 2012 Pearson Prentice Hall All rights reserved 7-1 CHAPTER The Economy at Full Employment While immigration is a big issue in the United States, emigration – the outflow of people – is a major issue in other countries PREPARED BY Brock Williams Copyright © 2012 Pearson Prentice Hall All rights reserved CHAPTER The Economy at Full Employment APPLYING THE CONCEPTS How can changes in the supply of labor affect real wages? The Black Death and Living Standards in Old England Do differences in taxes and government benefits explain why Europeans work substantially fewer hours per year than U.S workers or the Japanese? A Nobel Laureate Explains Why Europeans Work Less Than U.S Workers or the Japanese Can real business cycle models explain the origin and persistence of the Great Depression? Can Labor Market Policies Account for the Great Depression? Copyright © 2012 Pearson Prentice Hall All rights reserved 7-3 CHAPTER The Economy at Full Employment 7.1 WAGE AND PRICE FLEXIBILITY AND FULL EMPLOYMENT ● classical models Economic models that assume wages and prices adjust freely to changes in demand and supply Copyright © 2012 Pearson Prentice Hall All rights reserved 7-4 CHAPTER The Economy at Full Employment 7.2 THE PRODUCTION FUNCTION • production function The relationship between the level of output of a good and the factors of production that are inputs to production • stock of capital The total of all machines, equipment, and buildings in an entire economy • labor Human effort, including both physical and mental effort, used to produce goods and services When there are only two factors of production, capital and labor, the production function is written as follows: Y = F(K,L) Copyright © 2012 Pearson Prentice Hall All rights reserved 7-5 CHAPTER The Economy at Full Employment 7.2 THE PRODUCTION FUNCTION (cont’d) FIGURE 7.1 The Relationship between Labor and Output with Fixed Capital With capital fixed, output increases with labor input, but at a decreasing rate Copyright © 2012 Pearson Prentice Hall All rights reserved 7-6 CHAPTER The Economy at Full Employment 7.2 THE PRODUCTION FUNCTION (cont’d) PRINCIPLE OF DIMINISHING RETURNS Suppose output is produced with two or more inputs, and we increase one input while holding the other input or inputs fixed Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate Copyright © 2012 Pearson Prentice Hall All rights reserved 7-7 CHAPTER The Economy at Full Employment 7.2 THE PRODUCTION FUNCTION (cont’d) FIGURE 7.2 An Increase in the Stock of Capital When the capital increases from K1 to K2, the production function shifts up At any level of labor input, the level of output increases Copyright © 2012 Pearson Prentice Hall All rights reserved 7-8 CHAPTER The Economy at Full Employment 7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR FIGURE 7.3 The Demand and Supply of Labor Together, the demand and supply for labor determine the level of employment and the real wage • real wage The wage rate paid to employees adjusted for changes in the price level Copyright © 2012 Pearson Prentice Hall All rights reserved 7-9 CHAPTER The Economy at Full Employment 7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR (cont’d) Labor Market Equilibrium Panel C of Figure 7.3 puts the demand and supply curves together At a wage of $15 per hour, the amount of labor firms want to hire—7,500 workers—will be equal to the number of people who want to work—7,500 workers This is the labor market equilibrium: The quantity demanded for labor equals the quantity supplied Together, the demand and supply curves determine the level of employment in the economy and the level of real wages Copyright © 2012 Pearson Prentice Hall All rights reserved 7-10 CHAPTER The Economy at Full Employment 7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR (cont’d) Changes in Demand and Supply MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal cost Choose the level at which the marginal benefit equals the marginal cost FIGURE 7.4 Shifts in Labor Demand and Supply Shifts to demand and supply will change both real wages and employment Copyright © 2012 Pearson Prentice Hall All rights reserved 7-11 CHAPTER The Economy at Full Employment APPLICATION THE BLACK DEATH AND LIVING STANDARDS IN OLD ENGLAND APPLYING THE CONCEPTS #1: How can changes in the supply of labor affect real wages? According to the research of Gregory Clark of the UC, Davis, the level of real wages for laborers in England was nearly the same in 1200 as it was in 1800 Yet, during the period from 1350 to 1550, they were higher—nearly 75 percent higher in 1450, for instance, than in 1200 Why were real wages temporarily so high during this period? ▪ The simple answer was the bubonic plague—also known as the Black Death ▪ Arrived from Asia in 1348 and caused a long decline in total population through the 1450s ▪ With fewer workers, there was less labor supplied to the market The result was higher real wages In the era before consistent and rapid technological advance, changes in population was the primary factor controlling living standards As the economist Thomas Malthus (1766– 1834) observed, social maladies such as the Black Death would temporarily raise living standards until higher living standards led to increased population Copyright © 2012 Pearson Prentice Hall All rights reserved 7-12 CHAPTER The Economy at Full Employment 7.4 LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT FIGURE 7.5 Determining Full-Employment Output Panel B determines the equilibrium level of employment at L and the real wage rate of W Fullemployment output in Panel A is Y • full-employment output The level of output that results when the labor market is in equilibrium and the economy is producing at full employment Copyright © 2012 Pearson Prentice Hall All rights reserved 7-13 CHAPTER The Economy at Full Employment 7.5 USING THE FULL-EMPLOYMENT MODEL Taxes and Potential Output FIGURE 7.6 How Employment Taxes Affect Labor Demand and Supply In Panel A, a tax burden on labor shifts the labor demand curve to the left and leads to lower wages and reduced employment In Panel B, the supply curve for labor is vertical, which means that wages fall but employment does not change Copyright © 2012 Pearson Prentice Hall All rights reserved 7-14 CHAPTER The Economy at Full Employment APPLICATION A NOBEL LAUREATE EXPLAINS WHY EUROPEANS WORK LESS THAN U.S WORKERS OR THE JAPANESE APPLYING THE CONCEPTS #2: Do differences in taxes and government benefits explain why Europeans work substantially fewer hours per year than U.S workers or the Japanese? On average today, the French (and other Europeans) work onethird fewer hours than do U.S. workers. In the early 1970s Europeans actually worked slightly more hours than did U.S. workers. What explains this dramatic turnaround in the space of just 20 years? Nobellaureate Edward Prescott of the Federal Reserve Bank of Minneapolis and Arizona State University attributes the decreases in hours of work in Europe to: • Increases in the tax burden that ultimately falls on workers • Government spending and transfers play a larger role in European economies than in the United States Prescott notes that as the burdens of Social Security and Medicare increase, the United States may be tempted to increase its tax rates to European levels What will happen if we do not make changes in the underlying programs and allow tax rates to increase? Copyright © 2012 Pearson Prentice Hall All rights reserved 7-15 CHAPTER The Economy at Full Employment 7.5 USING THE FULL-EMPLOYMENT MODEL Real Business Cycle Theory • real business cycle theory The economic theory that emphasizes how shocks to technology can cause fluctuations in economic activity FIGURE 7.7 How an Adverse Technology Shock Affects Labor Demand and Supply An adverse shock to technology will decrease the demand for labor As a result, both real wages and employment fall as the market equilibrium moves from a to b Copyright © 2012 Pearson Prentice Hall All rights reserved 7-16 CHAPTER The Economy at Full Employment APPLICATION CAN LABOR MARKET POLICIES ACCOUNT FOR THE GREAT DEPRESSION? APPLYING THE CONCEPTS #3: Can real business cycle models explain the origin and persistence of the Great Depression? Real Business Cycle models not explain the Great Depression Economists Cole and Ohanian of UCLA modified the standard model to include other factors ▪ President Roosevelt’s New Deal allowed firms to collude if they recognized unions and raised wages ▪ President Hoover also had polices that raised wages Incorporating these factors into the model allow it to explain the origin and severity of the Great Depression Copyright © 2012 Pearson Prentice Hall All rights reserved 7-17 CHAPTER The Economy at Full Employment 7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT International Comparisons Copyright © 2012 Pearson Prentice Hall All rights reserved 7-18 CHAPTER The Economy at Full Employment 7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (cont’d) Crowding Out in a Closed Economy • crowding out The reduction in investment (or other component of GDP) caused by an increase in government spending P R I N C I P L E O F O P P O RT U N I T Y C O S T The opportunity cost of something is what you sacrifice to get it • closed economy An economy without international trade output = consumption + investment + government purchases Y=C+I+G Copyright © 2012 Pearson Prentice Hall All rights reserved 7-19 CHAPTER The Economy at Full Employment 7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (cont’d) Crowding Out in a Closed Economy FIGURE 7.8 U.S Consumption and Government Spending During World War II Increased government spending crowds out consumption by consumers The vertical bar highlights the time period during which crowding out occurred Copyright © 2012 Pearson Prentice Hall All rights reserved 7-20 CHAPTER The Economy at Full Employment 7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (cont’d) Crowding Out in a Closed Economy FIGURE 7.9 U.S Investment and Government Spending During World War II Increased government spending also crowds out private investment spending The vertical bar highlights the time period during which crowding out occurred Copyright © 2012 Pearson Prentice Hall All rights reserved 7-21 CHAPTER The Economy at Full Employment 7.6 DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT (cont’d) Crowding Out in an Open Economy • open economy An economy with international trade Y = C + I + G + NX Increased government spending need not crowd out either consumption or investment It could lead to reduced exports and increased imports Crowding in • crowding in The increase of investment (or other component of GDP) caused by a decrease in government spending Copyright © 2012 Pearson Prentice Hall All rights reserved 7-22 CHAPTER The Economy at Full Employment KEY TERMS classical models full-employment output closed economy labor crowding in open economy crowding out production function real business cycle theory real wage stock of capital Copyright © 2012 Pearson Prentice Hall All rights reserved 7-23 ... rights reserved 7-8 CHAPTER The Economy at Full Employment 7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR FIGURE 7.3 The Demand and Supply of Labor Together, the demand and supply for labor... Prentice Hall All rights reserved 7-10 CHAPTER The Economy at Full Employment 7.3 WAGES AND THE DEMAND AND SUPPLY FOR LABOR (cont’d) Changes in Demand and Supply MARGINAL PRINCIPLE Increase the... 7.4 Shifts in Labor Demand and Supply Shifts to demand and supply will change both real wages and employment Copyright © 2012 Pearson Prentice Hall All rights reserved 7-11 CHAPTER The Economy at