4. The Classical Model (I) PDF

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ECON 1006 Principles of Economics II (Macroeconomics) Semester 2, 2018/19 The Classical Model (I): The Labor Market Real Output (Real GDP) Peak Long-run trend: growth in potential GDP Peak Trough Trough Expansion Recession Expansion Time 1. The Classical Model • In this and the next topics, we will ...

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

The Classical Model (I): The Labor Market

Real Output (Real GDP) Peak

Long-run trend: growth in potential GDP

Peak

Trough

Trough Expansion

Recession

Expansion

Time

1. The Classical Model •

In this and the next topics, we will consider the long-run behavior of the economy and focus on the determination of potential GDP (i.e. the long-run trend).

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The Classical model o Assumes wages and prices adjust rapidly enough to maintain equilibrium in all markets, i.e. market-clearing. o Argue that government should have, at most, a limited role in the economy.

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In order to fully understand how the macroeconomy works in the long run, we have to explore the following markets: o Labor Market – The supply side o Goods Market The demand side o Loanable Funds Market

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In this topic, we focus on the supply side, i.e. the amount of output an economy produces. It depends on two factors: o The amounts of inputs (such as labor and capital) utilized in the production. o The production technology to transform inputs into outputs.

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Note that in the classical model, we focus on the real variables, which are measured in terms of real purchasing power (or dollars of constant purchasing power, say in 2014 dollars).

2. The Production Function •

The production technology is summarized by the production function (or aggregate production function). o It shows the relationship between maximum amount of output produced and the amount of inputs (such as labor and capital) employed, given the current technology. 1

ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

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For now, we focus on just one input, labor. The following production function shows the relationship between output and the amount of labor used, keeping the amount of other inputs and technology constant.

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Two important assumptions about a typical production function: o Marginal product (MPL) is positive. o Law of diminishing marginal returns: as more of any variable input is added, holding other inputs constant, its marginal product will eventually decline. Real Output (Y)

Production Function Y2

Y1

L1

Labor (L)

L2

Real Output (Y)

New Production Function Positive supply shock

Old Production Function

L1

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L2

Labor (L)

The factors affecting the production function is called a supply shock (or productivity shock) o A positive (or beneficial) supply shock raises the amount of output that can be produced for given quantities of labor.

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ECON 1006 Principles of Economics II (Macroeconomics)

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Semester 2, 2018/19

More output can be produced for a given amount of labor, which shifts the production function upward. It also increases the slope of the production function, i.e. the MPL increases.

A negative (or adverse) supply shock lowers the amount of output that can be produced for given quantities of labor.

What are the examples of supply shocks? o Technological improvement o Increase in employment in other inputs (e.g. capital stock) • It may due to lower input prices o Other factors such as weather and natural disasters

3. The Labor Market: Labor Demand •

To understand the labor demand, we need to understand individual firms’ employment decision, which is simply a marginal benefit and marginal cost comparison: o

o

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Marginal Revenue Product of Labor (MRPL) ▪ Suppose a firm considers employing an additional labor. If this worker can produce an additional output of 10 units per day and each unit of output can be sold at $10 (suppose other inputs remain fixed). ▪

What is the additional benefit of employing this additional worker?

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The MRPL measures the marginal benefit of employing an additional labor in terms of the extra revenue produced: 𝑀𝑅𝑃𝐿 = 𝑃 × 𝑀𝑃𝐿

Nominal wage (W) ▪ Given the MRPL = $100. Suppose the market nominal wage of each labor is $80 per day, should the firm employ this additional labor? • Firms will increase employment as long as MRPL ≥ W. • Firms will decrease employment as long as MRPL < W.

In general, firms will demand the amount of labors until 𝑀𝑅𝑃𝐿 = 𝑊 o

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In other words, the maximum amount that firms are willing to pay for an additional worker is their MRPL.

In terms of real wage (i.e. purchasing power), the maximum amount that firms are willing to pay for an additional worker is their MPL. 𝑃 × 𝑀𝑃𝐿 = 𝑊 𝑊 = 𝑀𝑃𝐿 𝑃

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

Example: Derive the labor demand curve. Consider the following production function of the economy: L MPL 1 10 2 9 3 8 4 7 •

Labor demand curve shows the total amount of labor demanded at each real wage. o It is exactly the same as the marginal product curve of labor. o It is downward sloping because of diminishing marginal returns to labor. o Therefore, at a lower real wage, more labors are profitable to be employed, other things constant.

Real wage (W/P)

Labor Demand (LD) Labor (L)

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Factors affecting labor demand (marginal benefits of employing labors): o

Any factor affecting the marginal product of labor (MPL) • Supply shocks

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Taxes affecting the marginal benefits of employing labors: • Corporate tax: A tax on firms’ profits earned. • Payroll tax contributed by firms

4. The Labor Market: Labor Supply •

In deciding how much to work, individuals weigh the benefits against the costs of working, i.e. the income-leisure tradeoff.

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How would an increase in real wage affect the amount of labor supplied? o Substitution effect:

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

An increase in real wage raises the cost of leisure, inducing households to supply more labor units. Income (or wealth) effect: • An increase in real wage makes workers effectively wealthier because for the same amount of work they now earn a higher real income, inducing households to consume more leisure (hence supply less labor units). •

o

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It is generally assumed that the substitution effect outweighs the wealth effect and the labor supplied would increase with real wage. ▪ The labor supply curve, which shows the total amount of labor supplied at each real wage, is upward sloping.

Real wage (W/P) Labor Supply (LS)

Labor (L)

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Factors affecting labor supply: o Households’ Wealth o Working-age population o Labor-force participation o

Taxes (or subsidies) affecting the returns to labors: • Payroll tax contributed by labors • Unemployment benefits

5. The Labor Market Equilibrium •

Based on the assumption that the real wage is flexible, the classical economists assumed the labor market clears, i.e. labor demand equals labor supply. o It ensures full employment (no cyclical unemployment) in the economy. o

Note that frictional unemployment and structural unemployment may still exist in real world.

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

Real wage (W/P) Labor Supply (LS)

*

(W/P)

Labor Demand (LD) Labor (L)

LF (full employment)

6. The Labor Market and Real Output •

Recall that the amount of output an economy produces depends on: o The amounts of inputs (such as labor and capital) utilized in the production. ▪ The amount of labor employed determined by the labor market equilibrium. o

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Real wage (W/P) Labor Supply (LS)

(W/P)

The production technology to transform inputs into outputs. ▪ The production function

Labor Demand (LD) Labor (L)

The following diagram shows the relationship between the labors employed and real output: o In the classical model, the economy reaches its potential output or GDP in the long run.

Output (Y) Production Function YF

Readings: • Chapter 20 (p.598 – 607) LF

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Labor (L)...