7.1 Wage and Price Flexibility and Full Employment

• The economic model of the economy at full employment that assumes wages and prices adjust freely and quickly to changes in demand and supply are called classical models.

• The term classical refers to a school or economics that believed that over a relatively short period of time wages and prices would adjust quickly and naturally to bring the economy back to full employment.

• The full-employment model is used to analyze the long-term issues, such as the role taxes play in determining the level of GDP and how immigration affects wages and GDP.

• Full employment means an economy has frictional and structural unemployment but no cyclical unemployment.

7.2 The Production Function

• Production function: to study how this production actually occurs. It explains how the total level of output or GDP in the economy is generated from the factors of production.

• The stock of capital is all the machines, equipment, and buildings in the entire economy.

• Labor consists of the efforts, both physical and mental, of all the workers in the economy used to produce goods and services.

• Production function is written as: Y = F(K,L)

  • Y = total output or GDP

  • K = the stock of capital

  • L = the labor force

  • F = the relationship between the factors of production and output

• The stock of capital a society has at any point in time is determined by investments it has made in new buildings, machines, and equipment in the past.

• With the stock of capital fixed at the constant level K, only variations in the amount of labor can change the level of output in the economy.

• Principle of Diminishing Returns: Suppose we produce output with two or more inputs and we increase on input while holding the other inputs fixed. Beyond some point -called the point of diminishing returns- output will increase at a decreasing rate.

• Capital is one of the key factors of production. The benefits of additional capital are a higher level of output from any level of labor input.

7.3 Wage and the Demand and Supply for Labor

• The amount of labor firms in the economy will hire depends on the real wage: the wage rate paid to employees adjusted for changes in the price level.

• The real wage tells us what goods and services workers are able to purchase from their labor and also what it costs, in real terms, for employers to pay their workers for their services.

• While the labor-demand curve is based on the decisions by firms, the labor-supply curve is based on the decisions of workers.

Labor Market Equilibrium

• Together, the demand and supply curves determine the level of employment in the economy and the level of real wages.

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.

• When firms increase their capital stock, they find that each worker becomes more productive with the additional capital.

• If the population increases, we would expect more people would want to work at any given wage.

• Workers who were employed before the increase in labor supply suffer because real wages have fallen.

• However, wages are an input price that firms use in determining the price of the goods and services they produce. Lower input prices -such as wage- eventually lead to lower prices for the products workers buy.

7.4 Labor Market Equilibrium and Full Employment

• Full-employment output is the level of output produced when the labor market is in equilibrium and the economy is producing at full employment which is also known as potential output.

• Potential output is not the absolute maximum level of output an economy can produce—an economy could produce more with higher levels of labor input—but potential output reflects the level of labor input that workers wish to supply.

• The level of potential output in an economy increases as the supply of labor increases or the stock of capital increases.

7.5 Using the Full-Employment Model

Taxes and Potential Output

• A tax on labor will make labor more expensive and raise the marginal cost of hiring workers.

• Higher taxes lead to less employment. With reduced employment, potential output in the economy will be reduced as the economy moves to a lower level of output on the short-run production function.

Real Business Cycle Theory

• Changes in technology will usually change the level of full employment or potential output. A significant technological improvement will enable the economy to increase the level of both actual and potential output.

• Real business cycle theory emphasizes that shocks to technology can be a major cause of economic fluctuations.

• A positive technological shock would increase labor demand and result in both higher wages and higher employment.

7.6 Dividing Output among Competing Demands for GDP at Full Employment

International Comparisons

Crowding Out in a Closed Economy

• Because the level of full-employment output is given by the supply of factors in the economy, an increase in government spending must come at the expense of other uses of GDP.

• Crowding out is the reduction in investment (or other component of GDP) caused by an increase in government spending

• Principle of Opportunity Cost: The opportunity cost of something is what you sacrifice to get it.

• A closed economy is an economy without international trade.

• Output = consumption + investment + government purchases

• Crowding out occurred in the United States during World War II as the share of government spending as a part of GDP rose sharply.

Crowding Out in an Open Economy

• An economy with international trade is called an open economy.

• In an open economy, full-employment output is divided among four uses: consumption, investment, government purchases, and net exports (exports – imports): Y = C + I + G + NX

• In practice, increases in government spending in an open economy would crowd out consumption, investment, and net exports.

Crowding In

• Crowding in is the increase of investment (or other component of GDP) caused by a decrease in government spending.

• In a closed economy, consumption or investment, or both, could increase.

• In an open economy, net exports could increase as well.