Macroeconomics Chapter 3

The production function tells us the amount of output that can be produced with any given quantities of

capital and labor. It can be graphed as a relationship

between output and capital, holding labor fixed, or as

a relationship between output and labor, holding

capital fixed. In either case, the production function

slopes upward, implying that greater use of capital or

labor leads to more output. A shift in the production

function, which indicates a change in the amount of

output that can be produced with given amounts of

capital and labor, is called a supply shock.

2. The extra output that can be produced when the capital stock is increased by one unit, with labor held constant, is called the marginal product of capital ( ) MPK .

In a graph of the production function relating output

to capital, the MPK can be measured as the slope of

the production function. The MPK falls as the capital

stock increases, reflecting the diminishing marginal

productivity of capital. Similarly, the marginal product of labor ( ) MPN is the extra output that can be

produced when labor increases by one unit, with capital held constant. The MPN—which can be measured

as the slope of the production function relating output

to labor—falls as employment rises, indicating that

labor also has diminishing marginal productivity.

3. To maximize profits, firms demand labor to the point

that the marginal revenue product of labor ( ) MRPN

equals the nominal wage, W; or, equivalently, to the

point that the MPN equals the real wage, w.

4. The labor demand curve is identical to the MPN

curve. Because an increase in the real wage causes

firms to demand less labor, the labor demand curve

slopes downward. Factors that increase the amount

of labor demanded at any real wage, such as a beneficial supply shock or an increase in the capital stock,

shift the labor demand curve to the right. Aggregate

labor demand is the sum of the labor demands of

firms in the economy.

5. An individual’s decision about how much labor to

supply reflects a comparison of the benefit and cost

of working an additional hour. The benefit of working an additional hour is the additional real income

earned, which can be used to increase consumption.

The cost of working an extra hour is the loss of an

hour’s leisure. An individual’s happiness, or utility,

is maximized by supplying labor to the point where

the cost of working an extra hour (the utility lost

because of reduced leisure) equals the benefit (the

utility gained because of increased income).

6. An increase in the real wage has competing substitution

and income effects on the amount of labor supplied.

The substitution effect of a higher real wage increases

the amount of labor supplied, as the worker responds to

the increased reward for working. The income effect

reduces the amount of labor supplied, as the higher real

wage makes the worker wealthier and thus able to

afford a greater amount of leisure. The longer an

increase in the real wage is expected to last, the stronger

the income effect is. Thus a temporary increase in the

real wage will increase the amount of labor supplied.

A permanent increase in the real wage will increase the

amount of labor supplied by a smaller amount than a

temporary increase in the real wage of the same size,

however, and may even lead to a decrease in the

amount of labor supplied.

7. The labor supply curve relates the amount of labor

supplied to the current real wage. The labor supply

curve slopes upward, indicating that an increase in

the current real wage—with other factors, including

the expected future real wage, held fixed—raises the

amount of labor supplied. Factors that decrease the

quantity of labor supplied at the current real wage,

and thus shift the labor supply curve to the left,

include an increase in wealth and an increase in the

expected future real wage. Aggregate labor supply,

which is the sum of labor supplies of the individuals

in the economy, is also influenced by changes in the

adult population and social or legal factors that affect

the number of people participating in the labor

market.

8. The classical supply–demand model of the labor

market is based on the assumption that the real wage

adjusts relatively quickly to equalize the quantities of

labor demanded and supplied. The equilibrium level

of employment, which arises when wages and prices

in the economy have fully adjusted, is called the

full-employment level of employment. Fluctuations in

employment and the real wage result from factors

that shift the labor supply curve and/or the labor

demand curve.

9. Full-employment output, or potential output, is the

amount of output produced when employment is at its

full-employment level. Increases in the full-employment

level of employment or beneficial supply shocks increase

the full-employment level of output.

10. Adults without jobs are classified as unemployed if

they looked for work during the preceding four weeks;

they are classified as not in the labor force if they

haven’t been looking for work. The labor force consists

of all employed workers plus all unemployed workers. The unemployment rate is the fraction of the labor

force that is unemployed.