Economics principles applications and tools global edition 9th edition osullivan solutions manual by robyn.gordon139

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7 The Economy at Full Employment Chapter Summary This chapter studies the economy at full employment. The model developed explains how GDP is produced with the supply of the factors of production—labor and capital. Since capital is fixed at a point in time, the text focuses on fixed capital with full employment labor applied. Labor market equilibrium provides the quantity of labor that, when combined with capital, produces full employment, or potential output. Here are the main points of the chapter: • If capital increases, the demand for labor increases. These increases raise wages and the level of labor employed. • An increase in the supply of labor causes the wage rate to fall, but the level of labor employed increases. • The full-employment model is used to explain taxation issues as well as immigration and economic fluctuations. • Government spending can also be studied using the full-employment model. Crowding out occurs as increased government spending as a percentage of GDP causes the other components to decline as a percentage. Learning Objectives: 1. Wage and Price Flexibility and Full Employment: Identify the key assumption of classical models in macroeconomics. 2. The Production Function: Explain the concept of diminishing returns to labor. 3. Wages and the Demand and Supply for Labor: Analyze how shifts in demand and supply affect wages and employment. 4. Labor Market Equilibrium and Full Employment: Explain how full employment is determined in a classical world. 5. Using the Full-Employment Model: Describe how changes in taxes can affect full employment. 6. Dividing Output among Competing Demands for GDP at Full Employment: Explain how countries must divide output across different uses.

Approaching the Material Students often find the material in this chapter difficult because they cannot relate to it on a personal level. Make the production examples personal—the “production” of grades in college works well. Make them owners of small businesses and ask them what would happen if business was slow. Would they cut 76

Chapter 7: The Economy at Full Employment 77

everyone’s wages or lay people off? How would they react as employees if their company reduced their wages? Later in the chapter, you will discuss technology shocks. Try using the introduction of computers as a positive technology shock and a massive computer virus as a negative technology shock.

Chapter Outline 7.1 Wage and Price Flexibility and Full Employment 1. Classical models are economic models that assume wages and prices adjust freely to changes in demand and supply. 2. Classical model was the dominant model until the Great Depression.

 Teaching Tip Ask students if they’ve heard of the Great Depression. Speak to them of this experience as having become a cultural touchstone that survives across the generation. Explain the depth and breadth of the Depression and how this was a huge, supposedly short run, deviation away from equilibrium. 3. The classical model is the one we will use to study the economy in the long run. And although Keynes said, “In the long run, we’re all dead,” it’s useful to study the economy at full employment. Because, although not instantaneous, wages and prices do eventually adjust.

 Teaching Tip This assumption regarding price and wage flexibility must be made clear at the outset for students to fully understand the chapter’s material. 4. Issues such as taxation, immigration, and government spending are studied using fullemployment models. A. Understanding Full Employment 1. Economy at full employment does not imply 0 percent unemployment. 2. Cyclical unemployment at 0 percent; frictional and structural > 0 percent. 3. Cyclical unemployment changes with business cycle. Therefore, the long run implies no business cycle.

7.2 The Production Function A. Production function is the relationship between the level of output and the factors of production that are inputs to production. For simplicity, we look at only labor and the stock of capital as factors of production. B. Stock of capital is total of all machines, equipment, and buildings in an entire economy. C. Labor is human effort, including both physical and mental effort, used to produce goods and services. D. Y = F(K, L) 1. Production function is drawn with a fixed level of K because the capital stock does not change instantaneously. 2. K = f(Investment in previous periods); fixed at a point in time.

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E. Therefore, labor is the only variable that changes in the figure. F. However, if the capital stock changes, this shifts the production function. 1. An increase in K will increase Y for all levels of Y => shift the production function up. Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

 Teaching Tip Students often benefit if you provide simple examples of production and the types of capital and labor used in the process. This can include any production process. For example, the local copy store has both copy machines (capital) and workers (labor).

7.3 Wages and the Demand and Supply for Labor 1. Real wage is the wage rate paid to employees adjusted for changes in the price level.

 Teaching Tip Students often have trouble grasping what the real-nominal difference means when applied to something like wages. The best way to show the difference is to introduce annual rates of inflation and changes in nominal wage rates. Show students how in some years the average wage grows more quickly, but other times the average wage is outpaced by inflation. Now make explicit that this means people are losing the ability to purchase goods and services when the latter occurs. Watch for the shock as some now understand the distinction. 2. Labor demand from firms. 3. Labor supply by workers. a. Substitution effect: With increased wages, opportunity cost of leisure rises, hours worked rises. This implies an upward-sloping labor supply curve. b. Income effect: With increased wages, workers may choose to work less and enjoy more leisure. This implies a downward-sloping labor supply curve. 4. Typically assume Substitution effect > Income effect; labor supply slopes upward. Remind students of the following key principle:

KEY PRINCIPLE: 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.

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A. Labor Market Equilibrium 1. Quantity of labor demanded equals quantity of labor supplied, determining equilibrium real wage. B. Changes in Demand and Supply 1. Increase in Ld increases real wage and equilibrium quantity. 2. Increase in Ls decreases real wage but increases equilibrium quantity. a. Increase immigration, increase Ls, pushing down real wage and increasing quantity. b. Current employees dislike immigration because wages fall. c. However, product prices are held down due to lower wages. Review this key question and the related application:

Question 1: How can changes in the supply of labor affect real wages? APPLICATION 1: THE BLACK DEATH AND LIVING STANDARDS IN OLD ENGLAND The Application points out that while real wages for laborers in England were nearly the same in 1800 as in 1200, from 1350 to 1550 wages were considerably higher. The simple explanation was the bubonic plague—the Black Death—arrived from Asia in 1348 and caused a long decline in total population through the 1450s. This reduction in labor supply resulted in higher real wages and lower output, consistent with the Malthusian view of demographic changes.

7.4 Labor Market Equilibrium and Full Employment A. Full-employment output is the level of output that results when the labor market is in equilibrium and the economy is producing at full employment. We show this diagrammatically as equilibrium in the labor market. B. Equilibrium in the labor market displays W* and L*, equilibrium wage and quantity respectively. From the production function we know that potential output is Y* = F(K*, L*).

 Teaching Tip It’s good to show the graph of the production function stacked on top of the labor market graph and illustrate how changes in the labor market affect potential output. Stacking the two graphs together gives a good visual representation of the links between what could be considered different topics covered in macroeconomics. C. Measuring an Economy’s Output at Full Employment 1. Start with an estimate of unemployment at full employment (cyclical unemployment equal to 0). 2. In 1996 unemployment was 5.6 percent and was close to the natural rate. The labor force equaled 126.7 million. RGDP equaled $7.8 billion, in 1996 dollars. Since unemployment was close to the natural rate, RGDP was close to potential.

7.5 Using the Full-Employment Model A. Taxes and Potential Output 1. Tax on employers for hiring workers, such as Social Security; increase MC of production due to increased labor cost for employers.

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2. 3. 4. 5. 6.

Increase MC of production with unchanged MB; less hiring as Ld falls. Decreased Ld causes falling real wage and declining employment levels. Decreased potential output due to the reduced employment. The size of the decline is determined by the slope of the Ls. If Ls is perfectly inelastic, decline in real wage with no change in L*

 Teaching Tip Ask students whether or not they see working as a choice. This will help them begin understanding the supply curve assumptions. Perhaps working is not a choice, but the intensity and/or hours of work may be a choice.

 Teaching Tip This Application leads into a discussion of how high taxes would have to be to discourage work. Ask the class at what tax rate they would start to work less. B. Real Business Cycle Theory 1. Real business cycle theory is the economic theory that emphasizes how shocks to technology can cause fluctuations in economic activity. 2. Changes in technology change full employment and potential output levels because they change labor productivity and hence labor demand.

 Teaching Tip It’s always good to emphasize divisions within the economics discipline and the real business cyclists provide a fruitful example for debate. The moral is that no model can explain all facets of our diverse economy.

Review this key question and the related application:

Question 2: What evidence is there that taxes on highly paid soccer stars in Europe affect their location decisions among countries? APPLICATION 2: DO EUROPEAN SOCCER STARS CHANGE CLUBS TO REDUCE THEIR TAXES? In this Application, a study found that when the rules limiting the number of foreign soccer players on one team were relaxed, the top tax rates did affect the mobility of soccer stars. In addition, players were influenced by the specific tax breaks offered by different countries. Despite the increase in “globalization” in recent years, tax rates are very different among countries.

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Review this key question and the related application:

Question 3: What explains Singapore’s high savings rates? APPLICATION 3: GOVERNMENT POLICIES AND SAVINGS RATES Singapore has one of the highest savings rates in the world, at about 48 percent. The reason is because the government of Singapore requires that all workers save a high percentage of their income in government accounts. These accounts are kept in people’s own names and held by the government to be used for retirement and other expenses such as housing and health care.

7.6 Dividing Output among Competing Demands for GDP at Full Employment A. International Comparisons 1. Show the large disparity across different nations and the comparative data regarding the division of output across C, I, G, and NX. a. United States has high C, low I, and negative NX. b. France has lower C, higher G, higher I, and small positive NX. c. China has very low C, very low G, and high positive NX. d. Japan and China have very high I.

 Teaching Tip Explore the differences by pointing out that the United States has the highest level of consumption and is the only nation among this group with a trade deficit. Look at the various levels of government activity relative to each nation’s GDP. Very simply, if one category takes a larger percentage, the other percentages must fall. Lastly, point out that the table is a snapshot and that these numbers fluctuate a great deal. B. Crowding Out in a Closed Economy 1. Crowding out is the reduction in investment (or other components of GDP) caused by an increase in government spending. 2. A closed economy is an economy without international trade. Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF OPPORTUNITY COST The opportunity cost of something is what you sacrifice to get it. 3. Use a closed economy model (no trade) to study crowding out. a. Y = C + I + G (in a closed economy) b. Y is fixed in the long run unless there are changes to the labor market and/or technology. c. An increase in G with a fixed Y must be offset by a fall in C + I. C. Crowding Out in an Open Economy 1. An open economy is an economy with international trade. a. Y = C + I + G + NX (in an open economy) 2. In an open economy, with trade, domestic C and I need not be crowded out. Instead, NX could go down.

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D. Crowding In Crowding in is the increase of investment (or other component of GDP) caused by a decrease in government spending. 1. A decline in government spending in long run causes other components such as I, C, or NX to increase. 2. The nature of changes in G will determine what components are crowded in/out.

 Teaching Tip Using various government Web sites, gather data on the trade deficit, budget deficit, and investment. Have the students compare interest rates and government deficits. Ask them about the relationships. A good Web site for macroeconomic data is at the St. Louis Fed: http://research.stlouisfed.org/fred2/.

Additional Applications to Use in Class Question: Why are durable goods an indicator of economic growth? ADDITIONAL APPLICATION: U.S. DURABLE GOODS ORDERS PLUNGE Anonymous “U.S. Durable Goods Orders Plunge” Posted 11/28/2006 on MSNBC.com FT.com Financial Times Summary: Key Points in the Article Durable goods posted their largest single monthly decline in more than six years during October 2006. New orders fell by 8.3 percent for the month. While the decline was worrisome, the previous two months posted gains that offset the drop. Economists indicated the volatility in durable goods failed to provide good information and that now more attention would fall on home sales and consumer confidence numbers due later today. The Fed chairman, Ben Bernanke, was also expected to speak and his comments were widely anticipated. The breakdown in durable goods numbers failed to provide much hope for some analysts. Nondefense durable good spending was down 44.5 percent. After excluding aircraft spending, the indicator fell by 5.1 percent. This number is thought to closely mirror overall business spending. Analyzing the News Business spending on durable goods is seen as a positive sign for economic growth. Businesses don’t tend to spend money in the face of an economic slowdown. Therefore, this component falling potentially indicates a greater slowdown than expected. Thinking Critically Questions 1. Why is durable good spending monitored? 2. Why is nondefense spending a more valuable number? 3. Why are Ben Bernanke’s comments so anticipated?

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Solutions to End-of-Chapter Exercises Chapter 7 SECTION 7.1: WAGE AND PRICE FLEXIBILITY AND FULL EMPLOYMENT 1.1 1.2 1.3 1.4

classical structural False The classical view of the labor market assumes that wages are sufficiently flexible so that the labor market is always in equilibrium. Alternatively, if there is excess supply or demand for labor, the wage will quickly adjust in order to eliminate the surplus or shortage of labor. As wages adjust quickly, unemployment will not be observed based on the classical view

SECTION 7.2: THE PRODUCTION FUNCTION 2.1 2.2 2.3

production function a. downward

2.4 2.5

downward

2.6

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2.7

No, the second increase in output is greater than the first.

SECTION 7.3: WAGES AND THE DEMAND AND SUPPLY FOR LABOR 3.1 3.2 3.3 3.4 3.5.

supplied supply, workers downward, more False. It is caused by a decrease in demand. a.

3.6 3.7

3.8

Immigration may not affect the overall supply of labor for the entire U.S. economy, but may have a stronger impact on supply near the border. It would reduce wages and increase employment, as the supply curve would shift to the right.

If an increase in the demand for labor raises wages, the Malthusian argument is that increases in population will shift the supply curve for labor to the right until wages fall back down to subsistence.

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3.9. Improved technology will shift the demand curve for labor to the right, raising real wages. This will eventually lead to a shift in the supply curve to the right, as population increases. In the long run, population has increased while real wages return to subsistence levels.

SECTION 7.4: LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT 4.1

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4.2

4.3 4.4 4.5 4.6 4.7

True increases, increases, decreases All else being equal, the economist who estimated natural unemployment to be lower would estimate a higher value for potential output. The main cause is that average work hours per year are less in Germany than in the United States. If these were equalized, per-capita output levels would be similar. Potential output increases.

SECTION 7.5: USING THE FULL-EMPLOYMENT MODEL 5.1

5.2 5.3 5.4

Demand for labor shifts to the left, wages go down, and employment goes down. steam engine, electric lighting Only top athletes or entertainers would be paying enough tax to make it worthwhile for them to relocate. For middle-class workers, the costs of relocation would exceed the tax savings.

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5.5

b. Wages would fall, while employment and output remain unchanged. Economists say labor bears the full burden of the tax because there is no change in what employers experience; labor input and total expense of hiring (wages + tax) are the same. c. Employment and output fall, while wages remain unchanged. d. More elastic labor supply in Europe than in the U.S. or Japan would magnify the employment effects of payroll taxes in Europe. 5.6

5.7

Labor supply almost vertical suggests than workers cannot adjust employment in order to avoid payment of the higher payroll tax, leading to increased tax revenue collected by the government. 5.8 No, if there is a negative technology shock, output and real wages will both fall. 5.9 If fewer people sold stocks when the capital gains tax was increased, total revenue could actually fall even though the tax rate was increased. 5.10 According to this study, married women are the most sensitive to tax rate changes. About one-half of the increase in labor supply following a decline in tax rates comes from new entrants in the labor force.

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SECTION 7.6: DIVIDING OUTPUT AMONG COMPETING DEMANDS FOR GDP AT FULL EMPLOYMENT 6.1 6.2 6.3 6.4 6.5 6.6 6.7

false open net exports high The best explanation is that Singapore forces its residents to save through the Central Provident Fund. Increased spending on swimming pools would crowd out consumption; spending on space exploration could crowd out either investment or consumption spending. The custom of high-value gifts might reduce consumption and increase saving.