Transcript Chapter 3

Chap 3: Productivity, Output, and Employment

Focus : The Labor Market

What factors determine real wage and the
employment level?
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How equilibrium is achieved in the labor
market?

Types and causes of unemployment.
1
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Production function relates the total output to the
total amount of inputs used in the production.
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Two characteristics of the production function:
1)
Strictly increasing Marginal product
2)
Diminishing Marginal Productivity
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Marginal product refers to increment in output for a
unit increase in an input holding other inputs
constant.
2
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Supply or Productivity Shocks refer to changes in
the production function.
Equilibrium in the Labor Market
Assumptions:
1)
2)
All workers are identical.
Individual firms and workers take market wage as
given.
3)
Firms maximize their profits.
4)
Workers maximize their utility.
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The Demand for Labor
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While making hiring decision, a firm compares the
cost of hiring (wage) with the benefit from hiring
(value of extra production).
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The Marginal Revenue Product of Labor (MRPN) =
Marginal Product of Labor (MPN) * Price (P)
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The demand for workers by a firm is given by the
condition that
MRPN = MPN * P = Nominal Wage (W)
Or, MPN = W/P = w (Real Wage)
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The labor demand curve is same as the MPN curve.
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The Supply of Labor
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While making labor supply decision, a worker
compares the cost of working (forgone leisure) with
the benefit from working (real wage).
The Substitution Effect – Higher real wage by
increasing the benefit from working increases the
labor supply.
The Income Effect - Higher real wage by increasing
the wealth of workers reduces the labor supply.
The substitution effect has positive and the income
effect has negative effect on the labor supply. The
longer the higher wage is expected to last, stronger
is the income effect and vice versa.
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The Labor Supply Curve of a worker relates
the amount of labor supplied with the current
real wage, holding other factors constant. It
slopes upwards.
The Labor Market Equilibrium
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The labor market attains equilibrium at the
employment level and the real wage at which
labor supply equals labor demand.
The equilibrium level of employment is called
Full Employment Level of Employment and
the corresponding output as the Full
Employment or Potential Output.
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Unemployment
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Frictional Unemployment – Unemployment
which arise as workers search for suitable
jobs and firms search for suitable workers.
Structural or Chronic Unemployment – Long
term unemployment.
Natural Rate of Unemployment = Frictional
Unemployment Rate + Structural
Unemployment Rate
Cyclical Unemployment Rate = Actual
Unemployment Rate - Natural Rate of
Unemployment
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