The Labor Market and Potential GDP

• The Supply of Labor– The quantity of labor supplied is the

number of labor hours that all the households in the economy plan to work at a given real wage rate.

– The supply of labor is the relationship between the quantity of labor supplied and the real wage rate, all other things remaining the same.

The Labor Market and Potential GDP

Figure 8.4 illustrates a labor supply curve.

The higher the real wage rate, the greater is the quantity of labor supplied.

The Labor Market and Potential GDP

– The quantity of labor supplied increases as the real wage rate increases for two reasons:

– Hours per person increase– Labor force participation increases

The Labor Market and Potential GDP

– Hours per person increase because the real wage rate is the opportunity cost of not working.

– But a higher real wage rates increase income, which increases the demand for normal goods, including leisure.

– An increase in the quantity of leisure demanded means a decrease in the quantity of labor supplied.

– The opportunity cost effect is usually greater than the income effect, so a rise in the real wage rate brings an increase in the quantity of labor supplied.

The Labor Market and Potential GDP

– Labor force participation increases because higher real wage rates induce some people who choose not to work at lower real wage rates to enter the labor force.

– The labor supply response to an increase in the real wage rate is positive but small.

– A large percentage increase in the real wage rate brings a small percentage increase in the quantity of labor supplied.

– The labor supply curve is relatively steep.

Shape of Labor Supply Curve

– The labor supply response to an increase in the real wage rate is positive but small.

– A large percentage increase in the real wage rate brings a small percentage increase in the quantity of labor supplied.

– The labor supply curve is relatively steep.

The Labor Market and Potential GDP

– The labor market is in equilibrium at the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied.

– Labor market equilibrium is full-employment equilibrium.

– The level of real GDP at full employment is potential GDP.

The Labor Market and Potential GDP

Figure 8.5(a) illustrates labor market equilibrium.

Labor market equilibrium occurs at a real wage rate of $35 and an employment of 200 billion labor hours.

The Labor Market and Potential GDP

Potential GDP

At a full employment level of 200 billion hours, potential GDP is 10 trillion dollars.

Unemployment at Full Employment

– The unemployment rate at full employment is called the natural rate of unemployment.

– Unemployment always is present for two broad reasons

– Job search (Frictional and Structural Unemployment)

– Job rationing

Unemployment at Full Employment

Figure 8.6 illustrates the relationship between the amount of job search unemployment and the real wage rate.

Unemployment at Full Employment

– The amount of job search unemployment changes over time and some of the sources of these changes are

– Demographic change– Unemployment compensation – Structural change

Unemployment at Full Employment

– Demographic change– As more young workers entered the labor

force in the 1970s, the amount of frictional unemployment increased as they searched for jobs. Frictional unemployment may have fallen in the 1980s as those workers aged.

– Two-earner households may increase search, because one member can afford to search longer if the other has an income.

Unemployment at Full Employment

– Unemployment compensation– The more generous unemployment benefit

payments become, the lower the opportunity cost of unemployment, so the longer workers search for better employment rather than any job.

– More workers are covered now by unemployment insurance than before, and the payments are relatively more generous.

Unemployment at Full Employment

– Structural change– An increase in the pace of technological

change that reallocates jobs between industries or regions increases the amount of search.

Unemployment at Full Employment

• Job Rationing– Job rationing occurs when employed

workers are paid a wage that creates an excess supply of labor.

– Job rationing can occur for two reasons– Efficiency wage– Minimum wage

Unemployment at Full Employment

– An efficiency wage is a real wage rate that is set above the full-employment equilibrium wage that balances the costs and benefits of this higher wage rate to maximize the firm’s profit.

– The cost of a higher wage is direct.– The benefit of a higher wage is indirect: it

enables a firm to attract high-productivity workers, stimulates greater work effort, lowers the quit rate, and lowers recruiting costs.

Unemployment at Full Employment

– A minimum wage is the lowest wage rate at which a firm may legally hire labor.

– If the minimum wage is set below the equilibrium wage rate, it has no effect.

– If the minimum wage is set above the equilibrium wage rate, it does affect the labor market.

Unemployment at Full Employment

• Job Rationing and Unemployment– If the real wage rate is above the equilibrium wage,

regardless of the reason, there is a surplus of labor that adds to unemployment and increases the natural unemployment rate.

– Most economists agree that efficiency wages and minimum wages increase the natural unemployment rate.