Economics principles tools and applications 9th by sullivan sheffrin perez chapter 07

Economics

NINTH EDITION

Chapter 7

The Economy at Full
Employment

Prepared by Brock Williams

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Learning Objectives

7.1 Identify the key assumption of classical models in macroeconomics.
7.2 Explain the concept of diminishing returns to labor.
7.3 Analyze how shifts in demand and supply affect wages and employment.
7.4 Explain how full employment is determined in a classical model.
7.5 Describe how changes in taxes can affect full employment.
7.6 Explain how countries must divide output across different uses.

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7.1 WAGE AND PRICE FLEXIBILITY
AND FULL EMPLOYMENT

•

Classical models
Economic models that assume wages and prices adjust freely to changes in demand and supply.

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7.2 THE PRODUCTION FUNCTION (1 of 4)

•

Production function
The relationship between the level of output of a good and the factors of production that are inputs to production.

•

Stock of capital
The total of all machines, equipment, and buildings in an entire economy.

•

Labor
Human effort, including both physical and mental effort, used to produce goods and services.

When there are only two factors of production, capital and labor, the production function is written as follows:

Y = F(K,L)

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7.2 THE PRODUCTION FUNCTION

With capital fixed, output increases with labor
input, but at a decreasing rate.

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(2 of 4)


7.2 THE PRODUCTION FUNCTION

(3 of 4)

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

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7.2 THE PRODUCTION FUNCTION

When the capital increases from K1 to K2, the
production function shifts up.
At any level of labor input, the level of output
increases.

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(4 of 4)


7.3 WAGES AND THE DEMAND AND
SUPPLY FOR LABOR

(1 of 3)

Together, the demand and supply for
labor determine the level of employment
and the real wage.

•

Real wage
The wage rate paid to employees
adjusted for changes in the price
level.

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7.3 WAGES AND THE DEMAND AND
SUPPLY FOR LABOR

(2 of 3)

Labor Market Equilibrium
Panel C of Figure 7.3 puts the demand and supply curves together.

At a wage of $15 per hour, the amount of labor firms want to hire—7,500 workers—
will be equal to the number of people who want to work—7,500 workers.

This is the labor market equilibrium: The quantity demanded for labor equals the
quantity supplied.

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

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7.3 WAGES AND THE DEMAND AND
SUPPLY FOR LABOR

(3 of 3)

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.

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APPLICATION 1

THE BLACK DEATH AND LIVING STANDARDS IN OLD ENGLAND
APPLYING THE CONCEPTS #1: How can changes in the supply of labor affect real wages?

According to the research of Gregory Clark of the UC, Davis, the level of real wages for laborers in England was nearly the same in 1200 as it was in 1800. Yet, during
the period from 1350 to 1550, they were higher—nearly 75 percent higher in 1450, for instance, than in 1200.
Why were real wages temporarily so high during this period?

•

The simple answer was the bubonic plague—also known as the Black Death

•

Arrived from Asia in 1348 and caused a long decline in total population through the 1450s.

•

With fewer workers, there was less labor supplied to the market. The result was higher real wages.

In the era before consistent and rapid technological advance, changes in population was the primary factor controlling living standards. As the economist Thomas
Malthus (1766–1834) observed, social maladies such as the Black Death would temporarily raise living standards until higher living standards led to increased
population.

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7.4 LABOR MARKET EQUILIBRIUM AND FULL EMPLOYMENT
Panel B determines the equilibrium level of employment at L and the real wage
rate of W. Full-employment output in Panel A is Y.

•

Full-employment output

The level of output that results when the labor market is in equilibrium and
the economy is producing at full employment.

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7.5 USING THE FULL-EMPLOYMENT MODEL (1 of 2)
Taxes and Potential Output
In Panel A, a tax burden on labor shifts the labor
demand curve to the left and leads to lower wages
and reduced employment.

•

In Panel B, the supply curve for labor is vertical,

which means that wages fall but employment does
not change.

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7.5 USING THE FULL-EMPLOYMENT MODEL (2 of 2)
Real Business Cycle Theory

•

Real business cycle theory
The economic theory that emphasizes how shocks to
technology can cause fluctuations in economic activity.

An adverse shock to technology will decrease the demand
for labor.
As a result, both real wages and employment fall as the
market equilibrium moves from a to b.

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APPLICATION 2

DO EUROPEAN SOCCER STARS CHANGE CLUBS TO REDUCE THEIR TAXES?
APPLYING THE CONCEPTS #2: What evidence is there that taxes on high paid soccer stars in Europe affect their location decisions among countries?

In 2009, a Portuguese soccer star moved from Manchester United in the United Kingdom to Real Madrid in Spain. Many speculated that the reason he moved was to avoid a top
United Kingdom tax rate of 50 percent in favor of a flat 24 percent rate (with no deductions) created to entice foreigners to locate in Spain. While this is an interesting anecdote, is
there any other evidence that the very top earners will move to countries with lower tax rates?

In an interesting study, economists Henrik Jacobsen Kleven, Camille Landais,and Emmanuel Saez used changes in the market for international soccer stars to test for the effects
of tax rates. Prior to 1995, the top European soccer clubs had limits on the number of foreign players on any one team. The European Court of Justice, however, ruled that these
limits violated the treaty of the European community. The economists found that prior to 1995, taxes on high earners did not have much effect on mobility of soccer stars, but after
1995, top tax rates did matter.

This type of evidence suggests that countries may not only be in competition for top athletes, but also for other highly paid individuals—from tennis players to corporate
executives.

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APPLICATION 3

GOVERNMENT POLICIES AND SAVINGS RATES
APPLYING THE CONCEPTS #3: What explains Singapore’s high savings rate?

•

In the United States, private consumption plus government consumption totals 84 percent of GDP. In Singapore, total consumption from
the private sector and the government is only 47 percent.

•

The World Bank estimates Singapore’s gross savings rate at 48 percent, compared to Hong Kong, which is only 27 percent.

•

Singapore requires that all workers save a very high percentage of their income in government accounts called the Central Provident
Fund.

•

Singapore does not have a U.S. style Social Security system and the citizens rely on this system to finance their retirement years.

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7.6 DIVIDING OUTPUT AMONG COMPETING
DEMANDS FOR GDP AT FULL EMPLOYMENT
(1 of 5)

International Comparisons

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7.6 DIVIDING OUTPUT AMONG COMPETING
DEMANDS FOR GDP AT FULL EMPLOYMENT
(2 of 5)

Crowding Out in a Closed Economy

•

Crowding out
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.

•

Closed economy
An economy without international trade.

output = consumption + investment + government purchases
Y=C+I+G

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7.6 DIVIDING OUTPUT AMONG COMPETING

DEMANDS FOR GDP AT FULL EMPLOYMENT
(3 of 5)

Crowding Out in a Closed Economy
Increased government spending crowds out consumption by
consumers.

The vertical bar highlights the time period during which crowding
out occurred.

SOURCE: U.S. Department of Commerce.

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7.6 DIVIDING OUTPUT AMONG COMPETING
DEMANDS FOR GDP AT FULL EMPLOYMENT
(4 of 5)

Crowding Out in a Closed Economy
Increased government spending also crowds out private investment
spending.

The vertical bar highlights the time period during which crowding out
occurred.

SOURCE: U.S. Department of Commerce.

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7.6 DIVIDING OUTPUT AMONG COMPETING
DEMANDS FOR GDP AT FULL EMPLOYMENT
(5 of 5)

Crowding Out in an Open Economy

•

Open economy
An economy with international trade.

Y = C + I + G + NX

Increased government spending need not crowd out either consumption or investment. It could lead to reduced exports and increased imports.

Crowding in

•

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

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KEY TERMS

Classical models
Closed economy

Crowding in
Crowding out
Full-employment output
Labor
Open economy
Production function
Real business cycle theory
Real wage
Stock of capital

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