Economics 10020/20020 Principles of Macroeconomics The Supply Side: Labor, Production, and Long-Run Growth

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1 s 10020/20020 Principles of Macroeconomics The Side: Labor,, and Long-Run Dennis C. Plott University of Notre Dame Department of s Spring 2015 Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

2 Long-Run over in Rich? Policies When we speak of long-run economic growth, we mean the process by which rising productivity increases the average standard of living. The most commonly used measure of this average standard of living is real GDP per capita: the amount of production in the economy, per person, adjusted for changes in the price level. As the chart shows, real GDP per capita has risen more than eight-fold since 1900; the average American can buy more than eight times as many goods and services now as in Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

3 Prosperity and Health over in Rich? Policies prosperity and health go hand-in-hand: richer nations can devote more resources to improving the health of their citizens, and healthier citizens are more productive. While growth in real GDP per capita is an important measure of our improvement, another important measure is the increase in our lifespans; these have also increased markedly over the last century. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

4 Prosperity and Health over in Rich? Policies Another good measure of our economic prosperity is the amount of time we can spend on leisure. As our lifespan grows, we can spend more time on leisure; and also, as we grow more productive, we can devote less time to work, and hence more to leisure. The chart shows estimates from Nobel Prize-winner Robert Vogel, who predicts that improvements in productivity and lifespan will continue to improve the lives of Americans over the coming decades. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

5 Obtaining over in Rich? Policies growth is not inevitable; history has seen long periods of stagnation where no sustained increases in output per capita occurred. Why have some countries been able to achieve rapidly increasing real GDP per capita, while other countries have failed to keep pace? Our goal in this section is to develop a model of economic growth to help answer questions such as this. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

6 From Prehistory to the Middle Ages over in Rich? Policies Economist Brad DeLong estimates that in 1,000,000 B.C., our ancestors had a GDP per capita of approximately $145. He estimates that GDP per capita in 1300 A.D. was also about $145. In other words, no sustained economic growth occurred before the middle ages; a peasant on a farm in 1300 A.D. was about as well off his ancestors. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

7 The Industrial Revolution over in Rich? Policies Significant economic growth did not really begin until the Industrial Revolution, the application of mechanical power to the production of goods and services which began in England around Before this, production of most goods had relied on human or animal power. The use of mechanical power allowed England and other countries like the United States, France, and Germany to begin to experience long-run economic growth. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

8 Why Did the Industrial Revolution Begin in England? over in Rich? Policies Nobel Laureate Douglass North argues that the Glorious Revolution of 1688 was a key turning point in the economic history of Britain. After that date, the British Parliament, rather than the king, controlled the government. The court system also became independent of the king. The government was then able to make credible promises regarding upholding property rights, protecting wealth, and the elimination of arbitrary tax increases. This, claims North, made entrepreneurs willing to make the investments necessary for the Industrial Revolution to take hold. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

9 Average Annual Rates Are Important over in Rich? Policies The graph shows Brad DeLong s estimated average annual growth rates for the world economy. The Industrial Revolution, and its subsequent spread throughout the world, resulted in sustained increases in real GDP per capita. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

10 Calculating Rates over in Rich? The growth rate of an economic variable like real GDP or real GDP per capita is equal to the percentage change from one year to the next. Policies Over periods of a few years, we can average the growth rates to find the approximate annual rate of growth. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

11 Rates over Longer Periods over in Rich? Policies For longer time periods, we wouldn t want to calculate each of the annual growth rates and then take an average in order to find the average annual growth rate; instead we would solve for the growth rate g, where: Previous real GDP (1 + g) t = Current real GDP with t the number of time periods between the previous and current periods. A useful shortcut called the Rule of 70 can help us to determine how long it will take for an economic variable to double: 70 Number of years to double = rate So if the growth rate is 5%, it will take about 14 years for the variable to double. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

12 Why Do Rates Matter? over in Rich? Policies The difference between 1.3% and 2.3% may not seem like much; but over a long period, it makes a remarkable difference. Over 50 years, a 1.3% growth rate leads to about a 91% increase in real GDP per capita. But a 2.3% growth rate leads to about a 212% increase. In the long-run, small differences in economic growth rates result in big differences in living standards. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

13 What Determines the Rate of Long-Run? over in Rich? Policies Increases in real GDP per capita rely on increases in labor productivity: the quantity of goods and services that can be produced by one worker or by one hour of work. Why can the average American consume eight times as many goods and services now, than as in 1900? Because the average American produces eight times as many goods and services in an hour now, than as in So most of the answer to what determines the rate of long-run growth is the same as the answer to what determines labor productivity growth? Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

14 Factors Affecting Labor Productivity over in Rich? Policies Increases in capital per hour worked Capital is manufactured goods that are used to produce other goods and services. The more capital a worker has available to use (including human capital, the accumulated knowledge and skills workers possess), the more productive he or she will be. Technological change Improvements in capital or methods to combine inputs into outputs (i.e., new technologies) allow workers to produce more in a given period of time. The role of entrepreneurs here is critical, in pioneering new ways to bring together the factors of production to produce better or lower-cost products. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

15 Can India Sustain Its Rapid? over in Rich? Policies To many people, the rapid economic rise of India was unexpected. Before its independence from England in 1947, growth rates in India were very low, and India was desperately poor. In 1991, the Indian government decided to scale back central planning, reduce regulations, and introduce market-based reforms. In order to continue to grow, many economists believe India will need to upgrade infrastructure, improve provision of educational and health services, and renew its commitment to the rule of law and market-based reforms. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

16 Differences in Incomes across Countries over in Rich? Policies Economists often refer to the high-income countries (or industrial countries) of Western Europe, Australia, Canada, Japan, New Zealand, and, in comparison to the poorer developing countries of the rest of the world. The 1980s and 1990s have seen some countries progress out of the developing category, like Singapore, South Korea, and Taiwan; these are often referred to as newly industrializing countries. Real GDP per capita is markedly different across the world, even after correcting for cost of living differences. In 2012 it ranged from a high of $103,900 in Qatar to a low of $400 in the Democratic Republic of the Congo. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

17 GDP per Capita in 2012 over in Rich? Policies The figure shows GDP per capita (in US $) in 2012 for each of the world s nations, adjusted for differences in the cost of living. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

18 Is Income All That Matters? over in Rich? Policies By concentrating on income differences between countries, are economists missing something important? While incomes have not been rising in, for example, sub-saharan Africa, economist Charles Kenny with the Bank argues that those countries have made rapid advances in health, education, and civil and political liberties. William Easterly, an economist at NYU, confirms that advances in these factors do not necessarily go hand in hand with income increases, but are essential to raising living standards. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

19 Long-Run over in Rich? Policies Two basic questions about growth: 1. What s the relationship between the long-run standard of living and the saving rate, population growth rate, and rate of technical progress? 2. How does economic growth change over time? Will it speed up, slow down, or stabilize? We will use the Solow model to explore these questions. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

20 The Solow Model over in Rich? Policies Due to Robert Solow (1924 ), won Nobel Prize (1987) for contributions to the study of economic growth. A major paradigm: widely used in policy making benchmark against which most recent growth theories are compared Looks at the determinants of economic growth and the standard of living in the long-run Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

21 over in Rich? Policies Developing a Model of An economic growth model seeks to explain growth rates in real GDP per capita over the long-run. As we noted previously, the key to this is labor productivity: the quantity of goods and services that can be produced by one worker or by one hour of work. Two main factors affect labor productivity: 1. The quantity of capital per hour worked, and 2. The level of technology. So our model will concentrate on changes in the quantity of capital, and technological change. Definition Technological change: A change in the quantity of output a firm can produce using a given quantity of inputs. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

22 Technological Change over in Rich? Policies There are three main sources of technological change: 1. Better machinery and equipment Inventions like the steam engine, machine tools, electric generators, and computers have allowed faster economic growth. 2. Increases in human capital Human capital is the accumulated knowledge and skills that workers acquire from education and training or from their life experiences. 3. Better means of organizing and managing production If managers can do a better job of organizing production, then labor productivity can increase. An example of this is the just-in-time system, first developed by Toyota; this involves assembling goods from parts that arrive at the factory exactly when they are needed. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

23 per Worker over in Rich? Policies Suppose we wanted to describe a per-worker production function: the relationship between real GDP per hour worked, and capital per hour worked, holding the level of technology constant. The first units of capital would be the most effective, allowing output per hour to increase most. Subsequent increases would result in diminishing returns: smaller increases in output resulting from increasing one factor of production progressively higher while keeping the other factors of production constant. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

24 More Capital or Technological Change? over in Rich? Policies If a country is relatively lacking in capital like many of the developing countries increases in capital will be very effective at increasing real GDP per capita. In countries where the amount of capital is already relatively high, technological change becomes a more effective way to increase output per hour. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

25 The Solow Model: Depreciation and Dilution over in Rich? Policies The depreciation rate is the rate at which the capital stock declines due to either capital goods becoming worn out by use or becoming obsolete. We can think of the effect of the labor force increasing faster than the capital stock as spreading out-diluting-the capital stock over more workers. Note: both depreciation and the population growth rate are greater than zero. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

26 The Solow Model: Determinants Population over in Rich? Policies Higher population growth means a lower capital-labor ratio, lower output per worker, and lower consumption per worker. Should a policy goal be to reduce population growth? Doing so will raise consumption per worker But it will reduce total output and consumption, affecting a nation s ability to defend itself or influence world events The Solow model also assumes that the proportion of the population of working age is fixed But when population growth changes dramatically this may not be true Changes in cohort sizes may cause problems for social security systems and areas like health care Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

27 over in Rich? Policies The Malthusian Model (1798) Thomas Robert Malthus ( ) argued in his book An Essay on the Principle of Population as It Affects the Future Improvement of Society that an ever-increasing population would continually strain society s ability to provide for itself. Mankind, he predicted, would forever live in poverty. Malthus began by noting that food is necessary to the existence of man and that "the passion between the sexes is necessary and will remain nearly in its present state". He concluded that the power of population is infinitely greater than the power in the earth to produce subsistence for man. According to Malthus, the only check on population growth was misery and vice. Malthus neglected the effects of technological progress; e.g. birth control. Since Malthus, world population has increased sixfold, yet living standards are higher than ever. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

28 The Dismal Science over in Rich? Policies... the dismal science Thomas Carlyle Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

29 The Kremerian Model (1993) over in Rich? Policies While Malthus saw population growth as a threat to rising living standards, economist Michael Kremer (1964 ) has suggested that world population growth is a key driver of advancing economic prosperity. If there are more people, Kremer argues, then there are more scientists, inventors, and engineers to contribute to innovation and technological progress. Evidence, from very long historical periods: 1. As world population growth rate increased, so did rate of growth in living standards 2. Historically, regions with larger populations have enjoyed faster growth Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

30 The Failure of the Soviet Union over in Rich? Policies Under Communism, the Soviet Union was a centrally planned economy, where the government owned nearly every business and made all production and pricing decisions. The Soviets concentrated on improving their capital stock, and in the 1950s, their output per hour improved faster than in. But Soviet managers had little incentive to develop new ways of doing things, and they did not have to worry about competition. This retarded technological change and resulted in slowing growth rates for output in the Soviet Union. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

31 New Theory over in Rich? Policies The model of economic growth we have developed was essentially developed by Nobel Laureate Robert Solow in the 1950s. Solow did not seek to explain technological change, instead treating it as the result of chance scientific discoveries. Paul Romer developed the new growth theory, a model of long-run economic growth that emphasizes that technological change is influenced by economic incentives and so is determined by the working of the market system. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

32 New Theory and Knowledge Capital over in Rich? Policies Romer argues that the accumulation of knowledge capital is a key determinant of economic growth. Increases in knowledge capital result from research and development, and other technological advances. Physical capital is rival and excludable a private good and this results in its diminishing returns. But knowledge capital is nonrival and nonexcludable a public good and hence results in increasing returns not at the firm level, but at the economy level. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

33 Government s Role in Knowledge Capital Generation over in Rich? Policies Public goods, such as knowledge capital generation, result in free-riding: benefiting from goods and services you do not pay for. Example: Bell Labs development of transistor technology resulted in immense profits for other firms. Because firms do not enjoy the entire benefit of their knowledge capital, they do not produce enough of it. The public good nature of knowledge capital leads to a role for government policy in: Protecting intellectual property with patents and copyrights Subsidizing research and development Subsidizing research and development Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

34 Protecting Intellectual Property over in Rich? Policies Governments seek to protect intellectual property through the use of patents and copyrights. Allowing firms to benefit from their own research and development increases their incentive to perform it. Patents are the exclusive right to produce a product for a period of 20 years from the date the patent is applied for. This period of time is designed to balance the chance for firm to benefit from its invention against the need of society to benefit from it. Copyrights act similarly for creative works like books and films, granting the exclusive right to use the creation during and 70 years after the creator s lifetime. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

35 Subsidizing R&D and Education over in Rich? Policies Subsidizing research and development Governments might perform research directly like NASA and the National Institutes of Health or subsidize researchers at institutions like universities. Similarly, they can provide tax-incentives to firms performing R&D. Subsidizing education In order to perform research and development, workers need to be technically trained. If firms provide this training, they recoup the cost by paying workers lower wages, decreasing the incentive for workers to take such jobs. A solution to this is to have the government subsidize education, as it does in all high-income countries. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

36 Joseph Schumpeter and Creative Destruction over in Rich? Policies Joseph Schumpeter was born in Austria in 1883, and grew up there before moving to. Schumpeter developed a model of growth emphasizing his view that new products unleashed a gale of creative destruction. Example: The automobile replaced the horse-drawn carriage by serving better the needs of consumers. This creation destroyed carriage-makers and associated firms. To Schumpeter, the entrepreneur is central to economic growth; and the profits of entrepreneurs provide the incentive for bringing together the factors of production labor, capital, and natural resources in new ways. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

37 in over in Rich? Policies rates in were relatively modest prior to In the 20th century, firms and the U.S. government invested heavily in research and development, resulting in increasing growth rates. rates remained high until the mid-1970s, when they fell unexpectedly, before picking up again in the mid-1990s. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

38 What Caused the Productivity Slowdown of ? over in Rich? Policies Some economists argue that there was not really a slowdown in economic growth the appearance is a result of how we measure growth. From the 1970s, most growth in output came in the form of services rather than goods. Improvements in services come mostly through quality differences, which are harder to measure for services than for goods. An alternative argument is that America concentrated more on quality-of-life issues, like health and safety, environmental regulations, and a change in educational focus. Other high-income countries experienced similarly timed slowdowns, suggesting that was not doing something uniquely counterproductive over this time. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

39 Is the U.S. Headed for Another Productivity Slowdown? over in Rich? Policies New technology has driven improvements in labor productivity from Examples: faster data processing (computers etc.); better communication (cell phones, the internet) Some economists argue that changes in quality of services have been particularly important over the last decade and a half. So GDP growth has understated the actual growth of the economy. But it may be that many of these gains are going toward improving consumer products rather than improving labor productivity. This casts doubt on the future of economic growth in the U.S. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

40 How Can We Predict Nations Rates? over in Rich? Policies The economic growth model predicts that poor countries will grow faster than rich countries. This is because: The effect of additional capital is greater for countries with smaller capital stocks There are greater advances in technology immediately available to poorer countries This leads to a prediction of catch-up: that the level of GDP per capita (or income per capita) in poor countries will grow faster than in rich countries. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

41 Catch-Up among High Income Countries over in Rich? Policies Examining high-income countries, we see strong evidence of the catch-up hypothesis. Countries that were richer in 1960, like the U.S. and Switzerland, experienced lower growth rates over the next decades than countries that were initially poorer, like Ireland, Singapore, and South Korea. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

42 Catch-Up among All Countries? over in Rich? Policies However if we extend the set of countries to all countries for which statistics are available, our catch-up model appears to be worthless. We need to address the failures of the catch-up model. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

43 Other High-Income Countries vs. the U.S. over in Rich? Policies The blue bars show real GDP per capita in 1990 relative to. The red bars show real GDP per capita in 2012 relative to. In each case, the red bar is lower; these countries are not catching up to the United States. Why? Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

44 Why Are High-Income Countries Not Catching the U.S.? over in Rich? Policies A combination of reasons explain this: U.S. labor markets are relatively flexible; hiring and firing workers is relatively unrestricted by government regulation. Similarly, American workers tend to enter the work force sooner and retire later than do workers in Europe. The U.S. financial system is relatively efficient, and the high volume of trading ensures high liquidity, making the U.S. an attractive place to invest. Small firms find obtaining capital relatively easy in the U.S. due to the advent of venture capital firms. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

45 The Lack of in Many Low-Income Countries over in Rich? Policies Economists point to four key factors in explaining why many low-income countries are growing so slowly: Failure to enforce the rule of law Wars and revolutions Poor public education and health Low rates of saving and investment We will address each of these over the following slides. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

46 Failure to Enforce the Rule of Law over in Rich? Policies The rule of law refers to the ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts. For entrepreneurs in a market economy to succeed, the government must guarantee property rights: the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. Otherwise, entrepreneurs will not risk starting a business. Also important is an independent court system to enforce contracts. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

47 NYC Parking Tickets and International Corruption over in Rich? Policies Every country sends delegates to the United Nations in New York City. Under international law, these delegates are immune from prosecution under U.S. law. This provides a test of a culture of corruption : when you are immune from the law, what do you do? Two economists examined the numbers of parking tickets per delegate from the least and most corrupt countries. They found the most corrupt countries had delegates that ignored U.S. parking laws the most, suggesting a culture of ignoring the rule of law. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

48 Other Reasons for Lack of in Poor Countries over in Rich? Policies Wars and revolutions Wars and revolutions make investment and technological growth difficult. Example: Mozambique had almost two decades of civil war in the 1970s and 1980s, with declining real GDP per capita. When the civil wars ended, it experienced growth: 3.7% per year, from 1990 to Poor public education and health With weak public schools and poor health care, workers are less productive. Low rates of saving and investment Undeveloped and insecure financial systems create a vicious cycle of low savings and investment, preventing growth. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

49 Pro- Policies over in Rich? Policies What sort of actions can governments take to encourage growth? Enhancing property rights and the rule of law Working toward independent courts and eliminating corruption is important for encouraging growth. Although the U.S. is relatively free from corruption today, in the 1800s this was not the case. Reform efforts were important in setting the stage for growth. Improving health and education Health care and education have increasing returns for a country, with their benefits spilling over to other members of the country. Improvements in these can help prevent brain drain, where highly educated and successful people leave developing countries to go to high-income countries. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

50 More Pro- Policies over in Rich? Policies What sort of actions can governments take to encourage growth? Policies that promote technological change Technological change is essential for growth as we have seen, often more important than acquiring capital. Low-income countries can encourage technological change by encouraging foreign direct investment. Policies that promote savings and investment Eliminating corruption is important here, so that people know their assets won t be seized. Once this is done, governments can encourage savings and investment through tax incentives, like tax-deferred savings plans, or investment tax credits. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

51 Will China s Standard of Living Exceed the U.S.? over in Rich? Policies If Chinese and American growth rates continue, China s standard of living would exceed that of the U.S. in Will this really happen? Several factors suggest that it will not: Much of Chinese growth is due to capital investment, which will have diminishing returns. Some of Chinese growth is due to transition to market economy. Aging Chinese population due to population control policies. China remains largely autocratic, with lingering concerns about security of property rights and independent rule of law. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

52 Is Good or Bad? over in Rich? Policies A central assumption made thus far is that economic growth is beneficial for citizens. This seems relatively clear for low-income countries; but some people maintain that further economic growth may not be desirable in high-income countries. Arguments against growth might include: Negative effects on the environment Depletion of natural resources Diminishment of distinctive cultures Since many of these arguments are normative, economic analysis can contribute to the debate but cannot settle the issue. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

53 Common Misconceptions to Avoid over in Rich? Policies High growth rates tend to increase standards of living, but a country can have high growth rates and still be very poor. Long-term, sustained economic growth seems to be the key to improvements in standard of living; not short-term growth. There is no single explanation for growth rates; nor is there a single economic variable that can explain growth. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

54 The Definition function: The relationship between the level of output of a good and the factors of production that are inputs to production. Stock of capital (K ): The total of all machines, equipment, and buildings in an entire economy. Labor (L): 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 = AF(K,L) With capital fixed, output increases with labor input, but at a decreasing rate. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

55 Labor Market Equilibrium: Wages and The Demand and of Labor Together, the demand and supply curves determine the level of employment in the economy and the level of real wages. This is the labor market equilibrium: The quantity demanded for labor equals the quantity supplied. Definition Real wage: The wage rate paid to employees adjusted for changes in the price level. Labor demand curve: A graph that illustrates the amount of labor that firms want to employ at each given wage rate. Labor supply curve: A graph that illustrates the amount of labor that households want to supply at each given wage rate. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

56 The Classical View of the Labor Market Classical economists assumed that the wage rate adjusts to equate the quantity demanded with the quantity supplied, thereby implying that unemployment does not exist. Definition Classical models: models that assume wages and prices adjust freely to changes in demand and supply. Full-employment output: The level of output that results when the labor market is in equilibrium and the economy is producing at full-employment. At equilibrium, the people who are not working have chosen not to work at that market wage. There is always full-employment in this sense. Classical economists believe that the labor market always clears. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

57 The Unemployment Rate and the Classical View Some economists argue that the unemployment rate is not a good measure of whether the labor market is working well. The economy is dynamic and at any given time some industries are expanding and some are contracting. A positive unemployment rate as measured by the government does not necessarily indicate that the labor market is working poorly. The measured unemployment rate may sometimes seem high even though the labor market is working well. Economists who view unemployment this way do not see it as a major problem. There are other views of unemployment, as we will now see. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

58 Explaining the Existence of Unemployment and Social (Implicit) Contracts Definition Sticky wages: The downward rigidity of wages as an explanation for the existence of unemployment. Social (implicit) contracts: Unspoken agreements between workers and firms that firms will not cut wages. Relative-wage explanation of unemployment: An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts. Explicit contracts: Employment contracts that stipulate workers wages, usually for a period of 1 to 3 years. Cost-of-living adjustments (COLAs): Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

59 The Classical Labor Market and the Curve The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. In the absence of sticky wages, the AS curve will be vertical. In this case, monetary and fiscal policy will have no effect on real output. Indeed, in this view, there is no unemployment problem to be solved! Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

60 Efficiency Wage Theory Definition Efficiency wage theory: An explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate. Empirical studies of labor markets have identified several potential benefits that firms receive from paying workers more than the market-clearing wage. Among them are lower turnover, improved morale, and reduced shirking of work. Even though the efficiency wage theory predicts some unemployment, the behavior it is describing is unlikely to account for much of the observed large cyclical fluctuations in unemployment over time. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

61 Application: Congress Extends Unemployment Insurance The standard unemployment benefits are managed by states and typically last for 26 weeks. In the recent recession the federal government has provided extended benefits to the unemployed, offering as much as an additional 47 weeks. Part of the debate surrounding the so-called fiscal cliff in Congress involved whether these benefits should be continued. In 2012 the average duration of unemployment was 39.4 weeks. Following the recession, the average duration peaked at 20.0 weeks in 1983, and following the recession, it peaked at 18.8 weeks in Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

62 Imperfect Information Firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information. If firms have imperfect or incomplete information, they may simply set wages wrong wages that do not clear the labor market. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

63 The Longer You are Unemployed, the Harder it is to Get a Job The authors of a recent paper conducted an interesting experiment to try to figure out what long-term unemployment does to one s eventual job prospects. They sent out fictitious job resumes to real job postings in 100 U.S. cities. Over 12,000 resumes were sent in response to 3,000 job postings. Fictitious job applicants were randomly assigned unemployment durations of 1 to 36 months. The researchers then tracked call backs to these resumes. The result? Call backs decreased dramatically as a response to unemployment duration. This effect was especially strong in cities that had strong job markets. The researchers suggested that employers were likely inferring low worker quality based on long duration of unemployment. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

64 Minimum Wage Laws Definition Minimum wage laws: Laws that set a floor for wage rates that is, a minimum hourly rate for any kind of labor. Currently, the federal minimum wage was $7.25 per hour. If some teenagers can produce only $6.90 worth of output per hour, no firm would be willing to hire them. In the 2014 State of the Union address, President Obama called on Congress to raise the national minimum wage from $7.25 to $10.10 an hour. LINK More on minimum wage: City Council raises Chicago minimum wage to $13 by 2019 San Francisco became the second U.S. city to raise its minimum wage to $15 an hour after Seattle. The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment. Which argument or arguments will win out in the end is an open question. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

65 Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

66 Do European Soccer Stars Change Clubs to Reduce Their Taxes? 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. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

67 and Time Frame Macroeconomic Equilibrium in the Long-Run and the Short-Run supply refers to the quantity of goods and services that firms are willing and able to supply. The relationship between this quantity and the price level is different in the long- and short-run. So we will develop both a short-run and long-run aggregate supply curve. Definition Long-run aggregate supply curve: A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

68 Long-Run Curve Macroeconomic Equilibrium in the Long-Run and the Short-Run In the long run, the level of real GDP is determined by the number of workers, the level of technology, and the capital stock (factories, machinery, etc.). None of these elements are affected by the price level. So the long-run aggregate supply curve does not depend on the price level; it is a vertical line, at the level of potential or full-employment GDP. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

69 Macroeconomic Equilibrium in the Long-Run and the Short-Run Short-Run Curve While the LRAS is vertical, the SRAS is upward sloping. Why? As prices of final goods and services rise, prices of inputs such as the wages of workers or the price of natural resources rise more slowly. A secondary reason is that some firms are slow to adjust their prices when the price level rises or falls. Economists tend to believe that some firms and workers fail to accurately predict changes in the price level. Based on this, there are three potential explanations for why the SRAS curve is upward-sloping: 1. Contracts make some wages and prices sticky 2. Firms are often slow to adjust wages 3. Menu costs make some prices sticky Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

70 Macroeconomic Equilibrium in the Long-Run and the Short-Run Why is the SRAS Curve Upward Sloping? 1. Contracts make some wages and prices sticky Prices and wages are said to be sticky when they do not respond quickly to changes in demand or supply. Some firms and workers fail to predict price level changes, and hence do not correctly build them into long-term contracts. 2. Firms are often slow to adjust wages Annual salary reviews are normal, for example. Also, firms dislike cutting wages it s bad for morale. 3. Menu costs make some prices sticky Altering prices is sometimes costly in itself. Firms have menu costs when it costs them money to change prices, for example by having to print new catalogs. A small optimal change in price may not be worth the hassle for a firm to perform. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

71 How Sticky Are Wages? Macroeconomic Equilibrium in the Long-Run and the Short-Run There is disagreement among economists about how sticky wages and prices actually are. To examine this, it is best to look at individual worker-level data. Some recent studies have done this, finding firms are reluctant to cut workers (nominal) wages. Instead, they: Offer lower salaries to new hires Fire current workers Decreases raises or freeze pay The graph shows the percentage of workers with no wage change in a given year. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

72 Shifts of the SRAS Curve vs. Movements along It Macroeconomic Equilibrium in the Long-Run and the Short-Run The short-run aggregate supply curve describes the relationship between the price level and the quantity of goods and services firms are willing to supply, holding constant all other variables that affect the willingness of firms to supply goods and services. A change in the price level not caused by factors that would otherwise affect short-run aggregate supply results in a movement along a stationary SRAS curve. But some factors cause the SRAS curve to shift; we will consider them in turn. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

73 Macroeconomic Equilibrium in the Long-Run and the Short-Run SRAS Shifts: Factors of and Technology An increase in the availability of the factors of production, like labor, allows more production at any price level. A decrease in the availability of factors such as labor decreases SRAS. Improvements in technology allow productivity to improve, and hence the level of production at any given price level. P AS 0 Y Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

74 Macroeconomic Equilibrium in the Long-Run and the Short-Run SRAS Shifts: Expected Future Prices If workers and firms believe the price level will rise by a certain amount, they will try to adjust their wages and prices accordingly. Widely-held expectations of future price-level increases are self-fulfilling. P AS 0 Y Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

75 Macroeconomic Equilibrium in the Long-Run and the Short-Run SRAS Shifts: Adjustments to Errors in Past Expectations Workers and firms sometimes make incorrect predictions about the price level. As time passes, they will attempt to compensate for these errors. Suppose everyone failed to predict an increase in the price level. Prices rise, therefore so does output. Then once firms and workers notice the rising prices, they update their expectations and increase their price demands, decreasing short-run aggregate supply. P AS 0 Y Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

76 Macroeconomic Equilibrium in the Long-Run and the Short-Run SRAS Shifts: Unexpected Changes in Prices of Resources A supply shock is an unexpected event that causes the short-run aggregate supply curve to shift. Example: Oil prices increase suddenly. Firms immediately anticipate rising input prices, and as a consequence will only produce the same amount of output if their own prices rise. Unexpected input price increases decrease SRAS; unexpected input price decreases would shift SRAS to the right instead. P AS 0 Y Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

77 Long-Run Macroeconomic Equilibrium Macroeconomic Equilibrium in the Long-Run and the Short-Run In the long run, we expect the economy to produce at the level of potential GDP; i.e., the LRAS level. So the long-run macroeconomic equilibrium occurs when the AD and SRAS curves intersect at the LRAS level. Our next task is to explain why long-run macroeconomic equilibrium cannot occur at any other level of output. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

78 Macroeconomic Equilibrium in the Long-Run and the Short-Run Long-Run Macroeconomic Equilibrium Suppose that interest rates rise. AD moves left because: Firms and households reduce their planned investments, decreasing aggregate demand. Workers lose their jobs, and firms experience decreases in sales. Workers become willing to accept lower wages, and firms expect lower prices for their output. So the SRAS curve moves to the right, with goods and services sold for lower prices, until we return to full-employment. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

79 Does It Matter What Causes AD to Fall? Macroeconomic Equilibrium in the Long-Run and the Short-Run GDP has four components; an decrease in any of the four could cause a recession. Does it make any difference which component causes the recession? Most post-wwii recessions in the U.S. have been preceded by falls in residential construction. Recent research suggests that recessions caused by financial crises tend to be larger and more long-lasting than declines due to other factors. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

80 Expansion Macroeconomic Equilibrium in the Long-Run and the Short-Run Suppose that firms become more optimistic about the future. They increase their investment, shifting AD to the right. Unemployment falls below its natural rate, forcing employers to pay more; the increased demand for goods raises prices. Firms and workers raise their expectations about the price level, shifting SRAS to the left restoring long-run equilibrium. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

81 Macroeconomic Equilibrium in the Long-Run and the Short-Run Shock In the previous analyses, AD moved suddenly. What if instead SRAS moved suddenly? We call this a supply shock. For example, suppose a sudden increase in oil prices shifts SRAS to the left. This causes stagflation, a combination of inflation and recession, usually resulting from a supply shock. With the lower level of output, people are unemployed and products go unsold. Workers accept a lower wage, and firms decrease prices in order to clear inventories. With the decrease in expectations about prices, SRAS moves to the right, restoring long-run equilibrium. How long does it take to restore full employment? It depends on the severity of the supply shock, but it is likely to take several years. An alternative to waiting this long is to use fiscal or monetary policy to increase aggregate demand. This will result in permanently higher prices but may be worth the cost. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

82 Forecasts for Returning to Potential GDP Macroeconomic Equilibrium in the Long-Run and the Short-Run After the recession, different groups estimated how long itwould take to return to potential GDP. In 2011, the White House and the Congressional Budget Office estimated that we would return to full employment by The Federal Reserve disagreed, believing it would take even longer. For comparison, the second worst post-depression recession was in ; recovery then took less than three years. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85

83 Forecasts for Returning to Potential GDP Macroeconomic Equilibrium in the Long-Run and the Short-Run How accurate were these forecasts? It turns out, they were too optimistic. Economists still disagree about why the U.S. economy was taking so long to return to potential GDP; we will discuss this in later chapters. Dennis C. Plott (Notre Dame) The Side: Labor,, and Long-Run ECON 10020/20020 Spring / 85