Chapter 5: BUSINESS CYCLES, LABOR SUPPLY, AND FIRMS

A. Facts about the business cycle

- GDP growth averages 3–3.5% per year over the long run, with large fluctuations in the short run.
- Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more
volatile than GDP.
- Unemployment rises during recessions and falls during expansions.
- Okun’s law: the negative relationship between GDP and unemployment
Growth rates of real GDP, consumption Unemployment

Growth rates of real GDP, consumption, investment

Okun’s law

1. Index of leading economic indicators

- Published monthly by the Conference Board.
- Aims to forecast changes in economic activity 6–9 months into the future.
- Used in planning by businesses and government, despite not being a perfect predictor.
2. Components of the LEI index
- Average workweek in manufacturing
- Initial weekly claims for unemployment insurance
- New orders for consumer goods and materials
- New orders, nondefense capital goods
- ISM new orders index
- New building permits issued
- Index of stock prices
- Lending credit index
- Yield spread (10-year minus 3-month) on Treasuries
- Index of consumer expectations
Index of leading economic indicators, 1970–2012

B. Time horizons in macroeconomics

- Long run: Prices are flexible, responding to changes in supply or demand.
- Short run: Many prices are “sticky” at a predetermined level.
The economy behaves much differently when prices are sticky.
1. Recap of classical macro theory
- Output is determined by the supply side:
o supplies of capital, labor
o technology
- Changes in demand for goods and services (C, I, G) only affect prices, not quantities.
- Assumes complete price flexibility.
- Applies to the long run.
2. When prices are sticky
. . . output and employment also depend on demand, which is affected by:
- fiscal policy (G and T)
- monetary policy (M)
- other factors, like exogenous changes in C or I
C. The Aggregate-Supply Curve in SR
1. Aggregate supply curve slopes upward in the short-run:
- Price level affects the economy’s output
- Increase in overall level of prices in economy
 Tends to raise the quantity of goods and services supplied
- Decrease in level of prices
 Tends to reduce quantity of goods and services supplied
Figure: The Short-Run Aggregate-Supply Curve
In the short run, a fall in the price level from P1 to P2 reduces the
quantity of output supplied from Y1 to Y2. This positive
relationship could be due to sticky wages, sticky prices, or
misperceptions. Over time, wages, prices, and perceptions adjust,
so this positive relationship is only temporary.

2. The short-run AS curve might shift:

- Changes in labor, capital, natural resources, or technological knowledge
- Expected price level increases: Aggregate-supply curve: shifts left
D. Factors of Production
Factors of production
- Inputs used to produce goods and services
- Labor, land, capital
Demand for a factor of production
- Derived demand: From firm’s decision to supply a good in another market
1. The Demand for Labor
a. Labor market
- Governed by supply and demand
b. Labor demand
- Derived demand
- Labor services = inputs into the production of other goods
Figure: The Versatility of Supply and Demand

The basic tools of supply and demand apply to

goods and to labor services. Panel (a) shows how
the supply and demand for apples determine the
price of apples. Panel (b) shows how the supply and
demand for apple pickers determine the wage of
apple pickers.

c. Assumptions for the firm

- Firm is competitive in both markets
 For goods and for labor
 Price taker
o Pay the market wage
o Get the market price for goods
 Decide
o Quantity of goods to sell
o Quantity of labor to hire
- Firm is profit-maximizing
d. Production function
- Relationship between the quantity of inputs used to make a good
- And the quantity of output of that good
- Becomes flatter as the quantity of input increases
e. Marginal product of labor (MPL)
- Increase in the amount of output
- From an additional unit of labor
f. Diminishing marginal product
- The marginal product of an input declines
- As the quantity of the input increases
- Explains the shape of the production function
Table: How the Competitive Firm Decides How Much Labor to Hire

Figure: The Production Function

The production function shows how an input into
production (apple pickers) influences the output from
production (apples). As the quantity of the input increases,
the production function gets flatter, reflecting the property
of diminishing marginal product.

g. The value of the marginal product of labor (VMPL)

- Marginal product of labor times the price of the output
- Marginal revenue product: Additional revenue from hiring one additional unit of labor
- Diminishes as the number of workers rises
Figure: The Value of the Marginal Product of Labor
This figure shows how the value of the marginal product (the
marginal product times the price of the output) depends on the
number of workers. The curve slopes downward because of
diminishing marginal product. For a competitive, profit-
maximizing firm, this value-of-marginal-product curve is also the
firm’s labor-demand curve.

h. Competitive, profit-maximizing firm

- Hires workers up to the point where the value of the marginal product of labor = wage
i. The value-of-marginal-product curve
- Is the labor-demand curve
j. Labor-demand curve
- Reflects the value of marginal product of labor
k. Shift in the labor-demand curve (VMPL)
- Change in the output price
  Demand for labor: VMPL = MPL × P of output
- Technological change
 Technological advance can raise MPL: increase demand for labor
 Labor-saving technology can reduce MPL: decrease demand for labor
- Supply of other factors : Affect marginal product of other factor
2. The Supply of Labor
- People face trade-offs
- Trade-off – Work versus leisure
- Labor-supply curve
 Reflects how workers’ decisions about the labor-leisure trade-off
 Respond to a change in opportunity cost of leisure
- Shift in the labor-supply curve
 Changes in tastes: Change in attitude toward work
 Changes in alternative opportunities: Opportunities available in other labor markets
 Immigration: Movement of workers from region to region or countryto country
3. Equilibrium in the Labor Market
- Wages in competitive labor markets
 Adjusts to balance the supply & demand for labor
 Equals the value of the marginal product of labor (VMPL)
- Changes in supply or demand for labor
 Change the equilibrium wage
 Change the value of the marginal product by the same amount
Figure: Equilibrium in a Labor Market

Like all prices, the price of labor (the wage) depends on

supply and demand. Because the demand curve reflects
the value of the marginal product of labor, in equilibrium
workers receive the value of their marginal contribution to
the production of goods and services.

- Increase in supply
 Decrease in wage
o Lower marginal product of labor
o Lower value of marginal product of labor
 Higher employment
 Figure: A Shift in Labor Supply
When labor supply increases from S1 to S2, perhaps
because of an immigration of new workers, the
equilibrium wage falls from W1 to W2. At this lower
wage, firms hire more labor, so employment rises from
L1 to L2. The change in the wage reflects a change in the
value of the marginal product of labor: With more
workers, the added output from an extra worker is
smaller.

- Economics of immigration
 Variety of labor markets for different kinds of workers
 A wave of immigration (physicians)
o Lower wages in those labor markets in which the new immigrants seek work (lower wages for
physicians)
o Higher wages in other labor markets (physicians buy more apples; derived labor demand;
higher wages for apple pickers)
- Increase in demand
 Higher wage
o No change in marginal product of labor
o Higher value of marginal product of labor
 Higher employment
Figure: A Shift in Labor Demand
When labor demand increases from D1 to D2, perhaps
because of an increase in the price of the firm’s output,
the equilibrium wage rises from W1 to W2, and
employment rises from L1 to L2. The change in the
wage reflects a change in the value of the marginal
product of labor: With a higher output price, the added
output from an extra worker is more valuable.

4. Productivity and wages

- Standard of living: Depends on our ability to produce goods and services
- Wages = productivity
 As measured by the value of the marginal product of labor
 Highly productive workers are highly paid
 Less productive workers are less highly paid
- Workers today: Are better off than workers in previous generations
- Productivity and real wages growth – 1960 to 2015
 Productivity (output per hour of work) grew about 2.0% per year
 Real wages (wages adjusted for inflation) grew at 1.8% per year
 Productivity and real wages double every 35 years
- Productivity and real wages growth
  1973 – 1995: significant slowdown in productivity growth (from 2.7 to 1.4%)
o Slowdown in real wage growth: from 2.7 to 1.2%
 1995 – 2015: productivity growth = 2.1% per year
o Real wages grew by 1.8% per year
Table: Productivity and Wage Growth in the United States

5. Land and Capital

- Capital: Equipment and structures used to produce goods and services
- Equilibrium
 Purchase price: Price a person pays to own that factor of production indefinitely
 Rental price: Price a person pays to use that factor for a limited period of time
6. Equilibrium: Land and Capital,
- Wage: Rental price of labor
- Rental price of land and capital
 Determined by supply and demand
 Demand is a derived demand: Reflects marginal productivity of the factor
- Each factor’s rental price: Value of marginal product for the factor
Figure: The Markets for Land and Capital

7. Equilibrium: Land and Capital

- Equilibrium purchase price depends on
 Current value of the marginal product
 Value of the marginal product expected to prevail in the future
8. Land and Capital.
- Linkages among the factors of production – Price paid to any factor of production = Value of the marginal
product of that factor – Marginal product of any factor depends on • Quantity of that factor that is available
- Diminishing marginal product
 Factor in abundant supply
 o Low marginal product
o Low price
- Diminishing marginal product
 Factor in scarce supply
o High marginal product
o High price
- Change in supply of a factor
 Change in equilibrium factor price
 Change in earnings of the other factors
9. The economics of the Black Death
- 14th century Europe, Black Death (bubonic plague)
 Wiped out about one-third of the population within a few years
 Grisly natural experiment to test the theory of factor markets
- Effects of the Black Death on survivors
 Reduced population: Smaller supply of workers
 Marginal product of labor rises: Higher wages
o Wages doubled
o Economic prosperity for peasant classes
 Marginal product of land fell: Lower rents
o Rents declined 50% or more
o Reduced income for the landed classes