labor markets determining output and employment. labor market statistics the labor market is a very...

Labor Markets

Determining Output and Employment

Labor Market Statistics

• The labor market is a very dynamic market. This makes it difficult to characterize.


• The labor market is a very dynamic market. This makes it difficult to characterize.

• Recall, Each month, the Department of Labor surveys 60,000 households. Each household is placed in one of four categories

A. Under 16 or institutionalized (or military)

B. Choose not to work: Not in Labor Force

C. Choose to work and are working: Employed

D. Choose to work, but can’t find a job: Unemployed

• Each month, people move between these four categories.

US Labor Market Facts

• US Population: 290M

• Civilian Population (16+): 220M

• Civilian Labor Force: 147M

• Civilian Employment: 139M

• Unemployment: 147M – 139M = 8M


• US Population: 290M• Civilian Population

(16+): 220M• Civilian Labor Force:

147M• Civilian Employment:

138M• Unemployment: 147M

– 138M = 9M

Participation Rate (147M/220M)*100 = 66%






– 139M = 8M


Employment Ratio

(138M/220M)*100 = 62%






– 139M = 8M


Employment Ratio

(138M/220M)*100 = 62%

Unemployment Rate

(8M/147M)*100 = 5.4%






– 138M = 9M


Employment Ratio

(138M/220M)*100 = 62%

Unemployment Rate

(8M/147M)*100 = 5.4%

ER = (1-UR)*PR


• Most unemployment spells in the US are short.

Unemployed: 9M

<5 WKS: 3m

5-15WKS: 3.5m

>15 wks: 2.5m



Unemployed: 9M

<5 WKS: 3m

5-15WKS: 3.5m

>15 wks: 2.5m

Average Duration

In 1 year, how many people are unemployed for 5 wks?



Unemployed: 9M

<5 WKS: 3m

5-15WKS: 3.5m

>15 wks: 2.5m

Average Duration


(52/5)*3M = 31.2M



Unemployed: 9M

<5 WKS: 3m

5-15WKS: 3.5m

>15 wks: 2.5m

Average Duration


(52/5)*3M = 31.2M

For 10 wks?

(52/10)*3.5M = 18.2M



Unemployed: 9M

<5 WKS: 3m

5-15WKS: 3.5m

>15 wks: 2.5m

Average DurationIn 1 year, how many people are unemployed for 5 wks?

(52/5)*3M = 31.2M

For 10 wks?

(52/10)*3.5M = 18.2M

For 20 wks?

(52/20)*2.5M = 6.6M



Unemployed: 9M

<5 WKS: 3m

5-15WKS: 3.5m

>15 wks: 2.5m

Average DurationIn 1 year, how many people are unemployed for 5 wks?(52/5)*3M = 31.2MHow many people are unemployed for 10 wks?(52/10)*3.5M = 18.2MFor 20 wks?(52/20)*3.5M = 6.6M

AD = (31.2/56)*(5wks) + (18.2/56)*(10wks) + (6.5/56)*(20wks) = 8.45wks



Unemployed: 9M

<5 WKS: 3m

5-15WKS: 3.5m

>15 wks: 2.5m

• Average duration in the US is approx. 13wks

Average DurationIn 1 year, how many people are unemployed for 5 wks?(52/5)*3M = 31.2MHow many people are unemployed for 10 wks?(52/10)*3.5M = 18.2MFor 20 wks?(52/20)*3.5M = 6.6M

AD = (31.2/56)*(5wks) + (18.2/56)*(10wks) + (6.6/56)*(20wks) = 8.45wks

What’s “Normal” in the Labor Market?


Frictional Unemployment: Currently unemployed, but in the process of getting a job (i.e., short term unemployment): Approx. 3.5%



+ Structural Unemployment (chronic unemployment): 1.5%




“Natural Rate of Unemployment”: 5%




“Natural Rate of Unemployment”: 5%

• Given the current unemployment rate of 5.4%, we currently have a cyclical unemployment rate of .4%

US Unemployment Rate: 1990-2002

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Is the “Natural Rate” Growing?

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The cost of unemployment

• “Capacity Output” of an economy is the level of output associated with full employment (i.e., unemployment is at the natural rate)



• The “output gap” is the difference between capacity output and actual output




• Okun’s law states that every 1% increase in cyclical unemployment increases the output gap by 2.5%.




• Okun’s law states that every 1% increase in cyclical unemployment increases the output gap by 2.5%.

• Therefore, our current .4% cyclical unemployment rate implies an output gap of 1.2% GPD ( Roughly $100B! )

Firms and Labor Demand

• In our labor market model. Firm’s are assumed to be perfectly competitive


• In our labor market model. Firm’s are assumed to be perfectly competitive (they take wages and prices as given)



• Firms produce output using three types of input: labor, capital, and technology




• Employment decisions are made in the short run




• Employment decisions are made in the short run (capital stock is fixed)




• Employment decisions are made in the short run (capital stock is fixed)

• Firms choose labor to maximize profits.

Properties of Production

• Production is increasing in all inputs (i.e., the more inputs you have, the more output you can produce)

• Production exhibits constant returns to scale (doubling all inputs exactly doubles output)

The Production Function (All other inputs are fixed)

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Labor Hours




• Production exhibits diminishing marginal product (increasing only one input will not proportionately increase output)

Diminishing Marginal Product of Labor

• The Marginal Product of Labor is the additional output produced from each additional hour of labor

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Labor Hours



• MPL(100) = (190-100)/100 = .9

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• MPL(100) = (190-100)/100 = .9

• MPL(700) = (520-490)/100 = .3

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• Production exhibits diminishing marginal product (increasing only one input will not proportionately increase output)

• Capital and Labor are complements (increasing capital makes labor more productive and visa versa)

The Production Function (Increasing Capital Stock)

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Labor Hours

Diminishing Marginal Product of Labor (increasing capital)

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Profit Maximization and Labor Demand

• Recall that firms take wages and prices as given, and choose employment to maximize profits.



• Profit maximization requires that Marginal Benefit = Marginal cost




• The marginal cost of an additional hour of labor is the hourly wage rate (w)





• The marginal benefit of an hour of labor is the value of the output produced ( p*MPL )





• The marginal benefit of an hour of labor is the value of the output produced ( p*MPL )

• Therefore, profit maximization implies that firms hire labor according to the rule: (w/p) = MPL

Productivity and Labor Demand

• Firms hire labor according to w/p=MPL

Labor Demand

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• Due to diminishing marginal returns, labor demand is downward sloping

Labor Demand

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• Due to diminishing marginal returns, labor demand is downward sloping

• Note that an increase in capital increases MPL and, hence, increases labor demand

Labor Demand

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Households and Labor Supply

• Households in the economy are assumed to be homogeneous (identical). They take wages, prices, and income as given and choose the number of hours to work in order to maximize welfare.



• This labor decision problem can be written as a standard consumer choice problem:



• This labor decision problem can be written as a standard consumer choice problem:

• Two Goods: ( consumption, leisure)

• A relative price (w/p )

• A fixed income (equal to you’re maximum possible earnings)

An example

• You have 80 hours available to work per week

• The price level is $2

• The wage rate is $10/hr

An example


• The price level is $2

• The wage rate is $10/hr

• Given an income of $800, a price of consumption of $2 and a price of leisure equal to $10, we can plot all affordable combinations of these two goods. 0

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An example


• The price level is $2• The wage rate is $10/hr

• Given an income of $800, a price of consumption of $2 and a price of leisure equal to $10, we can plot all affordable combinations of these two goods.

• Note that the slope is equal to 5 (the relative price of leisure)

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An example

• Lets assume that given a wage of $10, you choose to consume 40hrs/wk of leisure (i.e., work 40 hrs/wk). What would happen to your decision if the wage rose to $12/hr?

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An example

• Lets assume that given a wage of $10, you choose to consume 40hrs/wk of leisure (i.e., work 40 hrs/wk). What would happen to your decision if the wage rose to $12/hr?

• Given your new set of choices, do you adjust your choice to work more or less than your original 40hrs/wk?

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Income/Substitution Effects

• Any relative price change has two distinct effects on an individual’s decision.



• Substitution Effect: when a relative price changes, consumers tend to purchase more of the good that has become cheaper.



• Substitution Effect: when a relative price changes, consumers tend to purchase more of the good that has become cheaper.

• Income effect: A price change impacts a consumer’s overall purchasing power. This causes the consumer to typically scale up/down consumption of all goods.

An example

• In this example, leisure has become more expensive. Therefore, the substitution effect would dictate that you consume less leisure (i.e., work more)

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An example

• In this example, leisure has become more expensive. Therefore, the substitution effect would dictate that you consume less leisure (i.e., work more)

• However, A higher wage raises your income and, hence, should increase your consumption of both consumption and leisure (i.e., work less)

• We generally assume that the substitution effect dominates

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Labor supply

• Assuming that the substitution effect dominates (households respond to higher wages by working more), labor supply will be upward sloping

• Its possible that at high real wages, the income effect begins to dominate (backward bending labor supply)

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Another example

• Again, assume that given a wage of $10, you choose to consume 40hrs/wk of leisure. How would your decision change if you received a $400 gift?

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Another example


• Note that there is no substitution effect. A pure income effect will cause you to work less (consume more leisure)

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Another example



• This increase in non-wage income shifts labor supply to the left

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• This increase in non-wage income shifts labor supply to the left

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Temporary vs. Permanent Wage Rate Changes

• Recall that the labor supply curve incorporates the substitution effect and income effect of a rise in the current real wage. Therefore, circumstances that cause a temporary ride in the real wage are represented by movements along the labor supply curve.

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Temporary vs. Permanent Wage Rate Changes

• However, permanent changes in the real wage create an additional wealth effect (i.e., changes in expected future income). This extra income effect causes the labor supply curve to shift.

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Labor Market Equilibrium

• Add up individual firm’s hiring decisions to get aggregate labor demand

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• Add up individual household decisions to get aggregate labor supply

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• Add up individual household decisions to get aggregate labor supply

• A labor market equilibrium is a real wage that clears the market (i.e., supply equals demand)

• Hers, (w/p)* = 12, L*= 3000

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Example: Post-war Germany

• It is estimated that 20-25% of Germany’s capital stock was destroyed during WWII. How would the German labor market respond to this?

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• A lower capital stock decreases labor productivity and labor demand.

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• If the resulting drop in the real wage is perceived as permanent, we could also have an increase in labor supply (This only magnifies the initial effect)

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• Initially, unemployment would increase (at a real wage of 12, 100 hours are demanded, 300 are supplied) to 30%

• Eventually, the w/p drops to 8, employment falls to 200 (unemployment returns to 0%)

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Example: Post war Germany

• Does the previous analysis accurately reflect post-war Germany?



• Following the war, allied forces imposed price controls – this forces the real wage to remain at pre-war levels.




• During the price control period, unemployment in Germany was around 11%.




• During the price control period, unemployment in Germany was around 11%.

• Once price controls were lifted, real wages fell and unemployment dropped from 11% to 1%.

Example:The Bubonic Plague

• The Bubonic Plague, or “Black Death” ravaged Europe in the 1300’s. From 1347-1352, approximately 30% of the population in Europe was killed (25 million). What impact will this have on labor markets?

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• A decrease in labor supply creates a labor shortage (at the original wage of 12, 300 hours are demanded while only 100 are supplied)

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• A decrease in labor supply creates a labor shortage (at the original wage of 12, 300 hours are demanded while only 100 are supplied)

• Eventually, the real wage rises to 16.

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Example: The Bubonic Plague

• Data from this period is hard to find, but the previous analysis seems to be supported by history.



• Following the plague, massive labor shortages allowed workers to demand higher wages. (many landlords initially refused causing riots)



• Following the plague, massive labor shortages allowed workers to demand higher wages. (many landlords initially refused causing riots)

• Some argue that this dramatic shift in wealth from the relatively small group of landholders to the masses of laborers created the catalyst for the renaissance era.

Analysis of Labor Markets

Labor Demand


Labor Demand• Firms make labor decisions to

maximize profits given wages and prices – therefore, they choose labor according to the rule w/p = MPL




• Any increase (decrease) in labor productivity raises (lowers) labor demand





– Technological improvements

– Changes in Capital stock







Labor Supply







Labor Supply• Households choose make labor

decisions to maximize utility given wages and prices







Labor Supply• Households choose make labor

decisions to maximize utility given wages and prices

• Wages and prices influence a household’s potential income as well the cost of leisure therefore, we must consider both influences separately

– Income Effects

– Substitution Effects







Labor Supply• Temporary increases

(decreases) in wages create an income effect that is small relative to the substitution effect. Therefore labor supply increases (decreases) – a movement along the labor supply curve







Labor Supply• Permanent wage increases

(decreases) create an additional wealth effect that decreases (increases) labor supply – a shift in the labor supply curve

Labor Markets in the Long Run

• The US population grows at a rate of 1.5% per year

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• The growth of labor supply is less than 1.5% per year – households choose to work less (wealth effects)

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• Labor Productivity grows at a rate of 2% per year

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• Labor Productivity grows at a rate of 2% per year

• Real wages grow at around 3% per year 0

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Labor Markets in the Short Run

• In the short run, labor markets are hit with random outside events that influence productivity

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• In the short run, labor markets are hit with random outside events that influence productivity

• Shocks that perceived to be temporary shift labor demand – a temporary oil price increase lowers productivity and labor demand. This lowers employment and wages. 0

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• Shocks perceived to be more permanent create wealth effects that influence labor supply. A permanent rise in oil prices create a decline in wealth that increases labor supply

• Note that permanent shocks have a larger effect on wages, but a smaller impact on employment (in this case, employment doesn’t change)

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What's Missing?

What's Missing?

• Can households choose how many hours to work? (Intensive vs. Extensive margin)

What's Missing?


• Are all households the same?

What's Missing?



• Can we describe the US with one labor market?

What's Missing?




• Are wages/prices flexible?

What's Missing?




• Are wages/prices flexible?

• What about non-wage benefits?

labor markets determining output and employment. labor market statistics the labor market is a very...

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