7. The Aggregate Supply Curve

1
7. The Aggregate Supply Curve

• Abel, Bernanke, and Croushore
• (chapters 3 and 9.6)

2
Syllabus Outline

1. Introduction to Macroeconomics
2. The measurement and structure of the national
   economy
3. Goods market equilibrium the IS curve
4. Money market equilibrium the LM curve
5. The IS-LM model
6. Demand-side policies in the IS-LM model
   (Keynesian Macroeconomics)
7. The Aggregate Supply curve
8. Classical Macroeconomics in the AD-AS model
9. Keynesian Macroeconomics in the AD-AS model
10. The relationship between Unemployment and
    Inflation

3
Our goals in this chapter

• A) Introduce the production function as the main
  determinant of output
• 1. Discuss the marginal productivity of labor
  and capital
• 2. Analyze supply shocks
• B) Discuss the determinants of labor demand and
  supply
• C) Equilibrium in the classical model of the
  labor market
• 1. Full-employment output
• 2. Factors that change equilibrium
• D) Unemployment
• 1. Definitions of employment status
• 2. Frictional, structural, cyclical unemployment
• 3. Okuns Law
• E) Aggregate Demand and Aggregate Supply

4
How Much Does the Economy Produce? The Production
Function

• A) Factors of production
• B) The production function
• C) Application The production function of the
  U.S. economy and U.S. productivity growth
• D) The shape of the production function
• E) Supply shocks

5
How Much Does the Economy Produce? The Production
Function

• A) Factors of production
• 1. Capital
• 2. Labor
• 3. Others (raw materials, land, energy)
• 4. Productivity of factors depends on technology
  and management
• B) The production function
• Y A . F(K, N)
• Y real output produced in a given period
  of time
• A total factor productivity (TECHNOLOGY
  index, productivity in textbook)
• K capital stock, or quantity of capital
  used in the period
• N number of workers employed in the
  period
• F a function relating output Y to capital
  K and labor N

6
How Much Does the Economy Produce? The Production
Function

• C) Application The production function of the
  U.S. economy and U.S. productivity growth
• 1. Cobb-Douglas production function works well
  for U.S. economy
• Y A K 0.3 N 0.7
• 2. Data for U.S. economyTable 3.1
• 3. Technological growth calculated using
  production function (percentage increase in A)

7
Table 3.1 The Production Function of the United
States, 19802001
8
How Much Does the Economy Produce? The Production
Function
3. Technological growth calculated using
production function a. Technology index , A,
is measured indirectly by assigning to A the
value necessary to satisfy the previous
equation A Y / (K 0.3 N 0.7) b. Technology
index, A, moves sharply from year to year c.
Technology index grew slowly in the 1980s and the
first half of the 1990s, but increased in the
second half of the 1990s
9
How Much Does the Economy Produce? The Production
Function
D) The shape of the production function 1. Two
main properties of production functions a.
Slopes upward more of any input produces more
output b. Slope becomes flatter as input
rises diminishing marginal product as input
increases 2. Graph of the production function
10
Figure 3.1 The production function relating
output and capital
11
How Much Does the Economy Produce? The Production
Function
D) The shape of the production function 2.
Graph of the production function a. Marginal
product of capital MPK ?Y/?K,

• (1) Equal to slope of production function
  graph (Y vs. K)
• (2) MPK always positive
• (3) Diminishing marginal productivity of capital

12
Figure 3.2 The marginal product of capital
13
How Much Does the Economy Produce? The Production
Function
D) The shape of the production function 2.
Graph of the production function b. Marginal
product of labor MPN ?Y/?N,

• (1) Equal to slope of production function
  graph (Y vs. N)
• (2) MPN always positive
• (3) Diminishing marginal productivity of labor

14
Figure 3.3 The production function relating
output and labor
15
How Much Does the Economy Produce? The Production
Function
E) Supply shocks 1. Supply shocks affect the
amount of output that can be produced for a given
amount of inputs 2. Shocks may be positive
(increasing output) or negative (decreasing
output) 3. Examples weather, inventions and
innovations, government regulations, oil
prices 4. Supply shocks shift graph of
production function
16
How Much Does the Economy Produce? The Production
Function
E) Supply shocks 4. Supply shocks shift graph
of production function
(1) Negative (adverse) shock usually slope of
production function decreases at each level of
input (for example, if shock causes parameter A
to decline). (2) Positive shock usually slope
of production function increases at each level of
output (for example, if parameter A increases).
17
Figure 3.4 An adverse supply shock that lowers
the MPN
18
The Demand for Labor

• A) How much labor do firms want to use?
• B) The marginal product of labor and labor
  demand an example
• C) The marginal product of labor and the labor
  demand curve
• D) Factors that shift the labor demand curve
• E) Aggregate Labor Demand

19
The Demand for Labor

• A) How much labor do firms want to use?
• 1. Assumptions
• a. Hold capital stock fixedshort-run analysis
• b. Workers are all alike
• c. Labor market is competitive
• d. Firms maximize profits
• 2. Analysis at the margin costs and benefits of
  hiring one extra worker

20
The Demand for Labor

• A) How much labor do firms want to use?
• 2. Analysis at the margin costs and benefits of
  hiring one extra worker

a. If real (w) ? marginal product of labor (MPN),
the firm is paying the marginal worker more than
the worker produces, so the firm should reduce
the number of workers to increase profits. b. If
w ? MPN, the marginal worker produces more than
he or she is being paid, so the firm should
increase the number of workers to increase
profits. c. Firms profits are highest when w
MPN
21
The Demand for Labor

• B) The marginal product of labor and labor
  demand an example
• 1. Example The Clip Jointsetting the nominal
  wage equal to the marginal revenue product of
  labor (MRPN P ? MPN)
• 2. W MRPN is the same condition as w MPN,
  since W P ? w and MRPN P ? MPN
• 3. A change in the wage
• a. Begin at equilibrium where W MRPN
• b. A rise in the wage rate means W ? MRPN,
  unless N is reduced so the MRPN rises
• c. A decline in the wage rate means W ? MRPN,
  unless N rises so the MRPN falls

22
Table 3.2 The Clip Joints Production Function
23
(No Transcript)
24
The Demand for Labor
C) The marginal product of labor and the labor
demand curve 1. Labor demand curve shows
relationship between the real wage rate and the
quantity of labor demanded 2. It is the same
as the MPN curve, since w MPN at
equilibrium 3. So the labor demand curve is
downward sloping firms want to hire less labor,
the higher the real wage
25
Figure 3.5 The determination of individual
firms labor demand
26
The Demand for Labor
D) Factors that shift the individual firms labor
demand curve 1. Note A change in the wage
causes a movement along the labor demand curve,
not a shift of the curve 2. Supply shocks
Beneficial supply shock raises MPN, so shifts
labor demand curve to the right opposite for
adverse supply shock 3. Size of capital stock
Higher capital stock raises MPN, so shifts labor
demand curve to the right opposite for lower
capital stock
27
(No Transcript)
28
Table 3.3 The Clip Joints Production Function
After a Beneficial Productivity Shock
29
Figure 3.6 The effect of a beneficial supply
shock on labor demand
30
The Demand for Labor
E) Aggregate Labor Demand 1. Aggregate labor
demand is the sum of all firms labor
demand 2. Same factors (supply shocks, size of
capital stock) that shift firms labor demand
cause shifts in aggregate labor demand
31
The Supply for Labor
A) Supply of labor is determined by
individuals B) The income-leisure trade-off C)
Real wages and labor supply D) The labor supply
curve E) Factors that shift the labor supply
curve F) Aggregate labor supply G) Application
weekly hours of work and the wealth of nations
32
The Supply for Labor
A) Supply of labor is determined by
individuals 1. Aggregate supply of labor is sum
of individuals labor supply 2. Labor supply
of individuals depends on labor- leisure
choice B) The income-leisure trade-off 1.
Utility depends on consumption and leisure
2. Need to compare costs and benefits of working
another day a. Costs Loss of
leisure time b. Benefits More consumption,
since income is higher 3. If benefits of
working another day exceed costs, work
another day 4. Keep working additional days
until benefits equal costs
33
The Supply for Labor
C) Real wages and labor supply 1. An increase in
the real wage has offsetting income and
substitution effects a.
Substitution effect of a higher real wage Higher
real wage encourages work, since the
reward for working is higher b. Income effect
of a higher real wage Higher real wage
increases income for the same amount of work
time, and with higher income, the person can
afford more leisure, so will supply less
labor 2. A pure substitution effect a one-day
rise in the real wage A temporary real wage
increase has just a pure substitution effect,
since the effect on wealth is negligible
34
The Supply for Labor
C) Real wages and labor supply 3. A pure income
effect winning the lottery a. Winning the
lottery doesnt have a substitution effect,
because it doesnt affect the reward for
working b. But winning the lottery makes a
person wealthier, so a person will both
consume more goods and take more leisure this is
a pure income effect 4. The substitution
effect and the income effect together a
long-term increase in the real wage a. The
reward to working is greater a substitution
effect toward more work b. But with a
higher wage, a person doesnt need to work as
much an income effect toward less work c.
The longer the high wage is expected to last, the
stronger the income effect thus labor
supply will increase by less or decrease
by more than for a temporary reduction in the
real wage
35
The Supply for Labor

• C) Real wages and labor supply
• 5. Empirical evidence on real wages and labor
  supply
• a. Overall result Labor supply increases with
  a temporary rise in the real wage
• b. Labor supply falls with a permanent increase
  in the real wage

36
Equilibrium in the Labor Market The FE Line.

• Equilibrium in the labor market leads to
  employment at its full-employment level (Nbar)
  and output at its full-employment level (Ybar)
• If we plot output against the price level, we get
  a vertical line, since labor market equilibrium
  is unaffected by changes in the price level
• This is the FE line
• Also known as the LRAS line
• If the economy is not producing at Ybar,
  eventually it will return to this full-employment
  level of output

37
Factors that shift the FE/LRAS line

• The full-employment level of output is determined
  by the full-employment level of employment and
  the current levels of capital (K) and technology
  (A).
• any change in these variables shifts the FE/LRAS
  line