The Supply Side of the Economy

1
TOPIC 2

• The Supply Side of the Economy

2
Goals of Lecture 2

• Introduce the supply side of the macro economy.
• Discuss how countries grow and why some countries
  grow faster than others.
• Discuss labor productivity
• What does it mean?
• How does it respond coming out of recessions?
• Determine how wages are set in an economy.
  Determine why people work.
• Understand where unemployment comes from.

3
The Production Function

• GDP (Y) is produced with capital (K,
  price-weighted) and labor (N, hours)
• Y A F(K,N)
• Sometimes, I will modify the production function
  such that
• Y A F(K,N, other inputs) where other
  inputs include energy/oil!
• Realistic Example is a Cobb Douglas function for
  F(.)
• Y A K1-a Na
• A is Total Factor Productivity (TFP), an index of
  efficiency (technology)
• MUST READ NOTES 3 (my text posted on the
  teaching page) on the aggregate production
  function

4
Measurement

• Y is GDP (measured in dollars). As noted above,
  we want to measure Y in real dollars.ltltyou
  should know what this means from Notes 1 of the
  textgtgt.
• For our Cobb Douglas production function
  (previous slide), N and K are both measured in
  dollars.
• N often is measured in total wage bill
• K often is measured as the replacement cost of
  capital
• However, in practice, N can be measured in
  different ways (hours worked, number of workers).
• Wage bill is the preferred method (takes into
  account skill differentials).
• However, we will often talk about standard of
  living which is income per capita (Y/N where Y
  is income and N is some population measure).

5
Features of the Aggregate Production Function

• Define MPN Marginal Product of Labor dY/dN
• Define MPK Marginal Product of Capital dY/dK
• Math Note You should be comfortable taking these
  simple partial derivatives if you are not,
  practice this for the quizzes and exams.
• Diminishing Marginal Products
• From Cobb-Douglas MPN a A (K/N)1-a a (Y/N)
• Fixing A and K, MPN falls when N increases
• MPK (1-a) A (N/K)a (1-a) (Y/K)
• Fixing A and N, MPK falls when K increases
• Complementarity Across Inputs
• Increasing A or K, increases MPN
• Increasing A or N, increases MPK

6
Labor Share With Cobb-Douglas

• Labor Share of Income Income earned by
  workers divided by GDP
• (W/P)N/Y
• In equilibrium, real wages of workers will equal
  MPN (more on this below)
• Substituting (W/P) MPN into above
  yields
• Labor Share of Income (a) (Y/N) (N/Y)
• (MPN)
• a
• Cobb-Douglas predicts a constant labor share of
  a.
• Historically, a was stable at a level of about
  0.7 (in notes, I often just set a 0.7).

7
US Labor Share 1947Q1 2016Q2
Sharp Decline After 2000
Roughly Stable through 2000
8
Manufacturing Labor Share 1988Q1 2014Q2
9
Sub-Section A

• Economic Growth

10
Two Measures of Productivity

• Labor Productivity Y/N A (K/N)1-a
• Driven by A and K/N (usually reported in press)
• Total Factor Productivity (TFP) A Y/F(K,N)
• Basically TFP is a catch-all for anything that
  affects output other than K and N.
• Work week of labor and capital
• Quality of labor and capital
• Regulation
• Infrastructure
• Competition
• Specialization
• Innovation (including innovation in management
  practices)
• Changes in discrimination or culture
• Some components of TFP tend to be pro-cyclical
• (Definition of Pro-cyclical Variable increases
  when Y is high, decreases when Y is low)

11
Growth Accounting

• Y A K1-a N a (our production function)
• ?Y ?A (1-a)?K a?N
• Output, in a country grows from
• Growth in TFP (see entrepreneurial ability,
  education, roads, technology, etc.)
• Growth in Capital (machines, equipment, plants)
• Growth in Hours (workforce, population, labor
  participation, etc).
• Perhaps, we care about growth in Y/pop or Y/N
  (per capita output).
• ?(Y/pop) ?A (1-a)?(K/pop) a?(N/pop)
• or
• ?(Y/N) ?A (1-a)?(K/N)

12
How is TFP Measured

• The way TFP (A) is usually measured is via a
  statistical decomposition (referred to as the
  Solow Residual).
• Remember our assumed production function Y
  AK1-aNa
• Math Note We are going to transform the
  production function to make it a little easier to
  work with (you should get comfortable with this)
  by taking the logs
• ln(Y) ln(A) a0ln(K) a1ln(N) (where a0 1
  a1 0.3) (1)
• Given that we measure Y, K and N in the data, we
  can estimate (1) using standard regression
  techniques.
• ln(A) is the constant from the regression.
  This is our standard TFP measure.

13
US TFP Growth 1970Q1 2014Q1
14
Measuring TFP
Because A (TFP) is a catch-all term for anything
that affects production, the assumed production
function does not impose any structure on how to
measure the components of TFP. Economists are
very good at measuring the extent to which TFP
changes over time within a country. It is much
harder to measure why TFP has changed over
time. Economists try to measure this by using
detailed firm-level and household-level data to
measure production and wages.
15
How is Labor Productivity Measured

• Labor Productivity is easier to measure Y/N
• Y is usually real GPD
• N is usually total hours worked

16
Nonfarm Business Labor Productivity Growth
1988Q1 2016Q2
Puzzle?
17
Manufacturing Labor Productivity Growth 1988Q1
2016Q2
Puzzle?
18
Labor Productivity Growth Over Time

• 1900-1972 2.4 per year
• 1972-1996 1.4 per year.
• 1996-2004 2.6 per year. (Internet boom)
• 2005-2016 1.1 per year
• 2013-2016 0 per year
• Data from Robert Gordon (Professor at
  Northwestern)

19
Why is Labor Productivity/TFP Growth Lower

• Demographics?
• Slower growth in schooling?
• Innovations with less spill-overs on productivity
  (but huge spill-overs on leisure)
• What productivity growth we have seen replaces
  lower skilled workers. Contributing to
  inequality within the economy.
• Have we moved from big innovations in market
  productivity (electricity, assembly lines,
  transportation, manufacturing techniques, etc.)
  to big innovations in leisure technology
  (facebook, internet, games, etc.).

20
New Paper of MineThe Allocation of Talent and
Economic Growth
Question 1 How much of the observed TFP growth
in the U.S. since 1960 is due to better labor
market outcomes (including human capital
formation) for blacks and women? o A better
allocation of resources leads to higher economic
growth. o There have been large changes in the
allocation of women and minorities to occupations
in the labor market since 1960. Question
2 How much of the convergence of the U.S.
south to the U.S. north is due to a decline in
discrimination of the south?
21
Occupational Sorting Over Time An Overview

• Fraction of group (white men, white women, black
  men, black women) aged 25-55 working in the
  following occupations
• Executives, Mgmt, Architects, Engineers,
  Math/Computer Science, Natural Scientists,
  Doctors, and Lawyers.
• 1960 2010
• White Men 21.2 23.5
• White Women 3.0 (7.3)
  17.4 (21.0)
• Black Men 2.8
  14.6
• Black Women 1.0 (2.1)
  13.0 (15.2)
• Data U.S. Census and American Community Survey

22
Occupational Sorting Over Time An Overview

• Where were the other groups working in 1960?
• 53 of working white women worked in Nursing,
  Teaching, Sales, Secretarial and Office
  Assistances, and Food Prep/Service.
• o The comparable number for white men was 14
  (mostly sales)
• 55 of working black men worked as Freight/Stock
  Handlers, Motor Vehicle Operators, Machine
  Operators, Janitorial Services, and Personal
  Services.
• o The comparable number for white men was 19
• 47 of working black women worked in Household
  Services, Personal Services, and Food
  Prep/Services.
• o The comparable number for white men was 2

23
Wage Gaps Over Time An Overview

• Log difference in annual earnings of full time
  workers, conditional on experience, hours and
  occupation controls (relative to White Men)
• 1960 1980 2010
• White Women -0.56 -0.47 -0.26
• Black Men -0.37 -0.21 -0.16
• Black Women -0.82 -0.47 -0.31

24
Findings

• Macro Implications
• o 25 - 30 of per capita earnings in the U.S.
  between 1960 and 2010 was due to declining
  frictions for white women, black women, and black
  men. (Shines some light into the black box of
  TFP growth)
• o Other interesting results
• - Wage growth in the 1970s and the 2000s would
  have been negative
• absent the labor market improvements for
  blacks and women.
• - About 40 of the convergence of the south to
  the northeast between 1960 and 1980 is
  due to declining labor market frictions.
• - Not much remaining room for growth from this
  mechanism. Can explain some of the slow down in
  productivity since 2000.

25
Crazy Idea I have on Productivity Slowdown
26
Did Early 2000 Finance Boom Cause a Fall in
STEM Employment?
27
Sub-Section A1

• Cross-Country Growth

28
The Role of Investment and Growth

• Does a one time increase in investment today
  increase Y/N today? YES!
• Does a one time increase in investment today
  cause a sustained increase in Y/N into the
  future? No!
• Back of our mind equations
• S I NX (From the first lecture). Notice
  the link between saving and investment.
• K(t1) (1-d) K(t) I(t) Definition of
  Capital Stock Evolution
• or
• ?K(t, t1) I(t) - d K(t)
• All else equal (i.e. holding N constant),
  increasing I causes K tomorrow to increase
  causing K/N tomorrow to increase (i.e. Y/N
  tomorrow increases).

29
Time Path of Capital Stock One Time Increase in
I
K
No investment
No investment
time
t1
Suppose there is a one time increase in
investment at time t (perhaps due to an
investment tax credit). Suppose no investment
either prior to or after the tax credit.
30
Can Higher Investment Lead to Infinite Growth?

• Does a sustained increase in investment increase
  Y/N today? YES!
• Does a sustained increase in investment cause a
  sustained increase in Y/N? No!
• Suppose I is fixed at a high level and that K
  initially is sufficiently small.
• K grows if I gt d K But, notice that dK is
  also growing each period.
• (Summary To start, higher I will lead to higher
  K and Y/N will increase).
• Eventually, however, I will converge towards dK.
  More and more of the investment is going to
  replace outdated capital and the capital stock
  will grow by smaller and smaller rates. The
  increase in Y/N will converge back to zero.
• Summary High levels of investment will increase
  the capital stock and output, but both K and Y
  will eventually converge to a fixed level.

31
Time Path of K Permanent Increase in I
K
The new level of investment has successively less
effect due to growing depreciation of the capital
stock.
No investment
time
t1
Suppose there is a permanent increase in
investment at time t. Suppose no investment
prior to t. In all periods after t, the level
of investment remains fixed at the level in t.
32
Can Higher Investment Growth Cause Infinite
Growth?

• If a one time increase in I gives an increase in
  Y, why not continuously raise I to higher and
  higher amounts??? Answer Diminishing MPK!!!
• MPK .3 A (N/K) .7 As K increases, MPK falls.
• As K goes to infinity, MPK goes to zero (Y stops
  increasing).
• Suppose, we keep rising I (each year), K will
  increase by the amount of I (after controlling
  for depreciation), but Y will increase by
  continuously smaller and smaller amounts.
• Remember Y C I G NX. I/Y (investment
  rate) is bounded by 1 (if you invest all your
  output). This caps the increase in I. I
  cannot grow forever!
• Continuously increasing I will NOT lead to
  sustained economic growth.
• NOTE Investment decisions are NOT made in the
  dark (i.e. something must drive firm
  investment!)

33
What Causes Sustained Growth ?

• Sustained Increases in the growth of A are the
  only thing that can cause a sustained growth in
  Y/N.
• Empirically, when a country exhibits faster Y/N
  growth ..
• 33 typically comes from growth in K/N
• 67 typically comes from growth in A
• (where N employment (not hours) - limited data).

34
Growth Across Countries

• Most developed economies grow at the same rate
  that the technological frontier grows.
• Some helpful definitions
• Convergence countries inside of the
  technological frontier move towards the
  technological frontier.
• Divergence countries inside of the
  technological frontier grow at a rate less than
  the technological frontier.

35
Distribution of World GDP in 2015 (IMF, )
36
Distribution of World GDP in 2015 (IMF, )
Top 10 Other Notable Bottom 10

Qatar 132,099 Lithuania 28,359  Madagascar 1,462
Luxembourg 98,987 Russia 25,411 Eritrea 1,297
Singapore 85,253  Chile/Argentina 23,000  Guinea 1,214
Brunei 79,587  Turkey 20,438  Mozambique 1,186
Kuwait 70,166  Venezuela 16,673  Malawi 1,124
Norway 68,430  Brazil 15,615 Niger 1,080
UAE 67,617 China 14,107  Liberia 873
Switzerland 58,551 South Africa 13,165 Burundi 818
Hong Kong 56,701 Ukraine 7,519  Congo 770
USA 55,805 India 6,162  Cent. Afric. Repub 630

37
Some Data Distribution of World GDP in 2000
From Barro, 2003 includes 147 countries.
Horizontal axis is a log scale. All data are in
1995 U.S. dollars.
38
Some Data Distribution of World GDP in 1960
From Barro, 2003 includes 113 countries.
Horizontal axis is a log scale. All data are in
1995 U.S. dollars.
39
Growth Rate of GDP Per Capita 1960 - 2000
From Barro, 2003 includes 111 countries.
40
GDP per Capita in the United States, the United
Kingdom, and Japan, 18702009 (Weil 2015)
Sources Maddison (1995), Heston, Summers, And
Aten (2011).
41
The Distribution of Growth Rates, 19752009
(Weil 2015)
42
Convergence of Income Across U.S. States 1940 -
1980
43
Convergence of Income Across U.S. States 1980 -
2000
44
Source of GDP Growth
Latin America Brazil, Chile, Columbia, Mexico,
Peru, Uruguay, Bolivia, Ecuador, Paraguay,
Venezuela Emerging Asia Indonesia, Malaysia,
Philippines, Thailand, and China Advanced
Exporters Australia, Canada, New Zealand, and
Norway. From Sosa et al. (2013), IMF Report
45
Per Capita GDP vs. Life Expectancy (Acemoglu 2005)
46
Sub-Section B

• The Labor Market

47
Labor Market Firm Profit Decisions

• In a competitive market, a firm can sell as much
  Y as it wants at the going price p, and can hire
  as much N as it wants at the going wage w.
• Facing w and p, a profit maximizing firm will
  hire N to the point were MPN w/p (the benefit
  from an additional worker (in terms of additional
  output) must equal the cost which they are paid).
  ltltThis is straight from microgtgt
• With Cobb-Douglas MPN .7 Y/N .7 A (K/N).3
• If firms maximize profits w/p .7 Y/N .7 A
  (K/N).3
• If MPN gt w/p then the firm can increase profits
  by increasing N.
• If MPN lt w/p then the firm can increase profits
  by decreasing N.
• Reading Notes 4 from the supplemental notes

48
The Labor Demand Curve
real wage
w/p
MPN Nd
N
N
49
Notes on the Labor Demand Curve

• Nd slopes downward (Nd MPN .7 A (K/N).3)
• Nd rises with A and K (assumed complementarity
  across inputs)
• Assumption Y is not Fixed! Firms optimally
  choose N, K, Y and (to some extent) A to maximize
  profits.
• Caveat Who says that there is a demand for more
  Y?
• Need to look at the demand side of economy
  (introduced last -discussed in depth throughout
  the course).

50
The Other 1/2 of the Labor Market Labor Supply

• Labor Supply (Ns) Results from Individual
  Optimization Decisions
• Households compare benefits of working
  (additional lifetime resources) with cost of
  working (forgone leisure)
• Factors Affecting Labor Supply
• The Real Wage (w/p)
• The Households Present Value of Lifetime
  Resources (PVLR)
• The Marginal Tax Rate on Labor Income (tn)
• The Marginal Tax Rate on Consumption (tc)
• Value of Leisure (reservation wage) - non- work
  status (VL)
• The Working Age Population (pop)

51
The Labor Supply Curve
Ns(PVLR, tc, tn, pop, VL)
w/p
N
52
Labor Supply Notes (Most Derived From Scratch in
Lecture)

• In terms of wages and earnings, there is both
  an income and substitution effect - we will look
  at them separately BUT in the real world, they
  often occur jointly!!!!
• The Real Wage - HOLDING PVLR fixed A higher w/p
  encourages individuals to substitute away from
  leisure and toward work (leisure becomes more
  expensive). This is a substitution effect.
  ltltThis is why the labor supply curve slopes
  upwards!!gtgt
• Estimating this substitution effect is difficult
  since PVLR is not easily held constant.
  Estimates range from 0 - 2 (For a 1 increase in
  after-tax w/p holding PVLR fixed, labor supply
  either increases by 0 or 2). Very Wide Range
  little consensus.
• PVLR initial wealth present discounted value
  of earnings
• A higher PVLR induces individuals to work less
  (lower Ns) for a given after-tax wage, allowing
  them to enjoy more leisure (If leisure is
  preferred to work as I get richer, I can afford
  to work less).
• PVLR is net of taxes and non-work governmental
  transfers and inclusive of all other transfers.

53
Labor Supply Notes

• Marginal tax rate on labor income - Should have
  same substitution effect as the before tax real
  wage. Studies of the 1986 U.S. Tax Reform found
  that only high-earning married women worked more
  in response to lower marginal income tax rates.
• Marginal tax rate on consumption - see above
• Value of Leisure - If leisure/no-work becomes
  more/less attractive, households will work
  less/more (reservation wage). (Welfare programs,
  child care, etc.).
• Working Age Population Usually defined as
  16-64. (Includes changes in Labor Force
  Participation Rates)

54
Recap on Labor Supply

• Substitution Effect
• For a given PVLR, a higher after tax wage
  increases NS.
• (This is why Labor Supply Curve Slopes Upward)
• Income Effect
• For a given after-tax wage, higher PVLR decreases
  Ns.
• Evidence
• Weak Consensus is that, with equal () increase
  in PVLR and the after-tax wage, Ns falls (income
  effect dominates).

55
Temporary Increase in A
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p
N d(A,K)
N
N
56
Permanent Increase in A
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p
N d(A,K)
N
N
57
Can Technological Progress Destroy jobs?

• Facts A, N, w/p are trending up over time.
• N/pop is trending down (except in U.S. since
  1980).
• Higher A countries have higher w/p and lower
  N/pop.
• Implications
• Adjusting for pop, higher A goes with lower N.
• Higher A reduces Nd and destroys jobs? - NO!
• Labor Demand Increases.
• Higher A increases PVLR and reduces Ns - The
  Effect on Labor Supply is to fall.

58
Permanent Increase in Population
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p
N d(A,K)
N
N
59
Population and Jobs
60
Temporary Increase in Taxes (tc or tn)
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p
N d(A,K)
N
N
61
Permanent Increase in Taxes (tc or tn)
Ns(PVLR, tc, tn, pop, VL)
w/p
w/p
N d(A,K)
N
N
62
Labor Market Equilibrium (in long run!)

• We define Long Run Equilibrium in macroeconomics
  as occurring when the labor market clears.
• By definition, long run macro equilibrium exists
  when N N.
• At N, labor demand labor supply. So, by
  definition, all workers who want a job (the
  suppliers) are able to find a firm looking for a
  worker (the demanders).
• Implies that cyclical unemployment zero at N.
• Long run equilibrium is characterized by zero
  cyclical unemployment!
• It is an equilibrium in that there is no
  incentive for real wages to change at N
• Real wages (w/p) has two components nominal
  wages (w) and the price level (p).
• Note Y (by definition) A K.3(N).7
• Y is the long run equilibrium level of output
  (output where labor market is in equilibrium)

63
Our First Aggregate Supply Curve.

• Suppose prices (p) increase. What happens in the
  labor market?
• In terms of equilibrium, nothing happens!
• Increasing prices have no effect on labor demand
  (A and K do not change).
• Increasing prices have no effect on labor supply
  (taxes, population, etc. do not change).
• You may ask Doesnt PVLR change when prices
  increase??? No!
• As long as nominal wages adjust, real wages will
  be unchanged when p increases.
• The change in prices will be match exactly by
  the change in nominal wages real wages will
  not change (so PVLR will not change).
• No effect on labor supply.
• Key Because real wages will not change, changes
  in prices will have NO effect on the labor market
  (i.e., it will have no effect on N).
• Conclusion Changing prices will have NO effect
  on Y (since N is constant).

64
Our First Aggregate Supply Curve
LRAS Long Run Aggregate Supply Curve
p
Y
Y

• If labor market clears, changes in prices will
  lead to equal changes in nominal wages.
• As a result, there will be no change in N and
  hence, no change in Y.
• Leads to a vertical LRAS curve. Prices do not
  affect production in the long run!

65
What Shifts Y? (the LRAS)

• Anything that affects the labor market will
  affect Y!
• If N increases, Y will shift to the right.
• If N decreases, Y will shift to the left.
• Summary Y will shift right if
• A increases
• K increases
• population increases
• labor income taxes fall (and income effect is
  small relative to substitution effect)
• labor income taxes rise (and income effect is
  large relative to substitution effect)
• Note The long run aggregate supply curve (LRAS)
  is NOT the labor supply curve. We have lots of
  different markets in this class. There will be
  lots of different supply and demand curves.
  You need to keep track of them!

66
Things to Remember!

• The demand side of the economy is NOT important
  for determining Y!
• All we need to know is A, K and N and we know Y!
• The demand side of the economy is not important
  for economic growth!
• Key If I ever ask you about what determines Y
  (i.e., output/income/expenditure in the long
  run), you should think about A, K and the labor
  market.
• As a rule, K will be fixed unless I tell you
  otherwise (for simplicity, you will see why
  soon).
• Why do we care about the demand side of the
  economy?
• In the long run, prices will be determined by
  demand.
• Also, LRAS is dependent on labor market being in
  equilibrium. In the short run, labor market need
  not be in equilibrium.
• Demand will determine output in the SHORT RUN!

67
Summary.

• In the long run when labor markets clear.
• Supply side of economy (labor market, K, A, other
  inputs like oil) determines output.
• Demand side of economy (CIGNX) will determine
  prices.
• In the short run when labor markets do not
  clear
• Demand and Supply jointly determine prices and
  output (think of the simple examples I gave
  graphically in the lecture for topic 1).
• Three outstanding issues (we will get to them
  soon)
• When is the labor market NOT in equilibrium?
• What does the supply curve look like when labor
  market doesnt clear?
• What determines demand?

68
When are Labor Markets in Disequilibrium?

• Labor market is in disequilibrium when labor
  demand is not equal to labor supply.
• Any time labor demand labor supply, there is no
  cyclical unemployment (by definition)!
• Nominal wages do not adjust to clear the labor
  market
• We refer to this as sticky wages.
• Because of wage contracts (and uncertainty),
  nominal wages do not always adjust immediately.
• Need a model for short-run disequilibrium --- we
  will do that in Topic 6.

69
Cyclical Unemployment in Labor Markets

• When do we get cyclical unemployment in our
  models?
• Cyclical unemployment occurs when there are no
  jobs available (labor demand) for those with the
  skills and the desire to work (labor supply) at
  current wages.
• Cyclical unemployment occurs only in
  disequilibrium! (when desired labor demand lt
  desired labor supply - at given wages)

Ns
a
b
w/p
Nd
Unemployment
N(0)
N(1)