Long-Run Economic Growth

REVIEW QUESTIONS

1.What is a production function? What are some factors that can cause a nation's production function to shift over time? What do you have to know besides an economy's production function to know how much output the economy can produce?

Production function tells us the amount of output that can be produced with any given quantity of capital and labor. Factors that may cause a nations production function to shift overtime would be holding labor fixed (relationship between output and capital) and holding capital fixed (relationship between output and labor) either case the production function slopes upward, meaning a greater use of capital or labor leads to more output. In order to estimate how much output the economy can produce you'll need besides the economy's production function the supply shock it consists of a shift of production function, which implies a change in the amount of output that can be produced with given amounts of capital and labor.

2.. The production function slopes upward, but its slope declines from left to right. Give an economic interpretation of each of these properties of the production function.

The production function slopes upward from left to right. The slope of the production function reveals that, as the capital stock increases, more output can be produced. The marginal product of capital declines as the capital stock is increased. Because the marginal product of capital is the slope of the production function, the slope of the production function decreases as the capital stock is increased. The tendency for the marginal product of capital to decline as the amount of capital in use increases is called the diminishing marginal productivity of capital.

5. What is the MPN curve? How is the MPN curve related to the production function? How is it related to labor demand?

An MPN curve, marginal product of labor, is the extra output that can be produced when labor increases by one unit, with capital held constant. It can be measured as the slope of the production function relating output to labor falls as employment rises, Implying that labor also diminishes marginal productivity. It relates to labor demand because the labor demand curve is identical to the MPN curve, this is because an increase in the real wage causes firms to demand less labor, the labor demand curve slopes downward.

6. Use the concepts of income effect and substitution effect to explain why a temporary increase in the real wage increases the amount of labor supplied, but a permanent increase in the real wage may decrease the quantity of labor supplied.

Under the substitution effect, a temporary increase in real wage will cause workers to supply more labor in response to a higher reward for their work. But in the long term, the income effect come to scene; this is that as workers are becoming wealthier, they would be able to afford additional leisure time and the labor supply would decrease.

8. Define full-employment output. How is full-employment output affected by an increase in labor supply? By a beneficial supply shock?

Full-employment output, sometimes called potential output, is the level of output that firms in the economy supply when wages and prices have fully adjusted. Equivalently, full-employment output is the level of output supplied when aggregate employment equals its full employment level. As the labor supply increase and the economy continues being at full-employment, the output produced by the full-employment will also increase. When a beneficial supply shock occurs, the same quantity of full-employed people will be able to produce more output due to the shock, mostly cause by technological changes among others.

9. Why is the classical model of the labor market discussed in this chapter not very useful for studying unemployment?

The classical model of the labor market is based on the assumption that the real wage adjusts reasonably quickly to equate labor supply and labor demand.

12. What is frictional unemployment? Why is a certain amount of frictional unemployment probably necessary in a well-functioning economy?

Frictional unemployment is the one that arises as workers search for suitable jobs and firms search for suitable workers. In other words frictional unemployment arises from matching workers with jobs. A certain amount is necessary because not every job is adequate for everybody, people have to take their time to find the job in which they will be more productive and in which they Y = AK0.3N0.7.

14. Define the natural rate of unemployment and cyclical unemployment. What does negative cyclical unemployment mean?

The natural rate of unemployment is the rate of unemployment that prevails when output and employment are at their full-employment levels. The natural rate of unemployment reflects unemployment owing to frictional and structural causes. Meanwhile cyclical unemployment is the difference between the actual rate of unemployment and the natural rate of unemployment. Specifically, cyclical unemployment = u – u, where u is the actual unemployment rate and u is the natural rate. Negative cyclical unemployment is when output and employment exceed full-employment levels.

15. What is Okun’s law? If the unemployment rate increases by 2 percentage points between this year and next year, by how much will output change during the same period? Assume that the natural unemployment rate and full-employment output are constant.

Okun’s law is a law that states that the gap between an economy’s full employment output and its actual level of output increases by 2 percentage points for each percentage point the unemployment rate increases. If the unemployment rate increases by 2 percentage points between this year and next year it would be 4% increase.

ANALYTICAL PROBLEMS

2. How would each of the following affect the current level of full-employment output? Explain.

a. A large number of immigrants enter the country.

This means that the supply of labor will increase, increasing output and the number of people employed.

b. Energy supplies become depleted.

Output will decrease since energy is a necessity.

c. New teaching techniques improve the educational performance of high school seniors.

Since education is favorable for the development of technology and productivity, output will increase in the long term.

d. A new law mandates the shutdown of some unsafe forms of capital.

Output will decrease since sources of jobs and output development are being closed.

3. During the 1980s and 1990s the average rate of unemployment in Europe was high. Some economists claimed that this rate was in part the result of “real- wage rigidity,” a situation in which unions kept real wages above their market-clearing levels.

a. Accepting for the sake of argument that real wages were too high in Europe in the 1980s and 1990s, show how this situation would lead to unemployment (a situation where people who would like to work at the going wage cannot find jobs).

b.         What is the effect of real-wage rigidity on the output actually supplied by firms, relative to the output they would supply if there were no real-wage rigidity?

Real wage rigity creates a higher level of unemployment because firms can no longer pay so many jobs. Therefore less people working causes less output.

4. How would each of the following affect Helena Handbasket’s supply of labor?

a. The value of Helena’s home triples in an unexpectedly hot real estate market.

Since she would be wealthier, the income effect will enter to scene, she will be able to afford more leisure and she will reduce her supply of labor and

b. Originally an unskilled worker, Helena acquires skills that give her access to a higher-paying job.

Assume that her preferences about leisure are not affected by the change in jobs.

She would increase her supply of labor in the short-run as stated in the substitution effect, but in the long-run as her wealthy increase, she will decrease it as stated in the income effect.

c. A temporary income tax surcharge raises the percentage of her income that she must pay in taxes, for

the current year only. (Taxes are proportional to income in Helena’s country.)

Since her income will be reduced, she would reduce her supply of labor.