CHAPTER SUMMARY

1. The production function tells us the amount of out­put that can be produced with any given quantities of capital and labor. It can be graphed as a relationship between output and capital, holding labor fixed, or as a relationship between output and labor, holding capital fixed.

2. The extra output that can be produced when the capi­tal stock is increased by one unit, with labor held con­stant, is called the marginal product of capital (MPK). In a graph of the production function relating output to capital, the MPK can be measured as the slope of the production function. The MPK falls as the capital stock increases, reflecting the diminishing marginal productivity of capital. Similarly, the marginal prod­uct of labor (MPN) is the extra output that can be produced when labor increases by one unit, with capi­tal held constant. The MPN—which can be measured as the slope of the production function relating output to labor—falls as employment rises, indicating that labor also has diminishing marginal productivity.

3. To maximize profits, firms demand labor to the point that the marginal revenue product of labor (MRPN) equals the nominal wage, W; or, equivalently, to the point that the MPN equals the real wage, w.

4. The labor demand curve is identical to the MPN curve. Because an increase in the real wage causes firms to demand less labor, the labor demand curve slopes downward. Factors that increase the amount of labor demanded at any real wage, such as a benefi­cial supply shock or an increase in the capital stock, shift the labor demand curve to the right.

5. An individual's decision about how much labor to supply reflects a comparison of the benefit and cost of working an additional hour. The benefit of work­ing an additional hour is the additional real income earned, which can be used to increase consumption. The cost of working an extra hour is the loss of an hour's leisure. An individual's happiness, or utility, is maximized by supplying labor to the point where the cost of working an extra hour (the utility lost because of reduced leisure) equals the benefit (the utility gained because of increased income).

6. An increase in the real wage has competing substitution and income effects on the amount of labor supplied. The substitution effect of a higher real wage increases the amount of labor supplied, as the worker responds to the increased reward for working. The income effect reduces the amount of labor supplied, as the higher real wage makes the worker wealthier and thus able to afford a greater amount of leisure. The longer an increase in the real wage is expected to last, the stronger the income effect is. Thus a temporary increase in the real wage will increase the amount of labor supplied. A permanent increase in the real wage will increase the amount of labor supplied by a smaller amount than a temporary increase in the real wage of the same size, however, and may even lead to a decrease in the amount of labor supplied.

7. The labor supply curve relates the amount of labor supplied to the current real wage. The labor supply curve slopes upward, indicating that an increase in the current real wage—with other factors, including the expected future real wage, held fixed—raises the amount of labor supplied. Factors that decrease the quantity of labor supplied at the current real wage, and thus shift the labor supply curve to the left, include an increase in wealth and an increase in the expected future real wage.

8. The classical supply-demand model of the labor market is based on the assumption that the real wage adjusts relatively quickly to equalize the quantities of labor demanded and supplied. The equilibrium level of employment, which arises when wages and prices in the economy have fully adjusted, is called the full-employment level of employment. Fluctuations in employment and the real wage result from factors that shift the labor supply curve and/or the labor demand curve.

9. Full-employment output, or potential output, is the amount of output produced when employment is at its full-employment level. Increases in the full-employment level of employment or beneficial supply shocks increase the full-employment level of output.

10. Adults without jobs are classified as unemployed if they looked for work during the preceding four weeks; they are classified as not in the labor force if they haven't been looking for work. The labor force consists of all employed workers plus all unemployed work­ers. The unemployment rate is the fraction of the labor force that is unemployed.

11. Frictional unemployment reflects the time required for potential workers to find suitable jobs and for firms with vacancies to find suitable workers. Structural unemployment—long-term and chronic unemployment that exists even when the economy isn't in recession— occurs because some workers don't have the skills needed to obtain long-term employment, or because of delays as workers relocate from economically depressed areas to those that are growing. Frictional and structural unemployment together account for the natural rate of unemployment, which is the unemployment rate that exists when employment is at its full-employment level. Cyclical unemployment is the excess of the actual unem­ployment rate over the natural rate of unemployment.

12. According to Okun's law, a 1 percentage point increase in the rate of cyclical unemployment reduces output by 2%.

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