Chapter 7

The Economy at
Full Employment
Gross domestic product per capita is
higher in the United States than in France.
The primary reason for this is that the
French (and other Europeans) work onethird fewer hours than do U.S. workers.
You might be tempted to attribute this
difference to Europeans taste for leisure
or vacations. However, in the early 1970s
Europeans actually worked slightly more
hours than did U.S. workers. What
explains this dramatic turnaround in the
space of just 20 years?
Prepared By Brock Williams

Learning Objectives
Identify the key assumption of classical models in
macroeconomics.
Explain the concept of diminishing returns to labor.
Analyze how shifts in demand and supply affect wages and
employment.
Explain how full employment is determined in a classical
model.
Describe how changes in taxes can affect full employment.
Compare crowding out in a closed and open economy.

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7-2

7.1 WAGE AND PRICE FLEXIBILITY

AND FULL EMPLOYMENT

classical models

Economic models that assume wages and prices

adjust freely to changes in demand and supply.

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7.2 THE PRODUCTION FUNCTION

production function
The relationship between the level of output of a good
and the factors of production that are inputs to
production.

stock of capital
The total of all machines, equipment, and buildings in an
entire economy.

labor
Human effort, including both physical and mental effort,
used to produce goods and services.
When there are only two factors of production, capital
and labor, the production function is written as follows:

Y = F(K,L)

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7-4

7.2 THE PRODUCTION FUNCTION

(cont.)
FIGURE 7.1
The Relationship between
Labor and Output with Fixed
Capital
With capital fixed, output
increases with labor input,
but at a decreasing rate.

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7-5

7.2 THE PRODUCTION FUNCTION

(cont.)
PRINCIPLE OF DIMINISHING RETURNS
Suppose output is produced with two or more inputs, and we increase one
input while holding the other input or inputs fixed. Beyond some pointcalled
the point of diminishing returnsoutput will increase at a decreasing rate.

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7.2 THE PRODUCTION FUNCTION

(cont.)
FIGURE 7.2
An Increase in the Stock of
Capital
When the capital increases
from K1 to K2, the production
function shifts up.
At any level of labor input, the
level of output increases.

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7-7

7.3 WAGES AND THE DEMAND AND

SUPPLY FOR LABOR
FIGURE 7.3
The Demand and Supply of Labor
Together, the demand and supply for labor determine the level of employment and the real wage.

real wage
The wage rate paid to employees adjusted for changes in the price level.
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7-8

7.3 WAGES AND THE DEMAND AND

SUPPLY FOR LABOR (cont.)
Labor Market Equilibrium
Panel C of Figure 7.3 puts the demand and
supply curves together.
At a wage of $15 per hour, the amount of
labor firms want to hire7,500 workers
will be equal to the number of people who
want to work7,500 workers.
This is the labor market equilibrium: The
quantity demanded for labor equals the
quantity supplied.
Together, the demand and supply curves
determine the level of employment in the
economy and the level of real wages.
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7-9

7.3 WAGES AND THE DEMAND AND

SUPPLY FOR LABOR (cont.)
Changes in Demand and Supply
M AR G I N AL P R I N C I P L E
Increase the level of an activity as long as its marginal benefit exceeds its marginal
cost. Choose the level at which the marginal benefit equals the marginal cost.

FIGURE 7.4
Shifts in Labor Demand
and Supply
Shifts to demand and
supply will change
both real wages and
employment.

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7-10

AP P L I C AT I O N

THE BLACK DEATH AND LIVING STANDARDS IN OLD ENGLAND

APPLYING THE CONCEPTS #1: How can changes in the supply of
labor affect real wages?

According to the research of Gregory Clark of the UC, Davis, the level of real wages for
laborers in England was nearly the same in 1200 as it was in 1800. Yet, during the
period from 1350 to 1550, they were highernearly 75 percent higher in 1450, for
instance, than in 1200.
Why were real wages temporarily so high during this period?

The simple answer was the bubonic plaguealso known as the Black Death

Arrived from Asia in 1348 and caused a long decline in total population
through the 1450s.

With fewer workers, there was less labor supplied to the market. The result
was higher real wages.
In the era before consistent and rapid technological advance, changes in population was
the primary factor controlling living standards. As the economist Thomas Malthus (1766
1834) observed, social maladies such as the Black Death would temporarily raise living
standards until higher living standards led to increased population.
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7.4 LABOR MARKET EQUILIBRIUM AND

FULL EMPLOYMENT
FIGURE 7.5
Determining Full-Employment
Output
Panel B determines the
equilibrium level of employment at
L and the real wage rate of W.
Full-employment output
in Panel A is Y.

full-employment output
The level of output that results
when the labor market is in
equilibrium and the economy
is producing at full
employment.

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7.5 USING THE FULL-EMPLOYMENT

MODEL
Taxes and Potential Output
FIGURE 7.6
How Employment Taxes
Affect Labor Demand and
Supply
In Panel A, a tax burden on
labor shifts the labor
demand curve to the left
and leads to lower wages
and reduced employment.
In Panel B, the supply
curve for labor is vertical,
which means that wages
fall but employment does
not change.

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7.5 USING THE FULL-EMPLOYMENT

MODEL (cont.)
Real Business Cycle Theory
real business cycle theory
The economic theory that emphasizes how shocks to
technology can cause fluctuations in economic activity.

FIGURE 7.7
How an Adverse
Technology Shock Affects
Labor Demand and Supply
An adverse shock to
technology will decrease
the demand for labor.
As a result, both real
wages and employment fall
as the market equilibrium
moves from a to b.

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7-14

AP P L I C AT I O N

DO EUROPEAN SOCCER STARS CHANGE CLUBS TO REDUCE THEIR TAXES?

APPLYING THE CONCEPTS #2: What evidence is there that taxes on high paid
soccer stars in Europe affect their location decisions among countries?
In 2009, a Portuguese soccer star moved from Manchester United in the United Kingdom to Real
Madrid in Spain. Many speculated that the reason he moved was to avoid a top United Kingdom
tax rate of 50 percent in favor of a flat 24 percent rate (with no deductions) created to entice
foreigners to locate in Spain. While this is an interesting anecdote, is there any other evidence
that the very top earners will move to countries with lower tax rates?
In an interesting study, economists Henrik Jacobsen Kleven, Camille Landais,and Emmanuel Saez
used changes in the market for international soccer stars to test for the effects of tax rates. Prior
to 1995, the top European soccer clubs had limits on the number of foreign players on any one
team. The European Court of Justice, however, ruled that these limits violated the treaty of the
European community. The economists found that prior to 1995, taxes on high earners did not have
much effect on mobility of soccer stars, but after 1995, top tax rates did matter.
This type of evidence suggests that countries may not only be in competition for top athletes, but
also for other highly paid individualsfrom tennis players to corporate executives.

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AP PL I C AT I O N

CAN LABOR MARKET POLICIES ACCOUNT FOR THE GREAT DEPRESSION?

APPLYING THE CONCEPTS #3: Can real business cycle models explain the
origin and persistence of the Great Depression?

Real Business Cycle models do not explain the Great Depression

Economists Cole and Ohanian of UCLA modified the standard model to
include other factors.
President Roosevelts New Deal allowed firms to collude if they
recognized unions and raised wages.
President Hoover also had polices that raised wages.
Incorporating these factors into the model allow it to explain the origin and
severity of the Great Depression.

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7.6 DIVIDING OUTPUT AMONG COMPETING

DEMANDS FOR GDP AT FULL EMPLOYMENT
International Comparisons

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7-17

7.6 DIVIDING OUTPUT AMONG COMPETING

DEMANDS FOR GDP AT FULL EMPLOYMENT
(cont.)
Crowding Out in a Closed Economy
crowding out
The reduction in investment (or other component of
GDP) caused by an increase in government spending.

P R I N C I P L E O F O P P O RT U N I T Y C O S T
The opportunity cost of something is what you sacrifice to get it.

closed economy
An economy without international trade.
output = consumption + investment + government purchases
Y=C+I+G

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7-18

7.6 DIVIDING OUTPUT AMONG COMPETING

DEMANDS FOR GDP AT FULL EMPLOYMENT
(cont.)
Crowding Out in a Closed Economy
FIGURE 7.8
U.S. Consumption and
Government Spending During
World War II
Increased government
spending crowds out
consumption by
consumers.
The vertical bar highlights
the time period during
which crowding out
occurred.
SOURCE: U.S. Department
of Commerce.

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7-19

7.6 DIVIDING OUTPUT AMONG COMPETING

DEMANDS FOR GDP AT FULL EMPLOYMENT
(cont.)
Crowding Out in a Closed Economy
FIGURE 7.9
U.S. Investment and
Government Spending During
World War II
Increased government
spending also crowds out
private investment
spending.
The vertical bar highlights
the time period during
which crowding out
occurred.
SOURCE: U.S. Department
of Commerce.

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7-20

7.6 DIVIDING OUTPUT AMONG COMPETING

DEMANDS FOR GDP AT FULL EMPLOYMENT
(cont.)
Crowding Out in an Open Economy
open economy
An economy with international trade.
Y = C + I + G + NX
Increased government spending need not crowd out either consumption or
investment. It could lead to reduced exports and increased imports.

Crowding in
crowding in
The increase of investment (or other
component of GDP) caused by a
decrease in government spending.

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KEY TERMS

classical models

full-employment output

closed economy

labor

crowding in

open economy

crowding out

production function
real business cycle theory
real wage
stock of capital

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