TOPIC 2

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 K.3 N.7 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.<<you should know what this means from Notes 1 of the text>>. • 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 livings 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 = .7 A (K/N).3 = .7 (Y/N) Fixing A and K, MPN falls when N increases MPK = .3 A (N/K).7 = .3 (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. Two Measures of Productivity • Labor Productivity = Y/N = A (K/N).3 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 tends to be pro-cyclical • (Definition of Pro-cyclical: Variable increases when Y is high, decreases when Y is low)

7. Sub-Section A Economic Growth

8. Growth Accounting Y = A K.3 N .7 (our production function) %ΔY = %ΔA + .3%ΔK + .7%ΔN 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). %Δ(Y/pop) = %ΔA + .3%Δ(K/pop) + .7%Δ(N/pop) or %Δ(Y/N) = %ΔA + .3%Δ(K/N)

9. Productivity During Recession Y/N evolves by: Y falling (holding N constant) decreases Y/N N falling (holding Y constant) increases Y/N In recessions, both Y and N fall. The question of interest: Does Y or N fall more during a recession?

10. Output Per Worker (All Sectors): 1970Q1 – 2012Q2

11. Output Per Worker (Manufacturing): 1970Q1 – 2012Q2

12. Summary During recent recessions: N falls more than Y Y/N (a measure of productivity) actually increases We are producing more stuff – with less workers – during the recession! Note: The fact that productivity increases during recent recoveries is directly linked to the fact that recent recoveries have been “jobless” (discussed in lecture 1). The economy recovers but employment lags. Why are there jobless recoveries? Readings: #5,6, 35

13. The Role of Investment and Growth Does a one time increase ininvestment today increase Y/N today? YES! Does a one time increase ininvestment 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(t+1) = (1-δ) K(t) + I(t) Definition of Capital Stock Evolution or ΔK(t, t+1) = I(t) - δ 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).

14. Time Path of Capital Stock: One Time Increase in I K No investment No investment time t+1 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.

15. Can Higher Investment Lead to Infinite Growth? Does a sustained increase ininvestment increase Y/N today? YES! Does a sustained increase ininvestment 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 > δ K: But, notice that δK 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 δK 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.

16. 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 t+1 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.

17. 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!!!!!)

18. 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).

19. 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. Reading: #102, 103 (you can read for reference – fit in with topics later in the course as well)

20. Distribution of World GDP in 2011 (WorldBank, $)

21. Distribution of World GDP in 2009 (IMF, $)

22. 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.

23. 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.

24. Growth Rate of GDP Per Capita: 1960 - 2000 From Barro, 2003 – includes 111 countries.

25. Relative Growth Rate of GDP Per Capita: 1960 - 1988 U.S. is anchored at 1 in both years. Countries above the line have made gains relative to U.S.

26. Convergence of Income Across U.S. States: 1940 - 1980

27. Convergence of Income Across U.S. States: 1980 - 2000

28. The Importance of Economic Growth Baseline: Y/person in U.S. grows roughly by 2%/year (real). Assume a constant growth rate of 2% per year (real) for next 30 years. After 30 years, U.S. Y/person will be 81% higher than today. Scenario 1: Major recession today Suppose U.S. Y/person contracts 3% this year and next and then grows at 2% for next 28 years. After 30 years, U.S. Y/person will be 64% higher than today.

29. The Importance of Economic Growth Scenario 2: Major recession today and we fight it using tax and spending policy with little detriment to future growth Suppose U.S. Y/person grows at -1% this year, 0% next and then grows at 1.9% for next 28 years. After 30 years, U.S. Y/person will be 68% higher than today. Take Away: Y/person in the future is HIGHER relative to doing nothing! 68% > 64%

30. The Importance of Economic Growth Scenario 3: Major recession today and we fight it using tax and spending policy with BIG detriment to future growth Suppose U.S. Y/person grows at -1% this year, 0% next and then grows at 1.7% for next 28 years. After 30 years, U.S. Y/person will be 59% higher than today. Take Away: Y/person in the future is LOWER relative to doing nothing! 59% < 64% Conclusion: Fighting recessions today may have affects on future growth. Benefits of fighting recession depends on whether the policies used to prevent the recession affect future growth!

31. Bonus Section New Research Project: “The Allocation of Talent and Economic Growth” (Trying to Shed Light on the Black Box of TFP Growth)

32. Measuring TFP (A) • The way TFP (A) is usually measured is via a statistical decomposition (referred to as the “Solow Residual”). • Remember our assumed production function: Y = AK.3N.7 • 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) + α0ln(K) + α1ln(N) (where α0 = 1 – α1 ≈ 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.

33. 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.

34. Our Project 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 HUGE changes in the allocation of women and blacks 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?

35. 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. 19602006-2008 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

36. 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%

37. 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) 196019802008 White Women -0.56 -0.47 -0.26 Black Men -0.37 -0.21 -0.16 Black Women -0.82 -0.47 -0.31

38. Findings Macro Implications: o 15% − 20% of total wage growth in the U.S. between 1960 and 2008 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.

39. Counterfactual 1: 1960 δ’s Counterfactual 2: 2008 δ’s -15% Results/Counterfactuals: Model 1 • Base Model Prediction: 76.6% income increase (1.2 percent/year) • Increase explained by changing δ’s: 12.2 percentage points (chained weighted, avg.) • Percent of growth explained by changing δ’s: ~20%

40. Sub-Section B The Labor Market

41. 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). <<This is straight from micro>> • 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 > w/p then the firm can increase profits by increasing N. • If MPN < w/p then the firm can increase profits by decreasing N. Reading: Notes 4 from the supplemental notes

42. The Labor Demand Curve real wage w/p * MPN = Nd N N*

43. Notes on the Labor Demand Curve • Nd slopes downward (Nd = MPN = .7A * (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).

44. 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 Household’s 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)

45. The Labor Supply Curve Ns(PVLR, tc, tn, pop, VL) w/p N

46. 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. <<This is why the labor supply curve slopes upwards!!>> • 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.

47. 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 less/more (reservation wage). (Welfare programs, child care, etc.). • Working Age Population: Usually defined as 16-64. (Includes changes in Labor Force Participation Rates) Reading: #34

48. 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).

49. Temporary Increase in A Ns(PVLR, tc, tn, pop, VL) w/p w/p * N d(A,K) N N*

50. Permanent Increase in A Ns(PVLR, tc, tn, pop, VL) w/p w/p * N d(A,K) N N*