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. Highlight the link between output per worker and the number of workers. • 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! • Often cited “realistic” example of F(.) is a Cobb Douglas function: Y = A K1-α Nα 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 supplemental notes>>. • 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 = α A (K/N)1-α = α (Y/N) Fixing A and K, MPN falls when N increases MPK = (1-α) A (N/K)α= (1-α) (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 Production Function 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 = (α) * (Y/N) * (N/Y) (MPN) = α • Cobb-Douglas predicts a constant labor share of α (proves this to yourself). • Historically, α was stable at a level of about 0.7 (in notes, I often just set α = 0.7).

7. Rejection of Cobb-Douglas?: US Labor Share 1947Q1 – 2019Q1 Sharp Decline After 2000 Roughly Stable through 2000 • Note: Labor share measured as an index with 2000Q1 = 100

8. Manufacturing “Labor Share”: 1988Q1 – 2017Q1 • Note: Labor share measured as an index with 2000Q1 = 100

9. Thoughts? • Labor share is NOT constant over time – particularly for manufacturing. • At odds with Cobb-Douglas production function. • Automation may be reducing share of income accruing to workers. • This is something we will highlight during the class: o Historically capital/technology and labor were complements. o Now, capital/technology and labor are substitutes (particularly in manufacturing. • What changed? Is this a lasting change or will things revert? • For rest of class, our default will be Cobb-Douglas. But, we will discuss its limitations throughout.

10. Sub-Section A Economic Growth

11. Two Measures of Productivity • Labor Productivity = Y/N = A (K/N)1-α 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)

12. Growth Accounting Y = A K1-α N α (our production function) %ΔY = %ΔA + (1-α)%ΔK + α%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 + (1-α)%Δ(K/pop) + α%Δ(N/pop) or %Δ(Y/N) = %ΔA + (1-α)%Δ(K/N)

13. 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-αNα • 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) + (1-α) ln(K) + αln(N) (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.

14. US TFP Growth: 1970Q1 – 2014Q1

15. 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 why TFP has changed over time by using detailed firm-level and household-level data to measure production and wages.

16. How is Labor Productivity Measured • Labor Productivity is easier to measure: Y/N • Y is usually “real GPD” • N is usually total hours worked

17. Nonfarm Business Labor Productivity Growth: 1970Q1 – 2019Q1 Puzzle?

18. Manufacturing Labor Productivity Growth: 1988Q1 – 2019Q1 Puzzle?

19. U.S. Labor Productivity Growth Over Time • 1900-1973: 2.4% per year • 1973-1995: 1.6% per year. • 1995-2004: 3.2% per year. (“Internet boom”) • 2004-2015: 1.3% per year Data from Baily and Montalbano 2016 (Brookings Institute)

20. Reminder: Broad Causes of Productivity Growth • By definition, changes in Y/N can be decomposed into: o changes in A (total factor productivity = TFP) o changes in K/N (capital deepening) o shifts in quality of N over time (measure N in hours not quality hours)

21. What Causes Sustained Growth ? • Empirically, when a country exhibits faster Y/N growth (controlling for changes in labor composition) ….. 33% typically comes from growth in K/N 67% typically comes from growth in A • Sustained Increases in the growth of A are the only thing that can cause a sustained growth in Y/N. • Key economic insight: It is hard to grow solely from changes in K/N ….. the reason is diminishing marginal product of capital. • There is no diminishing returns to TFP growth.

22. Sub-Section A1 Cross-Country Growth

23. 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.

24. Distribution of World GDP in 2017 (IMF, $)

25. World Nominal GDP Per Capita in 2018 (IMF, $) Note: Purchasing price parity adjusted

26. 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.

27. 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.

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

29. GDP per Capita in the United States, the United Kingdom, and Japan, 1870–2009 (Weil 2015) Sources: Maddison (1995), Heston, Summers, And Aten (2011).

30. The Distribution of Growth Rates, 1975–2009 (Weil 2015)

31. Per Capita GDP vs. Life Expectancy (Acemoglu 2005)

32. Sub-Section A2 Why is US Productivity Growth Currently Low?

33. Reminder: Broad Causes of Productivity Growth • Data from Baily and Montalbano 2016 (Brookings Institute) • MFP is their term for TFP (i.e., A) (it stands for “multi-factor productivity” which is • another way to refer to “total factor productivity”).

34. Fact 1: Labor productivity slowdown is in most developed economies • Data from Deloitte Insights (Majumdar, 2017) • Suggests US centric stories like “increased regulation” are not primary drivers.

35. Fact 2: Labor productivity slowdown is in most U.S. industries • Data from Baily and Montalbano 2016 (Brookings Institute) • Suggests stories like mismeasurement of IT industries is not primary driver.

36. Why is US Labor Productivity/TFP Growth Lower? • It is a puzzle! o It is not a mismeasurement story (see work by Booth’s Chad Syverson) o It is not a US only story (rules out US regulation as the main culprit) • Demographics? • Slower labor market adjustment to structural change? • Slowdown in convergence of women in the labor market? o See my work “The Allocation of Talent and US Economic Growth” (with Chang-Tai Hsieh (and others)) o Large gains by women in the US labor force between 1960 and 2000. o Since 2000, relative gains by women have stopped.

37. 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. 19602010 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

38. 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%

39. Wage Gaps Over Time: An Overview Log difference in annual earnings of full time workers, conditional on years of schooling, hours worked in last year and occupation controls (relative to White Men) 196019802010 White Women -0.56 -0.47 -0.26 Black Men -0.37 -0.21 -0.16 Black Women -0.82 -0.47 -0.31 The wage gap for women in 2010 gets even smaller when conditioning on actual experience (years in the work force)

40. Is 3 or 4 percent GDP growth per year possible? • Some politicians promise growth rates of 3 or 4 percent per year? o They do not specify – but, lets suppose they mean real growth. o They do not specify growth in Y or Y/N – the former is possible by increasing N. • Is 3 or 4 percent growth in Y/N per year possible? o Possible – maybe for short periods of time. o However, given U.S. history, it is very unlikely to get sustained 3 pecent growth. o Also, given current economic conditions, I do not think it is likely at all. • Can Presidents and Congress affect short run growth rates? o No! (unless we are in a recession) o At best, policy makers can affect growth rates in the long run by affecting TPF.

41. Summary • There is a productivity slowdown – likely a combination of many factors. • Do not believe politicians who tell you they can magically raise growth in Y/N to 3 or 4 percent per year. That is crazy talk. I would be ecstatic if we could increase growth to about 2% per year (i.e., return to our long run average). • Growth in immigration (N) can increase Y but not necessarily Y/N unless it affects A. • Note: Demand side factors do not affect growth conditional on A, K and N. Conditional on A, K and N, demand side factors will only affect prices. (We will prove that later in the course).

42. Sub-Section B The Labor Market

43. 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

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

45. 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).

46. 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)

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

48. 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.

49. 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)

50. 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).