The Labor Market
The demand for labor is the relationship between the quantity of labor demanded and the real wage rate.
The real wage rate equals the money wage rate divided by the price level. The real wage rate is the quantity of goods and services that an hour of labor earns and the money wage rate is the number of dollars that an hour of labor earns.
Because
of diminishing returns, firms hire more labor only if the real wage
falls to reflect the fall in the additional output the labor
produces. There is a negative relationship between the real wage rate
and the quantity of labor demanded so, as illustrated in the figure,
the demand for labor curve is downward sloping.
The supply of labor is the relationship between the quantity of labor supplied and the real wage rate.
An increase in the real wage rate influences people to work more hours and also increases labor force participation. These factors mean there is a positive relationship between the real wage rate and the quantity of labor supplied so, as illustrated in the figure, the supply of labor curve is upward sloping.
In the labor market, the real wage rate adjusts to equate the quantity of labor supplied to the quantity of labor demanded. In equilibrium, the labor market is at full employment. In the figure, the equilibrium quantity of employment is 200 billions of hours per year.
Potential GDP is the level of production produced by the full employment quantity of labor. In combination with the production function shown in the previous figure, the labor market equilibrium in the figure of 200 billion hours per year means that potential GDP is $12 trillion.
W
hat
Makes Potential GDP Grow?
Potential GDP grows when the supply of labor grows and when labor productivity grows.
The supply of labor increases if average hours per worker increases, if the employment-to-population ratio increases, or if the working-age population increases. Only increases in the working-age population can cause persisting economic growth. Persisting increases in the working-age population result from population growth.
A
n
increase in population increases the supply of labor, which shifts
the labor supply curve rightward. The real wage rate falls and the
quantity of employment increases. The increase in employment leads to
a movement along the production function to a higher level of
potential GDP.
An increase in labor productivity increases the demand for labor and shifts the production function upward.
As the top figure illustrates, the increase in the demand for labor from LD0 to LD1 raises the real wage rate. The bottom figure shows that the production function has shifted upward, from PF0 to PF1. An increase in labor productivity leads to an increase in real GDP per person and increases the standard of living.
Why Labor Productivity Grows
Preconditions for Labor Productivity Growth
The institutions of markets, property rights, and monetary exchange create incentives for people to engage in activities that create economic growth and are preconditions for growth in labor productivity. Market prices send signals to buyers and sellers that create incentives to increase or decrease the quantities demanded and supplied. Property rights create incentives save and invest in new capital and develop new technologies. Monetary exchange creates incentives for people to specialize and trade.
Persistent growth requires that people face incentives to create:
Physical Capital Growth: Saving and investing in new capital expands production possibilities.
Human Capital Growth: Investing in human capital speeds growth because human capital is a fundamental source of increased productivity and technological advance.
Technological Advances: Technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to economic growth.