Technological Progress, Employment and Living Standards in the Long Run

Question 1

Production Function

Answer 1

Let’s model a production function that explicitly includes capital goods and technology
* Cobb-Douglas production function (variant of a Solow growth model)

𝑌=𝐴𝐹(𝐾,𝑁) =𝐴𝐾^α𝑁^(1-α)

• K denotes capital stock
• A is the total factor productivity that also includes the
  technology in use
• α is the share of capital used and
  0<α<1
• Y and N are as in Unit 14

Question 2

Production function assumptions

Answer 2

The production function exhibits constant returns to scale
* Technological progress is labour-saving
* The production function is characterised by diminishing returns to capital

Dividing by N:
y = Ak^α

Question 3

What y = Ak^α shows

Answer 3

This equation shows that output per worker will depend on:
* capital per worker
* total factor productivity (including technology)
* This equation is what is shown by Figure 16.2 in the textbook and we can obtain the average product of capital and marginal product of capital from it

Question 4

Production function: APL

Answer 4

Technological progress rotates the production function upwards
* Offsets the diminishing marginal returns to capital
* Makes it profitable to invest domestically, leading to increased capital intensity

Question 5

Technology and living standards

Answer 5

Technological progress and capital goods accumulation are complementary:
* New technologies require new machines
* Technological advance is needed for increasingly capital-intensive methods of production to be profitable
* This process allows a sustained increase in average living standards

Question 6

Capital and labour productivity

Answer 6

Unlike our concave production function, capital productivity remained roughly constant over time in the technology leaders. Why?
* These countries experienced a combination of capital accumulation and technological progress
* Technological progress results in:
* Process innovation – new ways of making and delivering products
* Product innovation – firm brings new varieties and qualities of products to the market

Question 7

Beveridge Curve

Answer 7

Job creation is strongly procyclical whereas job destruction is countercyclical
* Let’s introduce a new curve: the Beveridge curve
* It shows the inverse relationship between the unemployment rate and the job vacancy rate

During recessions, firms post fewer vacancies and lay off workers
* During booms, firms post more vacancies and hire more workers

Question 8

Labour Market Matching

Answer 8

Newly posted vacancies are not filled instantly because of issues/frictions with labour market matching:
* Mismatch – unemployed workers may not have the skills required for the job; jobseekers and vacancies may be located in different parts of the country
* Jobseekers and/or employers may not know about each other (information frictions)
* Policies and technology can improve efficiency
* Industry-specific shocks or shocks that prevent workers from moving increase the mismatch (lower efficiency)

Question 9

Changes in the Beveridge curve

Answer 9

The Beveridge curve can shift over time
* The German Beveridge curve shifted closer to the origin due to reforms that helped unemployed workers find jobs
* The US curve shifted away from the origin due to a skill- based mismatch
and limited worker mobility (industry-specific shocks and housing crisis)

Question 10

Long run labour market model

Answer 10

Long run: output, employment, prices, wages, capital, institutions and technologies can all adjust
* What determines economic performance in the long run?
* Long run employment rate depends on how well
policies and institutions deal with:
* Work incentives - depends on long run wage
setting curve
* Investment incentives - depends on long run price setting curve

Question 11

Long run labour market model assumptions

Answer 11

In the long run labour market model, we assume:
* Firms are all of a given size
* Changes in capital stock determined by entry or exit of firms
* In the long run, firms can enter or exit * Constant returns to scale (CRS)
* Long-run equilibrium in the labour market:
* wages, employment level, and the number of firms are constant

Question 12

Equilibrium markup

Answer 12

Recall from Unit 7 and 14 markup, 𝜇 = 1/elasticity of demand
* High markup ⇒ firms enter
* Lower markup ⇒ firms exit
* Self-correcting process:
* More firms ⇒ more competition ⇒ higher elasticity of demand facing firms ⇒ lower markup ⇒ fewer firms
* Fewer firms ⇒ less competition ⇒ lower elasticity of demand facing firms ⇒ higher markup ⇒ new firms attracted

Question 13

What shifts the markup?

Answer 13

Improvement in business operating environment
* An improvement due to legislation (e.g., property protection)

Reduced costs, decreases markup as more firms enter as safer to operate

Question 14

LRPCS EQ

Answer 14

Equilibrium markup (𝜇∗) prod of labouir (lambda)
* Therefore, long-run price-setting curve is given as:

w = lambda(1-markup)

• Recall the CRS assumption: long-run price-setting curve is flat

Question 15

What shifts long run price setting curve

Answer 15

Long-run price-setting curve can be shifted by:
* Output per worker - price-setting curve is higher the higher is output per worker
* Mark-up - price-setting curve is higher the lower the long run μ at which firm entry and exit is zero

Question 16

What changes the markup at which entry and exit are zero?

Answer 16

Competition
* Risk of expropriation
* Quality of human capital or infrastructure (better or worse)
* Expected long run tax rates
* Opportunity cost of capital (e.g., interest rate on
bonds)
* Expected material costs (e.g., imported inputs)
* Expected profits on foreign investments
* As usual changes in the markup shifts the long run PS curve

Question 17

Technology and employment

Answer 17

New technology can increase both real wages and
employment in the long run
* What determines the rate of increase in the productivity of labour?
* Adjustment gap: the adjustment process takes time, and may involve job destruction in the short run
* Diffusion gap: the lag between the first introduction of an innovation and its general use
* It takes time for whole economy to adopt the innovation

Question 18

How does the economy move from an old to a new equilibrium?

Answer 18

Adjustment gap: the lag between some outside change in labour market conditions and the movement to the new equilibrium

Question 19

What changes the diffusion gap and size of the wage adjustment gap?

Answer 19

Public policies
* Trade unions
* Employment association practices

Question 20

Technological change can indirectly shift the wage- setting curve due to:

Answer 20

Fair shares bargaining by unions
* Policies to help those affected (e.g., employment protection laws)
* Greater disutility of effort
* Improvement in the reservation wage

Question 21

Institutions and policies

Answer 21

Why do some countries do better than others?
* Using the labour market model and Beveridge curve, to achieve ‘good’ economic performance, an economy must:
* Ensure the price setting curve shifts up more than the wage setting curve
* Adjust rapidly and fully so the whole economy benefits from technological progress
* The Beveridge curve summarizes the economy’s ability to rapidly redeploy displaced workers

Question 22

Cross-country differences are explained by:

Answer 22

Institutions – inclusive trade unions
* Inclusive trade union is one that represents many firms and sectors but chooses not to exercise maximum bargaining power because wage increases affect job creation in the long run
* Policies – well designed unemployment insurance schemes and job placement services can achieve low unemployment rates
* No magic formula: institutions and policies used differ across successful countries and over time

Question 23

Explaining unemployment

Answer 23

Norway - inclusive trade unions and employers’ associations:
* Set wage demands in accordance with the productivity of labour
* Supported legislation and policies that shifted the wage-setting curve downwards
* Long run employment expanded
* See also Denmark’s flexicurity

Japan:
* Employers’ associations coordinate wage setting across firms
* Corporations deliberately do not compete in hiring workers, to avoid raising wages
* Spain:
* A combination of non-inclusive unions and government legislation that protects jobs rather than workers
* May help to account for Spain’s ‘poor’ labour market performance

Question 24

Changing institutions

Answer 24

Institutions and policies make a big difference for
employment and wage growth
* But changing institutions or policies is difficult because
it creates winners and losers

Question 25

Netherlands and UK

Answer 25

Netherlands and UK: both had increased unemployment rates in the 1970s due to the oil price shocks and the increased bargaining power of labour
* Price-setting curve shifted down and wage-setting curve up
* But both countries managed to shift the wage-setting curve down:
* Netherlands – institutions became more inclusive (as in Norway)
* UK – policies reduced the power of non-inclusive unions
* Evidence of use of different institutions and policies to reduce unemployment rates