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8.5.1EMPLOYMENT LEGISLATION

Labour market flexibility is a term often used in the explanation for differences between unemployment rates across countries.

Labour market flexibility: the ability of the labour market to adjust to economic shocks.

Countries differ significantly in their legal requirements in terms of hiring and firing workers. These differences can be found, for example, in redundancy payment requirements, notice requirements prior to redundancy, and in government policy on corporate restructuring. Research shows that the labour market of the United States is the most flexible in the OECD since there are few administrative requirements firms must observe before they can make workers redundant and neither notice nor severance pay are general legal requirements. By contrast, employment protection policies across Europe are much stronger. There is, however, a debate on the effects of more flexible labour markets on income inequality (which we address in Chapter 9) that indicates that labour market flexibility is not without costs.

Theoretically at least, better worker protection can have positive labour market effects through increasing workers’ motivation following on from job security. Negative effects are also possible since firms’ hiring decisions are in the knowledge of the difficulties of letting people go, if required, and so with higher redundancy costs, lower employment levels are likely.

There is some general consensus on the effects of labour protection legislation from research on OECD countries’ experiences (published in their Employment Outlook). First, low employment rates are associated with countries that have strong labour protection policies because it is more costly to hire workers. Second, there is no statistical correlation between unemployment and labour protection legislation. This is due to effects of the legislation regarding part-time workers, who have similar rights to full-time workers. There is a lower incentive to firms to offer part-time jobs when employment legislation is strong. A significant portion of workers who work part-time are women, hence, there are implications for female participation in the workforce. Lower participation is a corollary of strong employment legislation. Third, job security is higher and people hold jobs for longer when employment legislation is strong. Fourth, unemployment tends to last longer, on average, when employment legislation is strong. Somewhat paradoxically the conclusion is that unemployed workers appear to carry the costs of strong labour legislation while the employed carry

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the benefits. This is logical in terms of political economy explanations where strong unions can lobby government to enact legislation protecting their membership.

As with most economic issues finding a solution to unemployment is complex and can require a range of coordinated policies to achieve a satisfactory outcome. Since countries (and regions within them) are characterized by specific economic circumstances, what addresses one problem would not be appropriate in dissimilar situations. Economic analysis helps to understand what precisely characterizes the unemployment situation so that appropriate remedies can be found and enacted.

8 . 6 S U M M A R Y

•When the economy is out of long-run macroeconomic equilibrium, inflation and/or unemployment can result in the short run.

•Minimum wages and their effects can be considered via the labour market model although efficiency wages should be considered before drawing conclusions based on the model alone.

•Classical and Keynesian analyses of unemployment incorporate different assumptions about how the economy adjusts.

•Unemployment may be analysed by considering the recessionary gap approach using the aggregate demand and aggregate supply model.

•The sources of inflation – demand-pull and cost-push – can be analysed using the aggregate demand and aggregate supply model. The same model allows for consideration of an economy operating above its short-run capacity when an inflationary gap is said to exist. Both classical and Keynesian approaches can be used to analyse how the economy can eliminate an inflationary gap.

•Several hypotheses have been put forward to explain why aggregate prices tend to increase over time. International trends in oil prices have played a role in international inflation patterns.

•Governments may contribute to creating inflation.

•Several costs arise from inflation, both anticipated and unanticipated.

•The relationship between unemployment and inflation, called the Phillips curve, states that high unemployment is associated with low inflation and vice versa.

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•A model of the determination of the natural rate of unemployment implies that inflation and unemployment can occur simultaneously in an economy. Conclusions can be drawn on how to try to address the unemployment problem.

R E V I E W P R O B L E M S A N D Q U E S T I O N S

1.Use the labour market supply and demand model to show and explain the effects of the imposition of a minimum wage on unemployment and the wage rate. What factors outside your model might also have an impact on your conclusions regarding the level of unemployment?

2.Use the labour market supply and demand model to explain the different approaches of Keynesian and classical economists to how an economy reacts to unemployment.

3.Explain what is meant by a recessionary gap.

a)From a Keynesian perspective how can a recessionary gap be eliminated?

b)From a classical perspective how can a recessionary gap be eliminated?

4.Explain, using a figure of aggregate demand and aggregate supply, the difference between demand-pull and cost-push inflation and their respective impacts on macroeconomic equilibrium.

5.Explain what is meant by an inflationary gap.

a)from a Keynesian perspective how can a inflationary gap be eliminated?

b)from a classical perspective how can a inflationary gap be eliminated?

6.What are the main trends evident in the CPI of industrialized countries? Can you identify reasons behind the trends?

7.What is the Phillips curve (include a graph in your answer) and what are its implications for government policy on employment or inflation?

8.Describe the main elements of the model of the natural rate of unemployment. How according to the model is the natural rate determined?

F U R T H E R R E A D I N G A N D R E S E A R C H

•For an examination of labour mobility within the EU see sections 21.4 onwards in Mayes, 2001, ch. 21, 472–497.

•For literature on the effects of minimum wages see Brown, 1988; and Economic Journal, 2004.

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•For recent consideration of the Phillips curve see Lansing, 2002; and Mankiw, 2000.

R E F E R E N C E S

Brown, C. (1988) ‘Minimum wage laws: are they overrated?’ Journal of Economic Perspectives, 2(2), 133–145.

Economic Journal (2004), 114(494), 86–116, March.

Friedman, M. (1968) ‘The role of monetary policy’, American Economic Review, 58(1), 1–17.

Lansing, K. (2002) ‘Can the Phillips curve help forecast inflation?’ Federal Reserve Bank of San Francisco Economic Letter, No. 2002–29.

Mankiw, N. (2000) ‘The inexorable and mysterious tradeoff between inflation and unemployment’, Economic Journal, 111, c45–61.

Mayes, D. (2001) ‘Factor mobility’, in El-Agraa, A. (ed.) The European Union, Economics and Policies. 6th edn, Pearson, 472–497.

Miles, D. and A. Scott (2002) Macroeconomics: Understanding the wealth of nations. John Wiley & Sons, Ltd.

Mitchell, B. (1988) British Historical Statistics. Cambridge University Press, London. OECD (2004) ‘Standardised unemployment rates in 27 OECD countries’, OECD

Employment Outlook.

Phelps, E. (1967) ‘Phillips curves, expectations of inflation and optimal employment over time’, Economica, 34(3), 254–281.

Phillips, A. (1958) ‘The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 1861–1957’, Economica, 25(2), 283–299.

C H A P T E R 9

D E V E L O P I N G T H E

E C O N O M I C S Y S T E M :

G R O W T H A N D I N C O M E

D I S T R I B U T I O N

L E A R N I N G O U T C O M E S

By the end of this chapter you should be able to:

Describe the relationship between the level of people’s living standards and their economy’s level of labour productivity.

Reason as to why economic growth matters for people’s living standards.

Illustrate why rising productivity may not always translate into rising living standards.

Explain the main elements of the Solow model of growth and its main conclusions.

•Use the model to illustrate the effect of changes in savings for an economy.

•Use the model to illustrate the effect of changes in the labour input on an economy.

• Use the model to illustrate the effect of changes in technology on an economy.

Assess productivity growth patterns across countries to identify their main sources of growth.

Clarify the extension to the Solow model as outlined in newer (endogenous growth) models.

Comment on the main trends in international income distribution and their implications for welfare and equity.

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9 . 1 I N T R O D U C T I O N

One of the most fundamental and important economic issues, especially from a macroeconomic perspective, is that of economic growth. This issue focuses on how an economy can achieve a sustainable level of growth in economic activity that generates improvements in people’s living standards – real output per capita. Although this is of macroeconomic interest, given our earlier examination of how firms operate and attempt to maximize their profits, it is clear that what happens at the firm and microeconomic level impacts on living standards also – firms and their employees produce the real output. Understanding the determinants of economic growth is vital for identifying the links that exist within the economic system that impact on the level of aggregate economic activity and on its rate of growth. This is the focus of the first four sections of this chapter. In section 9.2 trends in living standards are presented and the relationship between living standards and labour productivity is explained. While rising labour productivity is one necessary condition for economic growth we will see that it is not sufficient on its own to ensure rising living standards, which is of key interest to economists.

The rate at which an economy grows or expands is usually quoted in terms of the annual percentage increase (or decrease) in GDP or GNP. The long-run implications of high or low economic growth are considered in section 9.3. The central model used to consider growth – the Solow growth model – is presented in section 9.4, where the effects of changes in savings behaviour, in employment, in capital investment and in technology for economic growth are all considered. Recent extensions to the model are also considered in terms of examining potential causes of changes in technology.

In section 9.5 the focus turns to the manner in which the ‘spoils’ generated by economic activity are distributed. The distribution of income across and within countries is examined and the extent to which these have changed over time is considered.

9 . 2 L I V I N G S T A N D A R D S A N D L A B O U R P R O D U C T I V I T Y R E L A T I O N S H I P S

Examining the trend in living standards over time reveals the pattern of living standards across economies. Table 9.1 provides some data on living standards over time.

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T A B L E 9 . 1 G D P P E R C A S E L E C T E D C O U N T R I E S ,

P I T A G R O W T H , I N % , 1 9 6 0 – 2 0 0 0

		1960 – 80	1980 – 2000	Change
High HDIa	Austria	104	42
	Belgium	102	67
	Cyprus	160	122
	Czech Republicb	133	0.5
	Denmark	68	49
	Finland	105	56
	France	102	40
	Greece	182	34
	Hungary	170	4
	Ireland	106	144
	Italy	126	43
	Japan	241	54
	Latviab (from 1965)	103	−22
	Luxembourg	50	122
	Netherlands	86	47
	Polandb (from 1970)	50	25
	Portugal	167	82
	Spain	137	68
	Sweden	64	34
	United Kingdom	49	55
	United States	55	56
Middle HDI	Chinab	71	180
	Indiab	15	102
	Malaysiab	168	85
	Romaniab	229	10
	Turkeyb	77	53
Low HDI	Burkina Fasob	0.22	26
	Malib	−0.6	6
	Nigerb	35	−37
	Sierra Leoneb	30	−60

Source: Excerpted from Table 1 in Weisbrot, Naiman and Kim (2000).

a HDI denotes the human development index reported by the United Nations, and explained in the text. b Data taken from Penn World Table 5.6 (Heston et al., 2002). Czech Republic and Latvian data finish in 1997.

Note: As mentioned in Chapter 1, updated Penn World Tables (version 6.1) are available at the Center for International Comparisons at the University of Pennsylvania. See http://pwt.econ.upenn.edu/

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A broad cross-section of countries is included in Table 9.1 ranked in groups according to their human development index (HDI) score in 2004. The HDI is based not on income solely but also includes criteria including health, education, life expectancy, income, poverty levels and environmental quality.

The broad trend that emerges is there has been a slowdown in economic growth, measured as GDP per capital internationally over the periods 1960 to 1980 and 1980 to 2000. The first period includes the ‘Golden Age’ period between 1950 and 1973 following World War Two and prior to the first oil-price shock when economies internationally, particularly the industrialized countries, expanded substantially. A minority of countries (highlighted in italics in Table 9.1) experienced higher growth in GDP per capita in the second period.

While real output per capita provides an indicator of living standards, another measure – real output per person employed – provides information on the productivity of an economy’s workforce. This measure is called labour productivity.

Labour productivity: the amount of real output, on average, produced by each worker in the economy. It is computed as

Real output

.

Workers employed

Measurement of labour productivity differs from living standards in terms of the denominator used because living standards is computed as

Real output

.

Population

In 2003 Finland’s real output was approximately ¤137bn (quoted in 2000 prices) and the number of workers employed was 2 365 000 (see http://

www.stat.fi for statistical information; figures for real GDP are taken from http: //www.stat.fi/tk/tp/tasku/taskue kansantalous.html while numbers employed is available at http://www.stat.fi/tk/tp/tasku/taskue tyoelama.html). Computing Finnish labour productivity yields a figure of ¤57 928. Comparing this to 2002 when real output was ¤134.5bn (in 2000 prices) and 2 372 000 workers were employed indicates that labour productivity was ¤56 703.

Repeating this exercise for 2001 gives rise to a figure of ¤55 555 (¤131.5bn/2 367 000). Hence we can say that real labour productivity increased

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in this economy between 2001 and 2003. This means that each worker on average increased the quantity of goods/services they produced.

The corresponding figures for living standards can be computed using figures for population. The population figure for 2001 was 5 201 000 and for 2002 (latest available data) was slightly higher at 5 213 000. Hence, living standards for each Finnish resident in 2002 were ¤25 801 and in 2001 were ¤25 284 indicating a rise in living standards of 2.04%. Over the same period the rise in labour productivity was quite similar at 2.06%.

When labour productivity rises over time this means that output is growing at a faster rate than the number of workers employed (the labour input). The importance of labour productivity for economic growth is evident if we consider that increased labour productivity reflects an increase in the productive efficiency of an economy. An economy that is able to increase the real output of the average worker may be making more efficient use of available resources, using them in more productive ways. In terms of our discussion of the production possibility frontier (refer back to Chapter 1), an economy that increases its average labour productivity with no change in the amount of available resources or technology over time experiences efficiency that allows it to increase its output and move its production point closer to its PPF. This would represent an improvement in the technical efficiency of the economy as better ways of using the resources are put in place. If more and more firms in an economy adopt the ‘best practice’ methods for producing their goods and services, technical efficiency would improve.

Logically, any barriers to the dissemination of best practice methods have repercussions for efficiency and it would be in the economy’s interest to eliminate such barriers where possible. Firms that are in industry or trade associations whereby they visit each others’ premises or are in regular contact and are aware of how best to produce their output are usually quick to implement and imitate improvements introduced by their peers, which has a positive impact on the firms and on the economy as labour productivity could also be expected to rise in an economy that applies improved technology.

In the 1970s and 1980s many international manufacturing companies tried to imitate the best practice production methods originating in Japan that allowed Japanese producers to become efficient and competitive in many consumer

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electronics products and in the car/automobile markets. Many firms in the USA, and elsewhere, found it difficult to produce products that could compete on price and quality relative to the available Japanese alternatives. Some firms went out of business, others attempted to adopt best practices, although this proved difficult since the Japanese model of production had many cultural aspects not easily imitated in non-Japanese firms.

Alternatively, an economy that experiences rising labour productivity might be enjoying the results of an increase in its resources (of capital, for example) available to each worker, allowing each worker to produce more. If the capital input expands because firms invest more in new machinery and equipment, for example, the country’s production possibility frontier moves outwards reflecting increases productive capacity of the economy. Again a higher amount of output can be produced caused by the rise in capital resources. If capital increases with no change in the labour input and output produced rises, once again labour productivity increases.

A complex mix of economic factors affect labour productivity and are, therefore, important in the context of economic growth. For example,

1.The income taxation structure within an economy can have significant implications for individuals’ incentives to work as individuals will not necessarily be willing to give up welfare payments if faced with poverty traps.

A poverty trap (also sometimes known as an unemployment trap) exists when the opportunity cost of moving from unemployment benefits to paid employment does not exist. Unemployed workers are often entitled to various benefits in addition to unemployment payments. These may include housing or rent allowances, reduced medical costs, food vouchers, etc. On taking up paid employment, especially of a low-paid nature, the benefits foregone may be greater than the wages earned. A vicious circle of poverty can be created which is difficult to break.

2.Women (and men) who opt to take care of children and not work outside the home may not be enticed into the workforce unless sufficient incentives exist to compensate them for childcare costs so that even if more employees are in demand by firms, they cannot attract additional workers without increasing wages.

3.High taxes on firms’ profits affect the location decisions of multinational firms and high employers’ taxes reduce their incentives to increase their workforce.