THEMES AND CAPSTONE UNITS
17: History, instability, and growth
18: Global economy
19: Inequality
21: Innovation
22: Politics and policy
UNIT 16
TECHNOLOGICAL PROGRESS,
EMPLOYMENT, AND LIVING
STANDARDS IN THE LONG RUN
HOW LONG-TERM TRENDS AND DIFFERENCES IN
LIVING STANDARDS AND UNEMPLOYMENT
BETWEEN COUNTRIES ARE THE RESULT OF
TECHNOLOGICAL PROGRESS, INSTITUTIONS, AND
POLICIES
• The increasing use of machinery and other capital goods in produc-
tion, along with technological progress made possible by increasing
knowledge, have been the foundation for rising living standards in the
long run.
• The ‘creative destruction’ of older ways of producing goods and
organizing production has led to continuous job loss as well as job
creation, but not higher unemployment in the long run.
• A country’s economic institutions and policies can be evaluated by their
capacity to keep involuntary unemployment low and to sustain increases
in real wages.
• Many successful economies have provided extensive forms of co-insur-
ance against the job losses arising from both creative destruction and
competition from other economies, so that most citizens of these
nations welcome both technological change and the global exchange of
goods and services.
• The main difference between high-performing economies and laggards
is that the institutions and policies of high performers incentivize their
main actors to increase the size of the pie, rather than fighting over the
size of their slice.
In 1412, the city council of Cologne prohibited the production of a
spinning wheel by a local craftsman because it feared unemployment
among textile manufacturers that used the hand spindle. In the sixteenth
century, new ribbon-weaving machines were banned in large parts of
Europe. In 1811, in the early stage of the Industrial Revolution in England,
the Luddite movement protested forcefully against new labour-saving
Eric Hobsbawm and George Rudé.
1969. Captain Swing. London:
Lawrence and Wishart.
Robot waiters
693
machinery, such as spinning machines that allowed one worker to produce
the amount of yarn previously produced by 200 workers. The movement
was led by a young unskilled artisan, Ned Ludd, who allegedly destroyed
the spinning machines.
The Swiss economist Jean-Charles-Léonard de Sismondi (1773–1842)
contemplated a new world ‘where the King sits alone on his island,
endlessly turning cranks to produce, with automatons, all that England now
manufactures’. The increasing use of information technology has caused
contemporary economists, including Jeremy Rifkin, to voice the same fears.
Sismondi and Rifkin made plausible arguments. But as we saw in Unit 1,
as a result of labour-saving innovations, many countries moved to the
upward part of the hockey stick and experienced sustained growth in living
standards. Workers were paid more–remember the real wage hockey stick
from Unit 2 (Figure 2.1). The ‘end of work’ also hasn’t happened yet, though
in 1932 Bertrand Russell, a philosopher, expressed anticipation rather than
fear of the end of work (https://tinyco.re/2000918), arguing that: ‘[T]here is
far too much work done in the world, that immense harm is caused by the
belief that work is virtuous, and that what needs to be preached in modern
industrial countries is quite different from what always has been preached.’
Technological progress has not created rising unemployment rates.
Instead it has raised the lowest wage that firms can pay while still covering
their costs. As a result, technological progress expands the resources the
firm has to invest in increasing production, and it also incentivizes
continued investment. By focusing only on the destruction of jobs, those
who worry about the end of work have ignored the fact that labour-saving
technological progress also induces the investment that helps to create jobs.
In most economies for which data is available, at least 10% of jobs are
destroyed every year, and about the same number of new ones are created.
In France or the UK, every 14 seconds a job is destroyed and another one
created. This is part of the creative destruction process at the heart of
capitalist economies that we described in Units 1 and 2.
Those who lose their jobs bear substantial costs in the short run. The
short run may not seem very short to them: it can last years or even
decades. Those who benefit may be the children of the handloom weaver
displaced by the power loom, or the children of the unemployed typist who
was displaced by the computer. They benefit by finding a job in an
occupation that is more productive than the job their parents did, and they
may share in the benefit from the new goods and services that are available
because the power loom or the computer exist.
The destructive part of creative destruction affects occupations that may
often be concentrated in particular regions, with large losses in wages and
jobs. Families and communities who are the losers often take generations to
recover. Like ‘short run’, the term ‘average’ often hides the costs to the
workers displaced and communities destroyed by the introduction of new
technologies.
Today, for example, information and communication technology (ICT) is
reshaping our societies. ICT is replacing much of routine labour, in many
cases further impoverishing the already poor. People who would have
previously anticipated rising living standards have fewer job opportunities.
Nevertheless, most people benefit from the fall in prices due to the new
technology. For better or worse, creative destruction as a result of techno-
logical progress is part of the dynamism of the capitalist economic system.
And while lives have been disrupted and the environment increasingly
Jeremy Rifkin. 1996. The End of
Work: The Decline of the Global
Labor Force and the Dawn of the
Post-Market Era. New York, NY:
G. P. Putnam’s Sons.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
694
threatened by this dynamism, the introduction of improved technologies is
also the key to rising living standards in the long run. We shall see that:
• technological change is constantly putting people out of work
• but the countries that have avoided high levels of unemployment are
among those in which the productivity of labour has increased the most
Figure 16.1 shows unemployment rates for 16 OECD countries from 1960
to 2019.
Unemployment rates were low and quite similar in the 1960s, and then
diverged in the 1970s, reflecting in part the different responses to the oil
shocks described in Unit 14. Of these countries, only Japan ( JPN), Austria
(AUT), and Norway (NOR) had unemployment rates that stayed below 6%
over the entire period. In Spain (SPA), unemployment was around 20%
from the mid 1980s to the end of the 1990s. It then halved in the 2000s
before jumping back above 20% following the financial crisis and Eurozone
crisis from 2009. In this respect Germany (GER) is unusual: unemployment
fell in the years following the global financial crisis.
While there has been no upward trend in unemployment rates over the
long run, there have been two important developments in the labour
market that have accompanied the growth in living standards. As we saw in
Unit 3 (Figure 3.1), average annual hours worked by people with jobs have
fallen. In addition, a larger fraction of adults are working for pay, which is
mainly due to the rise in the proportion of women who do paid work.
The patterns of unemployment in Figure 16.1 are not explained by
national differences in the rate of innovation, or waves of innovation over
time. They reflect differences in the institutions and policies in force in the
countries.
As production has become more capital-intensive, how have living stan-
dards improved over the long run without producing mass unemployment?
Divergent 1970s and 1980s Convergent 1990s and 2000s
1973 End of ‘golden age’
of capitalism
1973–74
First oil shock
1979–80
Second oil shock
2002–08 Third oil shock
2008 Start of global
financial crisis
0
8
15
23
30
19
60
–6
4
19
65
–6
9
19
70
–7
4
19
75
–7
9
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–8
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85
–8
9
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90
–9
4
19
95
–9
9
20
00
–0
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05
–0
9
20
10
–1
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9
Year
U
ne
m
pl
oy
m
en
tr
at
e
(%
)
SPA
IRL
ITA
FRA
FIN
SWE
US
CAN
UK
NLD
NZL
GER
AUS
AUT
JPN
NOR
Figure 16.1 Unemployment rates in selected OECD countries (1960–2019).
See more https://tinyco.re/9823123
Data from 1960–2004: David R Howell,
Dean Baker, Andrew Glyn, and John
Schmitt. 2007. ‘Are Protective Labor
Market Institutions at the Root of
Unemployment? A Critical Review of the
Evidence’ (https://tinyco.re/
2000761). Capitalism and Society 2 (1)
(January). Data from 2005 to 2019:
OECD. 2021. OECD Statistics
(https://tinyco.re/9377362).
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
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We begin by studying the accumulation of capital (the increasing stock of
machinery and equipment) and infrastructure (such as roads and ports),
which have always been fundamental to the dynamism of capitalism.
EXERCISE 16.1 WEALTH AND LIFE SATISFACTION
As we saw in Unit 3, technological progress increases your hourly pro-
ductivity. This means that by working the same number of hours you could
thus produce and consume more, or you can produce and consume the
same amount of goods while working fewer hours and enjoying more free
time.
The economist Olivier Blanchard argues that the difference in output
per capita between the US and France is partially due to the fact that
relative to those in the US, the French have used some of the increase in
productivity to enjoy more free time rather than raise consumption
(https://tinyco.re/2128090).
1. Think about two countries, one that has lower GDP per capita due to
fewer hours worked, and another that has higher GDP per capita due to
more hours worked (such as France and the US). Assuming that overall
life satisfaction consists only of free time and consumption, in which
country would you expect overall life satisfaction to be higher, and
why? Clearly state any assumptions you make about the preferences of
residents in each country.
2. Considering only working hours and GDP per capita, which country
(France or the US) would you prefer to live in, and why? How would
your answer change if you considered other factors as well?
QUESTION 16.1 CHOOSE THE CORRECT ANSWER(S)
Figure 16.1 (page 695) is a graph of unemployment rates for 16 OECD
countries from 1960 to 2019.
Based on this information, which of the following statements is
correct?
There is no correlation between unemployment rates across coun-
tries.
There has been a clear upward trend in unemployment in all coun-
tries in the last 30 years.
The unemployment rates of different countries were affected very
differently by the oil shocks of the 1970s.
The unemployment rate rose in all countries following the 2008
global financial crisis.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
696
innovation rents Profits in excess of
the opportunity cost of capital that
an innovator gets by introducing a
new technology, organizational
form, or marketing strategy. Also
known as: Schumpeterian rents.
creative destruction Joseph
Schumpeter’s name for the process
by which old technologies and the
firms that do not adapt are swept
away by the new, because they
cannot compete in the market. In
his view, the failure of unprofitable
firms is creative because it releases
labour and capital goods for use in
new combinations.
capital goods The durable and
costly non-labour inputs used in
production (machinery, buildings)
not including some essential inputs,
e.g. air, water, knowledge that are
used in production at zero cost to
the user.
capital-intensive Making greater
use of capital goods (for example
machinery and equipment) as
compared with labour and other
inputs. See also: labour-intensive.
labour productivity Total output
divided by the number of hours or
some other measure of labour
input.
••16.1 TECHNOLOGICAL PROGRESS AND LIVING
STANDARDS
In Unit 2 we saw how firms could earn Schumpeterian innovation rents
by introducing new technology. Firms that fail to innovate (or copy other
innovators) are unable to sell their product for a price above the cost of pro-
duction, and eventually fail. This process of creative destruction led to
sustained increases in living standards on average because technological
progress and the accumulation of capital goods are complementary: each
provides the conditions necessary for the other to proceed.
• New technologies require new machines: The accumulation of capital goods
is a necessary condition for the advance of technology, as we saw in the
case of the spinning jenny.
• Technological advance is required to sustain the process of capital goods
accumulation: It means that the introduction of increasingly capital-
intensive methods of production continues to be profitable.
The second point here needs explanation. Start with the production func-
tion that we used in Units 2 and 3. We discovered that output depends on
labour input, and that the function describing this relationship shifts
upward with technological progress, so that the same amount of labour
now produces more output. In Unit 3 the farmer had a fixed amount of
land: we assumed the amount of capital goods was fixed. But as we have
seen, the amount of capital goods which the modern worker uses is vastly
greater than that used by farmers in the past.
Now we include capital goods (machinery, equipment, and structures)
explicitly in the production function. If you look at the horizontal axis in
Figure 16.2, you will see that it records the amount of capital goods per
worker. This is a measure of what is called the capital intensity of produc-
tion. On the vertical axis, we have the amount of output per worker, also
known as labour productivity.
As was the case in Unit 3, the production function describes diminishing
marginal returns: as the worker works with more capital goods, output
increases, but at a diminishing rate (Charlie Chaplin showed in the 1936
film Modern Times (https://tinyco.re/2139871) that there is a limit to the
number of machines a worker can make use of). This means that with
increasing quantities of capital goods, we have a diminishing marginal
product of capital goods. The slope of the production function at each level
of capital per worker shows the marginal product of capital. It shows how
much output increases if capital equipment per worker increases by one
unit.
The magnified section at point A in Figure 16.2 shows how the marginal
product of capital is calculated: note that Y/worker is used as shorthand for
output per worker, and the marginal product of capital (MPK) is ΔY/ΔK.
The marginal product of capital at each level of capital per worker is the
slope of the tangent to the production function at that point.
Previous Leibnizes have showed how to use calculus to calculate the
MPK at any point on a given production function. Take a moment to have
another look at them.
Leibniz: Malthusian economics
Leibniz: Labour and production
16.1 TECHNOLOGICAL PROGRESS AND LIVING STANDARDS
697
concave function A function of two
variables for which the line
segment between any two points
on the function lies entirely below
the curve representing the function
(the function is convex when the
line segment lies above the func-
tion).
We can see from Figure 16.2 that the marginal product of capital is
falling as we move along the production function. A production function
that exhibits diminishing returns to capital is concave. Concavity captures
the fact that output per worker increases with capital per worker, but less
than proportionally.
Concavity means that an economy will not be able to sustain growth in
output per worker simply by adding more of the same type of capital. At a
certain point, the marginal productivity of capital becomes so low that it is
not worth investing any further. As we saw in Unit 14, business owners will
invest domestically only if the return is higher than the return to buying
0
15
22.5
0 20 30
Average product
of capital, Y/K
B
C A
Production function (after
technological progress)
Marginal product
of capital at A = ΔY / ΔK
Production function
A
Δ(Y/worker)
Δ(K/worker)
O
ut
pu
t p
er
w
or
ke
r (
$
th
ou
sa
nd
s)
Capital equipment per worker ($ thousands)
Figure 16.2 The economy’s production function and technological progress.
1. Diminishing returns to capital
The production function is
characterized by diminishing returns to
capital.
2. The marginal product of capital
The magnified section at point A shows
how the marginal product of capital is
calculated: it is the slope of the tangent
to the production function at A.
3. Higher capital intensity
The marginal product of capital is
falling as we move along the produc-
tion function to higher capital intensity.
4. Technological progress
This rotates the production function
upward.
5. The original production function
At point B on the original production
function, capital per worker is $20,000
and output per worker is $15,000.
6. After technological progress
Consider point C on the new produc-
tion function (after technological
progress), at which capital per worker
has risen to $30,000 and output per
worker has risen to $22,500.
7. The slope of the production function
We have chosen point C so that the
slope of the production function, and
therefore the marginal product of
capital, is the same as at point B.
8. The average product of capital
The dotted blue line goes from the
origin through the production functions
for the old and new technologies. Its
slope is the average product of capital.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
698
Taylorism Innovation in
management that seeks to reduce
labour costs, for example by
dividing skilled jobs into separate
less-skilled tasks so as to lower
wages.
bonds (the yield) or investing abroad, and at the same time, high enough
that they do not simply want to spend their profits on consumption goods.
Sustained economic growth requires technological change that increases
the marginal productivity of capital. This rotates the production function
upwards and makes it profitable to invest domestically, leading to increased
capital intensity. Follow the steps in the analysis in Figure 16.2 to see how
the combination of technological change and capital investment raises
output per worker.
New technology can also refer to new ways of organizing work.
Remember that a technology is a set of instructions for combining inputs to
make output. The managerial revolution in the early twentieth century
called Taylorism is a good example: labour and capital equipment were
reorganized in a streamlined way, and new systems of supervision were
introduced to make workers work harder. More recently, the information
technology revolution allows one engineer to be connected with thousands
of other engineers and machines all over the world. The ICT revolution
therefore rotates the production function upward, increasing its slope at
every level of capital per worker.
In Figure 16.2, you can see a dotted blue line from the origin through the
production functions for the old and new technologies. The slope of this
line tells us the amount of output per unit of capital goods at the point
where it intersects the production function: it is the amount of output per
worker divided by the capital goods per worker. From the diagram, we note
that points B and C on the two production functions have the same output
per unit of capital goods.
To see how technological progress and capital accumulation shaped the
world, we focus on the countries that have been the technology leaders.
Britain was the technological leader from the Industrial Revolution until
the eve of the First World War, when the US took over leadership. Figure
16.3 has capital per worker on the horizontal axis and output per worker on
the vertical axis.
We can now look at the path traced out over time by the UK and the US.
Looking first at Britain, the data begins in 1760 (the bottom corner of the
chart) and ends in 1990 with much higher capital intensity and productiv-
ity. The bottom right-hand side of the diagram shows the same points in the
familiar hockey-stick chart for GDP per worker. As Britain moved up the
hockey stick over time, both capital intensity and productivity rose. In the
US, productivity overtook the UK by 1910 and has remained higher since.
In 1990, the US had higher productivity and capital intensity than the UK.
Figure 16.3 shows that the economies that are rich today have seen
labour productivity rise over time as they became more capital-intensive.
For example, if we look at the US, capital per worker (measured in 1985 US
dollars) rose from $4,325 in 1880 to $14,407 in 1953, and $34,705 in 1990.
Alongside this increase in capital intensity, US labour productivity rose
from $7,400 in 1880 to $21,610 in 1953, to $36,771 in 1990. John
Habakkuk, an economic historian, has argued that wages were high for
factory workers in the US in the late nineteenth century because they had
the option to move to the west of the country: therefore the factory owners
had the incentive to develop labour-saving technology.
Productivity growth has reduced labour input per unit of output: the
fear of the Luddites and the forecasts of the ‘end of work’ authors was that
this would cause permanent job loss.
John Habakkuk. 1967. American
and British Technology in the
Nineteenth Century: The Search
for Labour Saving Inventions.
United Kingdom: Cambridge Uni-
versity Press.
16.1 TECHNOLOGICAL PROGRESS AND LIVING STANDARDS
699
From Figure 16.3 it is clear that the historical paths traced out by these
economies are not curved like the single production function in Figure
16.2. This is because they experienced a combination of capital accumu-
lation and technological progress. Successfully growing economies move
along paths similar to the blue dotted line between B and C in Figure 16.2.
We know from Unit 1 that other economies moved up the hockey stick
at very different times. Consider Japan, Taiwan and India in Figure 16.3.
Notice that by 1990, capital per worker in Japan was not only higher than in
the US, but also almost twice as high as in Britain. Japan had reached this
level in less than half the time it took Britain. Taiwan in 1990 was also more
capital-intensive than Britain. The lead in mass production and science-
based industries that the US had established was eroded as other economies
invested in education and research, and adopted American management
techniques.
Interpreting Figure 16.3 using the model of the production function in
Figure 16.2 shows that economies adopted more capital-intensive methods
of production as they became richer. However, while Japan and Taiwan
both experienced substantial technological progress, the fact that output
per worker remained below that of both the US and Britain means that they
remained on a lower production function.
Richard R Nelson and Gavin
Wright. 1992. ‘The Rise and Fall of
American Technological
Leadership: The Postwar Era in
Historical Perspective’
(https://tinyco.re/2811203). Journal
of Economic Literature 30 (4)
(December): pp. 1931–1964.
1800
1910
1953
1990
1760
1910
1973
1990
1990
1990
1,000
10,000
100,000
1760 1790 1830 1870 1910 1950 1990
Year
G
D
P
pe
r
w
or
ke
r
(1
98
5
PP
P
$,
ra
tio
sc
al
e)
0
10,000
20,000
30,000
40,000
0 20,000 40,000 60,000 80,000
Capital per worker (1985 PPP $)
G
D
P
pe
rw
or
ke
r(
19
85
PP
P
$)
US (1880–1990)
UK (1760–1990)
Japan (1870–1990)
Taiwan (1901–1990)
Figure 16.3 Long-run growth trajectories of selected economies.
See more https://tinyco.re/4493012
Robert C. Allen. 2012. ‘Technology and
the Great Divergence: Global Economic
Development Since 1820’. Explorations
in Economic History 49 (1) (January):
pp. 1–16.
1. The UK
The data begins in 1760 at the bottom
corner of the chart, and ends in 1990
with much higher capital intensity and
productivity.
2. GDP per worker
The bottom right-hand side of the dia-
gram shows the same points in the
familiar hockey-stick chart for GDP per
worker, using the ratio scale.
3. The US
In the US, productivity overtook the UK
by 1910 and has remained higher since.
4. Japan, Taiwan, and India
The paths of Japan, Taiwan, and India
show that moving along the hockey-
stick curve of living standards requires
capital accumulation and the adoption
of new technology.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
700
To summarize:
• Technological progress shifted the production function up: It was stimulated
by the prospect of innovation rents.
• This offset the diminishing marginal returns to capital: Capital productivity,
measured by the slope of a ray from the origin, remained roughly con-
stant over time in the technology leaders.
Technological progress played a crucial role in preventing diminishing
returns from ending the long-run improvement in living standards
resulting from the accumulation of capital goods.
QUESTION 16.2 CHOOSE THE CORRECT ANSWER(S)
The following diagram shows an economy’s production function
before and after technological progress:
O
ut
pu
t p
er
w
or
ke
r (
$,
th
ou
sa
nd
s)
Capital equipment per worker ($, thousands)
0
15
22.5
0 20 30
B
C A
Production function (after
technological progress)
Production function
Based on this information, which of the following statements is
correct?
The average product of capital at B is 20,000 / 15,000 = 1.33.
The marginal product of capital at C is (22,500 – 15,000) / (30,000 –
20,000) = 0.75.
The concavity of the production function indicates a diminishing
marginal product of capital.
As a result of a technological progress, the marginal product of
capital rises but the average product of capital remains constant,
for a given level of capital per worker.
16.1 TECHNOLOGICAL PROGRESS AND LIVING STANDARDS
701
stock A quantity measured at a
point in time. Its units do not
depend on time. See also: flow.
flow A quantity measured per unit
of time, such as annual income or
hourly wage.
•••16.2 THE JOB CREATION AND DESTRUCTION PROCESS
Labour-saving technological progress of the type illustrated in Figures 16.2
and 16.3 allows more outputs to be produced with a given amount of
labour, and it also contributes to the expansion of production. By
incentivizing investment, it compensates for some of the jobs it has
destroyed, and may even create more jobs than previously existed. When
more jobs are created than destroyed in a given year, employment increases.
When more jobs are destroyed than created, employment decreases.
We know that at any moment there are some people who are
involuntarily unemployed. They would prefer to be working, but don’t have
a job. The number of unemployed people is a stock variable, measured
without a time dimension. It changes from day to day, or year to year, as
some of the jobless are hired (or give up seeking work), other people lose a
job, and yet others decide to seek work for the first time (young people
leaving school or university, for example). Those without work are some-
times called the ‘pool’ of the unemployed: people getting a job or ceasing to
look for one exit the pool, while those who lose their jobs enter the pool.
The number of people getting and losing jobs is a flow variable.
The total job reallocation process is the sum of job creation and
destruction. Compared to that, the net growth of employment is typically
small and positive.
Figure 16.4 shows the job destruction, job creation, and net employment
growth in some countries. Note that in the UK from 1980 to 1998, more jobs
were destroyed than created: net employment growth was negative. Across a
set of countries at different stages of development, and with different
openness to international trade, we see a fairly similar rate of job reallocation.
In most countries, about one-fifth of jobs are created or destroyed each year,
in spite of widely varying rates of net employment growth.
Now imagine an economic system in which new jobs are created at a
rate of 2% each year, and job destruction is banned (that is, the job
destruction rate is zero). This economy would also see a net employment
growth of 2%. This is what a planner might seek to do. Figure 16.4 shows
−4
−2
0
2
4
6
8
10
12
14
16
18
Germany
(77–99)
France
(99–00)
US
(88–97)
Chile
(79–99)
UK
(80–98)
Brazil
(96–01)
Pe
rc
en
ta
ge
of
em
pl
oy
m
en
t
Job destruction
Job creation
Net employment change
Figure 16.4 Job destruction, job creation, and net employment across countries.
John Haltiwanger, Stefano Scarpetta,
and Helena Schweiger. 2014. ‘Cross
Country Differences in Job Reallocation:
The Role of Industry, Firm Size and
Regulations’ (https://tinyco.re/
2719834). Labour Economics (26):
pp. 11–25.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
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this is not the way a capitalist economy works in practice: there is no
planner. Competition and the prospect of gaining economic rents both
mean that creating some jobs often implies destroying others.
To understand how job creation and destruction take place in an
industry, we look at the impact of the information technology revolution in
the US retail sector since the 1990s. The adoption of systems that electron-
ically link cash registers to scanners, credit card processing machines, and
to management systems for both inventories and customer relationships
allowed tremendous increases in output per worker. Think of the volume of
retail transactions handled per cashier in a new retail outlet.
Research shows that labour productivity growth in the retail sector was
entirely accounted for by more productive new establishments (such as
retail units or plants) displacing much less productive existing
establishments (including older establishments of the same firm, as well as
shops and plants owned by others, where jobs were lost).
We showed the massive expansion of employment in the US firm
Walmart in Figure 7.1 of Unit 7. Walmart’s growth was partly based on
opening more efficient out-of-town stores, made possible by new retail and
wholesale technologies.
For the manufacturing sector, detailed evidence collected from all the
firms in the economy shows how productivity growth takes place through
the creation and destruction of jobs inside firms, and by their entry and
exit. Data for Finland in the years from 1989 to 1994, for example, shows
that 58% of productivity growth took place within firms (similar to the
Walmart example). The exit of low-productivity firms contributed to a
quarter of the increase, and 17% was contributed by the reallocation of jobs
and output from low- to high-productivity firms.
The French construction industry provides another example of the
reallocation of work from weaker to stronger firms. According to the
French National Institute of Statistics, more of the jobs in the economy
were destroyed than created in firms with very low productivity (in the
bottom 25%). Between 1994 and 1997, these firms created 7.1% of new jobs
and destroyed 16.1%, implying that employment in those firms shrank by
9.0%. In contrast, job creation exceeded destruction (17.1% against 11.8%)
in the top 25% of construction firms.
EXERCISE 16.2 SCHUMPETER REVISITED
1. In Unit 2 we discussed how Joseph Schumpeter characterized capitalist
economies by the process of ‘creative destruction’. In your own words,
explain what this term means.
2. Based on this definition, give examples of destruction and creation, and
identify the winners and the losers in the short and long run.
16.2 THE JOB CREATION AND DESTRUCTION PROCESS
703
bargaining power The extent of a
person’s advantage in securing a
larger share of the economic rents
made possible by an interaction.
procyclical Tending to move in the
same direction as aggregate output
and employment over the business
cycle. See also: countercyclical.
countercyclical Tending to move in
the opposite direction to aggregate
output and employment over the
business cycle.
acyclical No tendency to move
either in the same or opposite
direction to aggregate output and
employment over the business
cycle.
co-insurance A means of pooling
savings across households in order
for a household to be able to
maintain consumption when it
experiences a temporary fall in
income or the need for greater
expenditure.
Beveridge curve The inverse rela-
tionship between the
unemployment rate and the job
vacancy rate (each expressed as a
fraction of the labour force).
Named after the British economist
of the same name.
•16.3 JOB FLOWS, WORKER FLOWS, AND THE
BEVERIDGE CURVE
Jobs are created and destroyed by business owners and managers seeking to
gain Schumpeterian innovation rents, and in response to the pressure of
competition in markets for goods and services. For most workers this
means that nothing is permanent: in the course of a lifetime, people move
in and out of many jobs (often not by choice). Sometimes people move from
job to job, but they move in and out of unemployment too.
In Unit 5, we looked at the decisions of an employer (Bruno) and an
employee (Angela) about her work hours and rent. Once Bruno’s gun was
replaced by a legal system and contracts, we saw that taking a job was a
voluntary arrangement entered into for mutual gain. The balance of bar-
gaining power may have been unequally distributed but the exchange was,
nevertheless, voluntary.
When a worker leaves a job, it may be voluntary, but it can also be an
involuntary temporary lay-off (dictated by product demand conditions
facing the firm), or a redundancy (the job has been eliminated).
Jobs are also created, as can be seen by the movement of job destruction
and creation in the US in Figure 16.5. Job creation is strongly procyclical:
this means that it rises in booms, and falls during recessions. Conversely,
job destruction is countercyclical: it rises during recessions (if the change
in a variable was not correlated with the business cycle, it would be called
acyclical). The next section will show how aggregate policies interact with
those movements in job flows and worker flows.
This intense job reallocation process and the ability of the government
to provide co-insurance led the English economist and politician Lord
William Beveridge (1879–1963) to become the founding father of the UK
social security system. He is also remembered among economists because,
like Bill Phillips, they bestowed on Beveridge one of their highest honours:
they named the Beveridge curve after him.
The Beveridge curve
Beveridge suggested a simple relationship between job vacancy rates (the
number of jobs available for workers) and the level of unemployment (the
number of workers looking for jobs), expressed as a fraction of the labour
force.
Beveridge noticed that when unemployment was high, the vacancy rate
was low; and when unemployment was low, the vacancy rate was high:
• During recessions, there will be high unemployment: When the demand for a
firm’s product is declining or growing slowly, firms can manage with
their current staff even if a few of them quit or retire. As a result, they
advertise fewer positions. In the same conditions of weak demand for
firms’ products, people will be laid off or their jobs entirely eliminated.
• During booms, unemployment will decline: The number of vacant jobs
posted by firms increases, and more workers will be employed to cope
with rising demand for products.
The downward-sloping relationship between the vacancy rate and the
unemployment rate over the business cycle is illustrated in Figure 16.6,
which shows two examples of what came to be called the Beveridge curve,
We met the concept of co-insur-
ance in Unit 13, when we
explained how households that
have been fortunate during a
particular period use their savings
to help a household hit by bad
luck, and in Unit 14, when we
explained how correlated risk
limits the usefulness of co-insur-
ance, helping to explain the
government’s role in providing co-
insurance through a system of
unemployment benefits.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
704
labour market matching The way
in which employers looking for
additional employees (that is, with
vacancies) meet people seeking a
new job.
using data from Germany and the US. Each dot represents a quarter, from
2001 Q1 until 2021 Q2.
Why are there vacant jobs that are not filled, and unemployed people
looking for a job at the same time? We can think of matching being tricky in
many parts of life. For example, think of our love lives: how often are we
looking for the perfect partner but are unable to find someone suitable?
Some factors prevent newly unemployed people from being matched
with newly posted jobs (we call this process labour market matching):
5.0
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9.0
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Em
pl
oy
m
en
t(
%
)
Job creation
Job destruction
Recession
Figure 16.5 Job creation and destruction during business cycles in the US (2000
Q1–2010 Q2).
Steven J. Davis, R. Jason Faberman, and
John C Haltiwanger. 2012. ‘Recruiting
Intensity During and After the Great
Recession: National and Industry
Evidence’ (https://tinyco.re/2991501).
American Economic Review 102 (3):
pp. 584–588.
US
2001 Q1
2009 Q4
2018 Q4
2020 Q2
2021 Q2
Germany
2001 Q1
2005 Q1
2009 Q2
2015 Q2
2021 Q2
0.0
1.0
2.0
3.0
4.0
5.0
6.0
0.0 3.0 6.0 9.0 12.0 15.0
Unemployment rate (%)
Va
ca
nc
y
ra
te
(%
)
Figure 16.6 Beveridge curves for the US and Germany (2001 Q1–2021 Q2).
OECD Employment Outlook and OECD
Labour Force Statistics: OECD. 2021.
OECD Statistics (https://tinyco.re/
9377362).
16.3 JOB FLOWS, WORKER FLOWS, AND THE BEVERIDGE CURVE
705
• A mismatch between the location and nature of the workers looking for jobs
and the jobs available for workers: This is sometimes a matter of skills
required by firms and the skills of jobseekers. For example, research
explains that one of the reasons for inefficiency in the US labour market
in recent years (https://tinyco.re/2991501) has been that vacancies are
concentrated in a few industries. The telephone engineer whose job was
recently eliminated may not have the computer skills required to fill the
vacancies in the company’s billing department. Or the redundant
workers and the vacancies may be located in different parts of the
country. Travelling to another area to find a job would mean severing
ties with neighbours, schools, and relatives.
• Either jobseekers or those seeking to hire may not have relevant information:
As we have seen in Unit 6, economic actors with different skills and
needs— jobseekers and firms in this example—look for opportunities for
mutual gains from trade. But the firm and the jobseeker may not know
about each other (although there is evidence that technology is
improving this matching process).
Matching should be easier when there is a larger pool of the unemployed
from which to select. Observing a combination of high unemployment and
a large number of vacancies is an indicator of inefficiency in the matching
process in the labour market.
Notice three things about the German and American Beveridge curves
shown in Figure 16.6:
• Both curves slope downward, as expected: The US data oscillates between
vacancy rates of about 3% with unemployment rates between 3% and 4%
(at the top of the business cycle), to vacancy rates of a little over 2% and
unemployment around 6% (at the trough of the cycle). A similar pattern
also holds if we look at more outlier data points such as those from 2020
Q2 to 2021 Q2.
• The position of each nation’s Beveridge curve is different: The German
labour market appears to do a better job of matching workers seeking
jobs to firms seeking workers. To see this, notice that the vacancy rate in
Germany for every year is lower than in the US for any year, although
the two countries experienced a common range of unemployment rates.
So, fewer job openings were wasted in Germany.
• Both the curves shifted over the course of the decade: The German curve, hav-
ing established itself over the period 2001 Q1 to 2005 Q1, turned towards
the origin and established a new Beveridge curve in the period 2009 Q2 to
2012 Q1. The latter Beveridge curve was closer to the origin, with a
smaller sum of the vacancy rate and the unemployment rate than before.
How did this improvement in the German labour market occur? New policies
called the Hartz reforms seemed to have worked. Enacted between 2003 and
2005, the Hartz reforms provided more adequate guidance to unemployed
workers in finding work and reduced the level of unemployment benefits
sooner, so as to provide the unemployed with a stronger motive to search.
The US curve shifted too, but unlike Germany, conditions deteriorated.
For the period 2001 Q1 to 2009 Q2, the US seems as if it is moving along a
curve. After that the curve moves out from the origin and then seems to
establish a new curve, above and to the right of the older one, suggesting
the American labour market became less efficient in matching workers to
Natasha Singer. 2014. ‘In the
Sharing Economy, Workers Find
Both Freedom and Uncertainty’
(https://tinyco.re/2844216). The
New York Times. Updated 16
August 2014.
Michael Burda and Jennifer Hunt.
2011. ‘The German Labour-Market
Miracle’ (https://tinyco.re/
2090811). VoxEU.org. Updated 2
November 2011.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
706
US
2001 Q1
2009 Q4
2018 Q4
2020 Q2
2021 Q2
Germany
2001 Q1
2005 Q1
2009 Q2
2015 Q2
2021 Q2
0.0
1.0
2.0
3.0
4.0
5.0
6.0
0.0 3.0 6.0 9.0 12.0 15.0
Unemployment rate (%)
Va
ca
nc
y
ra
te
(%
)
jobs. Between 2001 and 2008, business-cycle movements displaced workers
in all industries all over the country in the usual way, so there wasn’t much
of a geographical and skills mismatch between workers looking for work
and vacant jobs, so why did the Beveridge curve move?
• Many redundancies in one industry: The global financial crisis between
2008 and 2009, and the recession that followed, particularly affected the
housing construction industry. There was a skill-based mismatch
between the unemployed and vacancies available.
• The collapse of US housing prices: When house prices fell, many
homeowners were trapped in a house that was worth less than they had
paid for it. They could not sell their house and move to an area with
more job vacancies, and this restricted their choice of jobs.
The result was that the economy moved to a situation where, for a given
level of vacancies, there was a higher rate of unemployment.
EXERCISE 16.3 BEVERIDGE CURVES AND THE GERMAN
LABOUR MARKET
According to the Beveridge curves, the German labour
market does a better job at matching workers with job
openings, but over some intervals (for example, 2001
Q1 to 2005 Q1), average unemployment in Germany in
Figure 16.6 (page 705) was higher than in the US.
Consider the possible role of aggregate demand
(Section 13.2 on Okun’ law, and Section 14.10 on
aggregate demand and unemployment). What kind of
data could be used to find support for your hypothesis?
QUESTION 16.3 CHOOSE THE CORRECT ANSWER(S)
The graph shows the plot of Beveridge curves for the
US and Germany for the period 2001 Q1 to 2021 Q2.
Based on this information, which of the statements
below is correct?
The Beveridge curves depict the negative relation-
ship between the vacancy rate and the
employment rate.
The US labour market was better at matching
workers with vacancies during the financial crisis
of 2008–9.
The US Beveridge curve shifted after the financial
crisis, improving the matching rate.
The matching rate in Germany improved after its
Beveridge curve shifted around 2007.
Vincent Sterk. 2015. ‘Home Equity,
Mobility, and Macroeconomic
Fluctuations’ (https://tinyco.re/
2186300). Journal of Monetary
Economics (74): pp. 16–32.
16.3 JOB FLOWS, WORKER FLOWS, AND THE BEVERIDGE CURVE
707
expropriation risk The probability
that an asset will be taken from its
owner by the government or some
other actor.
wage-setting curve The curve that
gives the real wage necessary at
each level of economy-wide
employment to provide workers
with incentives to work hard and
well.
•16.4 INVESTMENT, FIRM ENTRY, AND THE PRICE-
SETTING CURVE IN THE LONG RUN
In Figure 16.1 we saw the remarkable divergence in unemployment rates
across advanced economies that began in the 1970s. In the most recent
period shown on the chart, European countries like Spain, Greece, or
France experienced very high unemployment rates, ranging from around
10% in France to more than 15% in Spain, while in other countries,
especially those in East Asia (South Korea, Japan) and in northern Europe
(Austria, Norway, Netherlands, Switzerland, and Germany), unemployment
was between 5% and 6%.
To explain the main trends over time and differences in the unemploy-
ment rate among countries, we extend concepts from earlier units to model
the long run. In this long-run model, things that may change slowly and
which are assumed to be constant in medium- or short-run models—such
as the size of the capital stock, and the firms operating in the economy—can
fully adjust to a change in economic conditions.
Determinants of economic performance in the long run
In the long run, the unemployment rate will depend on how well a
country’s policies and institutions address the two big incentive problems
of a capitalist economy:
• Work incentives: Wage and salary workers must work hard and well, even
though it is difficult to design and enforce contracts that accomplish this
(as we saw in Unit 6).
• Investment incentives: The owners of firms must invest in job creation
when they could invest abroad, or simply use their profits to buy con-
sumption goods and not invest at all. As we saw in Unit 14, firms
considering investment decisions will take account not only of the rate
of profit after taxes, but also the risk of adverse changes such as hostile
legislation or even confiscation of their property, which is referred to as
expropriation risk. Just as workers cannot be forced to work hard but
have to be motivated to do so, firms cannot be forced to create new jobs
or to maintain existing ones.
Solving both problems simultaneously would mean a low level of
unemployment at the same time as rapidly rising wages. But ways of
addressing one of these problems may make it difficult to address the other.
For example, policies that lead to very high wages may induce employees to
work hard, but leave owners of firms with little incentive to invest in
creating new productive capacity and jobs.
In the next section we will see that countries differ in how successfully
they address these two incentive problems simultaneously.
The wage-setting curve that we have used in Units 6, 9, 14, and 15
shows that wages must be higher when unemployed workers expect to find
a new job easily or when they receive a generous unemployment benefit,
both of which reduce the expected cost of job loss. This is why the wage-
setting curve is positively related to the employment level, and why an
increase in the unemployment benefit will shift the curve upward, as this
research demonstrates.
David G Blanchflower and Andrew
J Oswald. 1995. ‘An Introduction to
the Wage Curve’ (https://tinyco.re/
2712192). Journal of Economic
Perspectives 9 (3): pp. 153–167.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
708
price-setting curve The curve that
gives the real wage paid when
firms choose their profit-
maximizing price.
The necessary incentives for investment by owners of firms are
represented by the price-setting curve in the labour market model (see
Unit 9).
We will extend the labour market model to the long run by allowing
firms to enter and exit, and owners to expand the capital stock or allow it to
shrink. To simplify, let’s assume that firms are all of a given size, and that
the capital stock grows or shrinks simply by the addition or subtraction of
firms. We assume that there are constant returns to scale so that in the long
run, percentage increases in employment are matched by the same
percentage increase in capital.
We define the long-run equilibrium in the labour market as a situation
in which not only real wages and the employment level, but also the
number of firms, is constant (remember that equilibrium is always defined
by what is unchanging, unless there is some force for change from things
not considered in the model).
There are two conditions that determine how the number of firms may
change:
• Firm exit due to a low markup: Owners may withdraw their funds or even
close firms if the existing markup is too low, meaning that the expected
rate of profit after taxes is not attractive relative to the alternative uses
to which the owners could put their assets. These alternative uses could
be investing in foreign subsidiaries, outsourcing part of the production
process, buying government bonds, or distributing its profits as
dividends to the owners. In this case, the number of firms falls.
• Firm entry due to a high markup: If the markup is sufficiently high, the
resulting high profit rate will attract new firms to enter the economy.
When is firm exit due to too low a markup likely to happen? This will occur
when the economy is highly competitive as a result of a great number of
competing firms, resulting in a high elasticity of demand for the firm’s
products and hence a small markup. When there are ‘too many’ firms to
sustain a high enough markup, then firms will exit, which will tend to raise
the markup.
Similarly, when there are few firms in the economy, the degree of com-
petition will be limited, the markup will be high, and the resulting profit
rate will be sufficient to attract new firms to enter. As a result, the economy
will become more competitive and the markup will fall.
This means that the markup has a tendency to self-correct. If it is too
low then firms will exit and it will rise, and if it is too high then firms will
enter and it will decline.
Figure 16.7a illustrates this process by showing how the number of
firms and the profit-maximizing markup are related. For each number of
firms, the downward-sloping line gives the markup that maximizes the
firm’s profits. It slopes downward because:
• The more firms there are, the more competitive the economy is.
• This means a higher elasticity of demand facing the firms when they sell
their products (less ‘steep’ demand curves).
• The markup that maximizes the firm’s profits will fall, because, as we
saw in Unit 7, the markup, μ, is 1/(elasticity of demand).
16.4 INVESTMENT, FIRM ENTRY, AND THE PRICE-SETTING CURVE IN THE LONG RUN
709
The other line in the figure is horizontal and shows the markup that is just
sufficient to retain the existing number of firms, which we call μ*. Follow
the steps in the analysis in Figure 16.7a to see why the number of firms will
be stable at 210.
Now, using Figure 16.7a, think what would occur if as a result of a
change of government, the risk of expropriation of private property by the
government decreased. This is an improvement in the conditions for
operating a business, and could include changes in legislation that reduce
the probability that the government will take over firms or implement
unpredictable changes in taxation. With better business conditions, a lower
markup is required for firms to operate in this economy. Follow the steps in
Figure 16.7b to see how this leads to an increase in the number of firms in
equilibrium.
From the equilibrium markup to the price-setting curve in the
long run
As before, once we know the markup μ* and the average product of labour
λ, we know the real wage w that must result: it is the share of the average
product of labour (or, equivalently, of output per worker) that is not
claimed by the employer through the markup. With constant returns to
scale, if capital per worker remains constant, higher employment is
consistent with constant output per worker: the long-run price-setting
curve is flat. We note as well that in the model, the unemployed and
employed workers are identical because of the presence of involuntary
unemployment in the labour market equilibrium.
M
ar
ku
p,
μ
190
Firms entering Firms leavingEquilibrium
number of firms
High markup, attracts
entry of firms
Equilibrium markup, μ*
Low markup, promotes
exit of firms
210 250
B
A
C
Profit-maximizing markup
Number of firms, n
Figure 16.7a Firm entry, exit, and the equilibrium markup.
1. The profit-maximizing markup
The downward sloping line gives the
markup that maximizes the firm’s
profits, for a given number of firms. The
number of firms is constant and equal
to 210 at the equilibrium markup, μ*.
2. Competition and number of firms
The more firms there are, the more
competitive the economy, which will
result in a higher elasticity of demand
and a lower markup.
3. Firm exit
With 250 firms, the markup is below μ*
and firms will leave the economy.
4. Firm entry
With 190 firms, the economy is at B and
the markup exceeds μ*, so new firms
will enter.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
710
The long-run price-setting curve is given by:
As Figure 16.8 shows, this fact allows us to translate the equilibrium
markup into the real wage paid, which fixes the height of the price-setting
curve. In the left-hand panel, the equation of the long-run price-setting
curve is drawn as a horizontal line, with the equilibrium markup on the
horizontal axis and the wage on the vertical axis: with a zero markup, the
wage is equal to output per worker; and when the markup is equal to 1 (or
equivalently 100%), the wage is equal to zero.
The right-hand panel of Figure 16.8 shows the long-run price-setting
curve at different levels of the long-run equilibrium markup. By employ-
ment on the horizontal axis in the long-run model, we mean employment
with constant capital per worker. We can summarize the factors that will
shift the long-run price-setting curve through their effects on either output
per worker or the markup.
The long-run price-setting curve is higher:
• the higher the output per worker
• the lower the long-run markup at which firm entry and exit are zero
M
ar
ku
p,
μ
Number of firms, n
Firms entering New number of
equilibrium firms
Initial equilibrium
markup
New equilibrium
markup, μ*
210 250
A
C
Profit-maximizing markup
Figure 16.7b An improvement in conditions for doing business: Firm entry, exit, and
the equilibrium markup.
1. An improvement in conditions for
doing business
This lowers the equilibrium markup.
The existing markup at A is now ‘too
high’.
2. New firms enter the market
The economy grows until there are 250
firms.
16.4 INVESTMENT, FIRM ENTRY, AND THE PRICE-SETTING CURVE IN THE LONG RUN
711
THE LONG-RUN PRICE-SETTING
CURVE
Once we know the equilibrium
markup μ* and the productivity of
labour λ, we know the real wage w
is given by:
w is the output per worker that is
not claimed by the employer
through the markup.
What lowers the markup at which entry and exit are zero?
• higher competition
• lower risk of expropriation of owners in the home economy
• higher quality environment for doing business: for example, better
human capital or infrastructure
• lower expected long-run tax rate
• lower opportunity cost of capital: for example, a lower interest rate on
bonds
• lower expected profits on foreign investments
• lower expected long-term cost of imported materials
Re
al
w
ag
e
Markup, μ* Employment
low μ* high μ*
medium μ*
Price-setting curve (high μ*)
0
0
Price-setting curve (medium μ*)
Price-setting curve (low μ*)
Output per
worker, λ
w = λ(1 – μ*)
λ
Figure 16.8 Changes in the long-run markup shift the price-setting curve.
1. The-long run price-setting curve
In the left-hand panel, the equation of
the long-run price-setting curve is
shown as a downward-sloping line in
the diagram, with the equilibrium
markup on the horizontal axis and the
wage on the vertical axis.
2. A low markup
A low long-run equilibrium markup is
associated with a higher long-run
price-setting curve.
3. A high markup
Long-run price-setting curves are lower
for higher markups.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
712
EXERCISE 16.4 MEASURING THE CONDITIONS FOR INVESTMENT
Go to the World Bank’s Doing Business database (https://tinyco.re/
2588313).
1. In the ‘Topics’ section, collect (download) data on three characteristics
of the business environment that will affect the long-run markup, for 20
countries of your choice. Justify your choice of characteristics.
Now go to the World Bank’s DataBank database (https://tinyco.re/
2009817).
2. Download GDP per capita data for the 20 countries of your choice. For
each characteristic, create a scatterplot with the characteristic of the
business environment (rank) on the horizontal axis, and GDP per capita
on the vertical axis. Summarize the relationship between the two
variables (if any).
3. Explain why a good business environment may raise GDP per capita.
4. Why might high GDP per capita improve the business environment?
5. From your answers to questions 3 and 4, explain the potential
challenges when interpreting the relationship between two variables
using a scatterplot.
QUESTION 16.4 CHOOSE THE CORRECT ANSWER(S)
Figure 16.8 (page 712) depicts the graphs of the long-run price-setting
curve and the markup at which firm entry and exit are both zero.
Based on this information, which of the following statements is
correct?
An increase in the degree of competition in the economy will lower
the price-setting curve.
A lower interest rate leads to a lower price-setting curve.
Lower worker productivity leads to a higher price-setting curve for a
given markup μ*.
Higher risk of expropriation of businesses overseas results in a
higher price-setting curve.
QUESTION 16.5 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct regarding the model of
the labour market?
In the short- and medium-run models the amount of capital is fixed,
while in the long-run model the amount of capital can vary.
Labour-saving technological progress raises unemployment in both
the short and long run.
In the long-run model, firms enter the market when the markup is
low.
In the long-run model, the markup is independent of the number of
firms.
16.4 INVESTMENT, FIRM ENTRY, AND THE PRICE-SETTING CURVE IN THE LONG RUN
713
diffusion gap The lag between the
first introduction of an innovation
and its general use. See also:
diffusion.
•••16.5 NEW TECHNOLOGY, WAGES, AND
UNEMPLOYMENT IN THE LONG RUN
We have seen that, contrary to the fears of the Luddites, the constant
increase in the amount produced in an hour of work has not resulted in
ever-increasing unemployment. It is wages that on average have risen, not
unemployment.
In many countries, the combination of technological progress and
investment that raises the capital stock roughly doubled the productivity of
labour each generation. Our model showed the result: a rise in the real
wage that was consistent with profits high enough to motivate firm owners
to continue investing, rather than using their wealth in other ways.
The Luddites were right to be concerned about the hardships
experienced by those thrown out of work. What they missed is that the
additional profits made possible by the introduction of the new technolo-
gies provided a kind of self-corrective: additional investments that would
sooner or later result in the creation of new jobs.
The upward shift in the price-setting curve is illustrated in Figure 16.9a,
which shows the status quo (‘old technology’) with the long-run equilibrium
at A, and a technological advance that shifts the long-run equilibrium to B.
At point B, the real wage is higher and so is the employment rate, in other
words, unemployment is lower. The model shows that technological
progress need not raise unemployment in the economy as a whole.
Before examining the experiences of unemployment in different coun-
tries, we need to understand:
• What determines the rate of increase in the productivity of labour? This
accounts for the upward shift in the price-setting curve.
• How does the economy shift from A to B? Both are long-run equilibria in
the labour market.
New knowledge and new technology: The innovation diffusion
gap
It often takes years, if not decades, before an improved technology is widely
introduced in an economy. This diffusion gap causes differences between
the productivity of labour in the most advanced firms and the firms that lag
technologically.
In the UK, one study found that the top firms are more than five times as
productive as the bottom firms. Similar differences in productivity have
been found in firms in India and China. In Indonesia’s electronics
industry—a part of the highly competitive global market—data from the
late 1990s show that the firms at the 75th percentile were eight times as
productive as those in the 25th percentile.
The low-productivity firms manage to stay in business because they pay
lower wages to their employees, and in many cases earn a lower rate of
profit on the owner’s capital as well. Closing diffusion gaps can greatly
increase the speed at which new knowledge and management practices are
in widespread use.
This may occur when a union bargains for wages such that equivalent
workers are paid the same throughout the economy. One consequence of
this is that the least productive firms (which are also those paying low
wages) will experience wage increases, making some of these firms
unprofitable and putting them out of business. The union might also
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
714
support government policies that complement its role in hastening the exit
of unproductive firms, raising average productivity in the economy and
shifting up the price-setting curve. In this case, associations of workers can
help bring about creative destruction instead of resisting it.
Associations of owners may also be part of the process of creative
destruction by not seeking to prolong the life of unproductive firms,
knowing that their demise is part of the process of making the pie larger.
But in many cases, employees and owners of the lagging firms do not act in
this way. They gain protection through subsidies, tariff protection, and
bailouts that guarantee, at least for a time, the survival of the unproductive
firm and its jobs.
The rate at which the economy’s price-setting curve shifts upward
depends on which of these attitudes towards the process of creative
destruction is predominant. Economies differ greatly in this respect.
Adjustment to technological change: The employment and wage
adjustment gap
Economies differ too in how they make the journey from the status-quo
equilibrium like A to a new equilibrium such as B in Figure 16.9b.
Recall that the price-setting curve in the long-run model is the level of
the real wage such that firms will neither enter nor leave the economy. So
the move from point A (at 6% unemployment) to point B (at 4% unemploy-
ment) occurred because firms entered the economy, a process that takes
some time. What happened along the way? Follow the steps in the analysis
in Figure 16.9b to see one possible path.
Re
al
w
ag
e
Employment, N
U = 6%
(initial long-run
unemployment rate)
U = 4%
(new long-run
unemployment rate)
0
0
Wage-setting curve
Output per worker
(new technology)
Output per worker
(old technology)
Real wage (new)
Real wage (old)
A
B Price-setting curve
(new technology)
Price-setting curve
(old technology)
Figure 16.9a The long-run unemployment rate and new technology.
1. The long-run equilibrium before the
new technology is introduced
This is at point A.
2. A technological advance
This shifts output per worker and the
price-setting curve upwards.
3. The long run equilibrium effect on
employment
At point B, the real wage is higher and
unemployment is lower.
16.5 NEW TECHNOLOGY, WAGES, AND UNEMPLOYMENT IN THE LONG RUN
715
Was this a win-win journey? Only if you compare the start and end
points or have a sufficiently long time horizon. The time between the
introduction of new technology and the new long-run equilibrium is
usually measured in years or even decades, not weeks or months. Younger
workers might have more to gain from the eventual higher wages and
employment, but older workers might never experience the outcome at B.
Also, note that in Figure 16.9b, we assumed that the real wage did not
decline in the short run. But if the economy were to move to point D, firms
could lower the real wage so that it lies on the wage-setting curve at the
new level of unemployment. This is more likely to happen if the new invest-
ment that would take the economy to point E is slow in arriving. In that
case, wages may fall under the pressure of greater unemployment before
employment adjusts upwards.
We have already seen that in Britain, the adjustment to the technological
progress in the eighteenth and nineteenth centuries (the Industrial Revolu-
tion) was not rapid. There was a prolonged delay before real wages began to
rise continually, starting around 1830.
Re
al
w
ag
e
U = 6%
(initial long-run
unemployment rate)
U = 4%
(new long-run
unemployment rate)
0
0
Wage-setting curve
Output per worker
(new technology)
Output per worker
(old technology)
Real wage (new)
Real wage (old)
A
B
E
Price-setting curve
(new technology)
Price-setting curve
(old technology)
New technology shifts up
output per worker and the
price-setting curve
D
A→D: Introduction of a new
technology leads to a rise
in unemployment
D→E: High profits encourage
new firms to enter
E→B: Lower unemployment
leads to rising real wages
B: The new long-run rate of
unemployment is 4%
Employment, N
Figure 16.9b The long-run unemployment rate and new technology.
1. The response to new technology
A new technology means that fewer
workers can produce the same output.
How does the economy adjust?
2. The implementation of the new
technology
The new technology initially displaces
a substantial number of workers from
their jobs. At point D, the wage is the
same but there are fewer jobs.
3. Economic profits are high at D
New firms will be attracted to the eco-
nomy and investment will rise.
Unemployment eventually falls as the
economy moves from D to E.
4. Wages rise
With lower unemployment, firms have
to set higher wages to secure adequate
worker effort, so wages go up.
5. A new equilibrium
Adjustment stops when the economy is
at point B, with higher real wages and
lower long-run unemployment.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
716
adjustment gap The lag between
some outside change in labour
market conditions and the
movement of the economy to the
neighbourhood of the new equilib-
rium.
Just as was the case with the diffusion gap, public policies, trade union,
and employer association practices can alter the size of this employment
and wage adjustment gap. Government policy can help reallocate workers
to new firms and sectors by providing job-matching and retraining
services, and by providing generous but time-limited unemployment bene-
fits. This helps workers released from failing firms to move quickly to
better ones.
The size of these adjustment gaps also depends on institutions and poli-
cies that could ease or hamper the creation of jobs in new sectors. If the
wage is below the price-setting curve, profits are sufficient to create new
investment and form new firms. This is part of the process of adjusting to
creative destruction. Some countries have well-designed product-market
regulation and competition policy that make it easier to start a new busi-
ness. In others, incumbent businesses have succeeded in making it difficult
for new firms to enter, which slows or even prevents the economy moving
to point B.
Looking back at Figure 16.1, you may wonder why the unemployment
rate does not shrink continuously in a world with continuous technological
progress. The reason is that other forces in the economy lead to the wage-
setting curve shifting upwards. Trade unions could be responsible for this
shift (as in Unit 9), but there are other explanations:
• Unemployment benefits: Elected members of government may adopt more
generous unemployment benefits as the economy adjusts to the new
technology. They wish to assist those out of work. This improves the
reservation position of workers and shifts the wage-setting curve up.
• Rural wages: Technological improvements in the countryside and
migration from rural areas to cities associated with the implementation
of new technology in manufacturing may raise rural incomes and there-
fore increase the workers’ reservation option, which lowers the cost of
losing a manufacturing job. As a result, urban employers must pay more
to induce employees to work. This situation could occur in developing
countries with large rural sectors.
We further explore these forces in Unit 17, when we investigate the golden
age of capitalism following the Second World War.
Lessons from creative destruction and consumption smoothing
By this time, you may have noticed two recurring themes in this course:
• Creative destruction: Improvements in living standards often occur by a
process of technological progress in which jobs, skills, entire sectors, and
communities become obsolete and are abandoned. We study this process
in Units 1, 2, 16, and 21.
• Consumption smoothing: Households faced with shocks to their income
seek to even out the ups and downs of their standard of living through
borrowing, unemployment benefits, mutual assistance among family and
friends, and other forms of co-insurance. We studied this process in
Units 10, 13, and 14.
The two themes above are related. People suffering from job destruction
will suffer less if they can smooth their consumption. Economies differ
greatly in the extent to which their policies, culture, and institutions allow
16.5 NEW TECHNOLOGY, WAGES, AND UNEMPLOYMENT IN THE LONG RUN
717
employment protection legislation
Laws making job dismissal more
costly (or impossible) for
employers.
In our ‘Economist in action’ video,
John Van Reenen uses the game of
cricket to explain how the eco-
nomy’s average productivity is
affected by the survival of low pro-
ductivity firms. https://tinyco.re/
4875966
consumption smoothing. In those that do this well, resistance to the
creative-destructive forces of technological progress is likely to be low. In
those that do not, owners and employees alike will try to find ways to resist
(or halt) the process of creative destruction, preferring to defend their firm’s
assets and existing jobs.
The attitude of unions to the process of job destruction and creation is
an example. In countries with adequate consumption-smoothing
opportunities, trade unions tend not to insist on a worker’s right to keep a
particular job. Instead they demand adequate new job opportunities, and
support in searching and training for new work.
In other countries, unions and government policy seek to protect the
status quo matching of workers to jobs, for example by making it more
difficult to terminate a labour contract, even when the worker has
performed inadequately. This employment protection legislation may be
harmful to labour market performance by enlarging the diffusion and
adjustment gaps, and slowing the rate of technical progress, while at the
same time pushing the wage-setting curve up.
These differing responses to the opportunities and challenges presented
by creative destruction will help us understand why some economies
performed better than others in recent history.
QUESTION 16.6 CHOOSE THE CORRECT ANSWER(S)
Watch our ‘Economist in action’ video featuring John Van Reenen
about the determinants of the productivity of firms. Based on the video,
which of the following statements is correct?
The huge variation in productivity across countries and firms is due
to differences in management practices.
A country’s openness to foreign direct investment (FDI) is more
important for improving productivity than creative destruction.
The ‘creative’ part of creative destruction is effective in improving
productivity in the short and long run.
A country’s openness to imports can affect its productivity.
QUESTION 16.7 CHOOSE THE CORRECT ANSWER(S)
Figure 16.9b (page 716) depicts the long-run adjustment process in the
labour market after technological progress.
Based on this information, which of the following statements is
correct?
The new technology does not cause any increase in unemployment,
either in the short run or in the long run.
At D firms increase investment, and hence employment, due to the
large gap between the real wage paid and the workers’ wage-
setting curve.
Lower unemployment at E implies a higher wage required to induce
workers to exert high effort, resulting in the higher real wage at B.
The adjustment from equilibrium A to the new equilibrium at B is
immediate.
Samuel Bentolila, Tito Boeri, and
Pierre Cahuc. 2010. ‘Ending the
Scourge of Dual Markets in
Europe’ (https://tinyco.re/
2724010). VoxEU.org. Updated 12
July 2010.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
718
short run (model) The term does
not refer to a period of time, but
instead to what is exogenous:
prices, wages, the capital stock,
technology, institutions. See also:
wages, capital, technology, institu-
tions, medium run (model), long run
(model).
long run (model) The term does
not refer to a period of time, but
instead to what is exogenous. A
long-run cost curve, for example,
refers to costs when the firm can
fully adjust all of the inputs includ-
ing its capital goods; but
technology and the economy’s
institutions are exogenous. See
also: technology, institutions, short
run (model), medium run (model).
••16.6 TECHNOLOGICAL CHANGE AND INCOME
INEQUALITY
What happens to the distribution of income in an economy when a new
technology is introduced that raises the productivity of labour? Think
about the case we just studied in Figures 16.9a and 16.9b, where we
highlight the contrast between the short-run immediate impact, and the
long-run outcome that results once the higher profits, made possible by
the innovation, have motivated additional investments by firm owners.
In the short run, the economy moves from point A to point D in Figure
16.9b. The new technology raises output per worker and reduces the
number of people employed. For those employed at D, we assume that in
the short run the real wage is unaffected.
What is the effect on inequality in the short run, at point D? Inequality
increases for two reasons: first, because of the rise in the number of unem-
ployed workers with low or no income, and second because in the short run
only the employers reap the benefit of the new technology. The employers’
share of output goes up. This is summarized in the first row of Figure 16.10.
Of course, had wages at D fallen to meet the wage-setting curve at the new
unemployment rate, this would have exacerbated the rise in inequality.
But this is not where the process ends. Point D in Figure 16.9b is not a
Nash equilibrium because at the new level of productivity and the old real
wage, firms are making sufficient profits to either attract new firms to enter
or to incentivize existing firms to expand their output. Looking back to
Figure 16.9b, the economy expands and more people are employed. This
also pushes wages up along the wage-setting curve. This process will
continue until the wage is sufficiently high that firms stop expanding or
entering the economy, that is until the economy reaches point B, the new
Nash equilibrium.
Comparing the new Nash equilibrium at point B with the initial one at
point A, both workers and employers benefit from the new technology. The
wage share is back at its initial level and inequality is lower at B because the
unemployment rate is lower. Note that although the wage share at B is no
higher than at A, real wages are higher.
The long-run effect of the change in technology was to slightly reduce
inequality because:
• the share of output going to employees was restored to its pre-existing
level in the long run due to an increase in real wages
• the higher real wage allowed employers to maintain motivation for
workers to work hard at a lower level of unemployment
In
Figure
16.9b
Employment Unemployment Wage
share
Inequality
Short run (number of firms and their capital stock do not change) A to D Down Up Down Up
Long run (outcome adjusts fully to the new Nash equilibrium of
the model, no change in wage-setting curve)
A to B Up Down No
change
Slightly
down
Figure 16.10 Effects of technological improvements on the labour market model:
Short and long run.
16.6 TECHNOLOGICAL CHANGE AND INCOME INEQUALITY
719
To see the effect on inequality, we will represent the initial situation by a
Lorenz curve (introduced in Unit 5 and used also in Units 9 and 10), and
then see how its shape changes. In Figure 16.11, the unemployed, workers,
and employers are shown on the horizontal axis.
The solid line in Figure 16.11 is the Lorenz curve corresponding to the
situation at point A in Figure 16.9b. When unemployment increases to D
(on the horizontal axis), the Lorenz curve shifts out to the dashed one. The
kink is lower, reflecting the lower wage share at point D. In the long run,
unemployment falls to B and the wage share returns to its initial level. The
Lorenz curve shifts inwards.
Follow the steps in the analysis in Figure 16.11 to see how the Lorenz
curve changes on the way to the new equilibrium.
Cu
m
ul
at
iv
e
sh
ar
e
of
in
co
m
e
(%
)
Cumulative share of the population
from lowest to highest income (%)
Unemployed Employed Employers
0
0
100
B A D 100N
Initial wage
share (s)
New wage
share (s’)
Figure 16.11 Effects of a new technology on inequality: Short and long run.
1. Unemployment before a new
technology is introduced
The economy starts in long-run equilib-
rium before the new technology, with a
share A of the population being
unemployed (corresponding to point A).
A share of N - A workers are employed,
and the initial share of output going to
employees is s.
2. The implementation of the new
technology
This displaces some workers from their
jobs so that unemployment now
increases to D (corresponding to point
D). We assume that wages remain the
same for the remaining workers, so
since output per worker has risen,
wages as a share of output declines
from s to s’.
3. Economic profits are high
New firms will be attracted to the eco-
nomy and investment will rise, so
existing firms will expand. Unemploy-
ment eventually falls to the level
shown by point B, the new long-run
equilibrium.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
720
EXERCISE 16.5 TECHNOLOGICAL PROGRESS AND INEQUALITY
The Einstein in Unit 9 showed that the Gini coefficient g can be calculated
from the three groups of people in the economy-wide labour market as
follows:
Here, u represents the fraction unemployed, n the fraction of the labour
force in employment, the quantity 1 − n − u the fraction of the labour force
that are employers, w the real wage, and λ the output per worker. The
expression w/λ is the fraction of total output that workers’ wages can
purchase, called the wage share. This is clear because wn is total wages
paid, and λn is total output produced.
In the initial Lorenz curve (prior to the technical change), suppose there
were 6 unemployed, 84 employed workers and 10 employers, with wages
sufficient to purchase 60% of output.
1. Confirm that the Gini coefficient in this case would be 0.336.
2. Now suppose that technological progress leads to 4 workers losing
their jobs while output stays constant, and the wage level of the
remaining workers also stays constant, so profits increase by the
amount that the total wage bill has dropped. What is the new wage
share? What is the new Gini coefficient?
3. In the long run, assume there are 4 unemployed, 86 employed, and 10
employers, and the wage share returns to 60%. What is the Gini coeffi-
cient now? In your own words, explain why inequality increased in the
short run and fell in the long run.
QUESTION 16.8 CHOOSE THE CORRECT ANSWER(S)
Does the introduction of a new labour-saving technology result in …?
Higher wage share of output and higher Gini coefficient in the short
run.
Lower wage share of output and higher Gini coefficient in the short
run.
Lower wage share of output and lower Gini coefficient in the short
run.
Higher unemployment, lower wage share of output, and higher Gini
coefficient in the long run.
16.6 TECHNOLOGICAL CHANGE AND INCOME INEQUALITY
721
•••16.7 HOW LONG DOES IT TAKE FOR LABOUR MARKETS
TO ADJUST TO SHOCKS?
How long is the long run? In 1923, John Maynard Keynes wrote:
What you think about Keynes’ quote, especially the italicized part, may
depend on your age (he was 40 at time and would live another 23 years).
The sea is flat in equilibrium, in Keynes’ metaphor, but if you are interested
in safe navigation what may be more important is what happens in the
passage from one equilibrium to another, in other words, getting through
the storm. Keynes advocated what we have earlier termed a dynamic view
of the economy, that is, one that focuses on changes.
In Section 16.5 we studied how, if the labour market is knocked out of
equilibrium by a labour-saving innovation that puts employees out of work,
there may be a new long-run equilibrium in which the displaced workers
are re-employed at higher wages. Keynes’ point is that good economic poli-
cies have to be based on an understanding of how the economy gets from
one equilibrium to the other and how long it takes.
But many economists since have taken what Keynes called the ‘easy’
approach and just focused on one or more equilibria. When something
changes (like a new technology), economists compare the equilibrium
before and after the change. This is termed the comparative static approach
(static means unchanging, so the idea is to compare two things that are dif-
ferent–the before and after–but are themselves static.)
Hal Varian (1947– ), an important American economic theorist, points out
the difficulties in knowing what happens out of equilibrium and so tells the
readers of his popular microeconomics text (https://tinyco.re/2912410): ‘we
will generally ignore the question of how the equilibrium is reached, and focus
only on the issue of how firms behave in the equilibrium.’
Varian is right: it is important to know what happens in equilibrium and
how the level of employment, wages, and profits that occur in equilibrium
will differ depending on conditions and policies adopted. It is also not true
that in the long run ‘we’ are all dead, unless the only people you count as
‘we’ are those alive now, not future generations who will live after you and
experience the long run effects of the policies adopted now. And we know
from Unit 4 that people do care about the wellbeing of others, so the long
run matters even if it is very long.
If when things change, the economy moves quickly from one equilib-
rium to another, the comparative static approach advocated by Varian
makes sense. If the process of equilibration takes a long time or if we cannot
even be sure that the economy will move to another equilibrium (see ‘Do
bubbles exist?’ in Unit 11 (page 484)), then Keynes’ emphasis on the
dynamics of the adjustment process seems appropriate.
In Unit 11 we explained that when a market is not in equilibrium, there are
opportunities for economic actors to benefit by changing the price or quantity
they are selling or buying. These so-called rent-seeking activities are part of
the process by which a new equilibrium is established. In a fish market, for
John Maynard Keynes. 1923. A
Tract on Monetary Reform.
London, Macmillan and Co.
The long run is a misleading guide to current affairs. In the long run
we are all dead. Economists set themselves too easy, too useless a task
if in tempestuous seasons they can only tell us that when the storm is
past the ocean is flat again. (A Tract on Monetary Reform)
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
722
Kathryn Graddy: Fishing for perfect
competition https://tinyco.re/
5896400
Richard Freeman: You can’t
outsource responsibility
https://tinyco.re/6963044
example, rent seeking just means offering or charging a different price, and the
process of getting to a new equilibrium is relatively quick.
But in the labour market, if competition from other firms has reduced the
demand for the good you are producing and put you out of work, the process
is going to be slower. The reason is that the rent seeking that may bring about
a new equilibrium may involve you retraining to develop a new set of skills,
or you may have to uproot your family and seek work in a new location.
The debate on how quickly the US labour markets would adjust to the
‘shock’ of competition from imports of manufactured goods from China is
a case in point. Around the turn of the current century after more than a
decade of rapidly rising imports from China, there was a consensus among
US economists that imports were not having any major negative effect on
wages or employment, in part because workers producing goods competing
with imports could easily relocate to other regions. In another of our earlier
‘Economist in action’ videos (https://tinyco.re/6012955) on global produc-
tion and outsourcing, Richard Freeman asked if wages in the US were
‘being set in Beijing’ and answered with a resounding ‘no’.
Yet evidence was accumulating even then that the adjustment of the US
economy to the China shock was not going to be a simple textbook
comparative static jump from one equilibrium to another. Most economists
did not then anticipate the extent to which China would quickly come to
dominate global production of manufactured goods: having produced one-
twentieth of the world’s manufactured goods in 1990, a quarter of a century
later it produced a quarter of the global total.
But it was not just the unexpected size of the China shock that
overturned the optimism of many economists; the labour market’s
adjustment did not work as quickly as they had assumed.
The impact on US labour markets was geographically concentrated: parts
of the state of Tennessee specializing in furniture production and facing com-
petition from China were hard hit, while nearby Alabama specializing in
heavy industry was barely affected since China did not export heavy indus-
trial goods. The geographical concentration of the effects of the China shock
has allowed economists to study how labour markets adjusted.
They found that in US labour markets, the long run is a very long time.
‘China exposed’ regions suffered major losses in manufacturing employ-
ment; many of the jobless found it impossible to find work locally and gave
up, they left the labour force. Very few left the region. Localities hit by
import competition in the 1990s continued to be depressed into the second
decade of this century. Between 1999 and 2011, the China shock led to a
loss of 2.4 million jobs.
The conclusion of a major study of the China shock sounded more like
Keynes than Varian. If one had to project the impact for the US labour
market with nothing to go on other than a standard undergraduate eco-
nomics textbook, one would predict large movements of workers between
US tradable industries (meaning, exporting or competing with imports), for
example, from apparel and furniture to pharmaceuticals and jet aircraft.
You would also expect limited reallocation of jobs from tradables to non-
tradables, and no net impacts on US aggregate employment. The reality of
adjustment to the China trade shock has been very different.
Adjustment to the introduction of labour-saving machinery, which we
have studied in this unit, is likely to be similarly slow. In Unit 18 we return
to China in the world economy, and show that the response to the China
shock in Germany was quite different.
EconTalk. 2016. ‘David Autor on
Trade, China, and U.S. Labor
Markets’ (https://tinyco.re/
2829759). Library of Economics
and Liberty. Updated 26 December
2016.
David Autor and Gordon
Hanson. NBER Reporter 2014
Number 2: Research Summary.
Labor Market Adjustment to Inter-
national Trade (https://tinyco.re/
2846538).
16.7 HOW LONG DOES IT TAKE FOR LABOUR MARKETS TO ADJUST TO SHOCKS?
723
•••••16.8 INSTITUTIONS AND POLICIES: WHY DO SOME
COUNTRIES DO BETTER THAN OTHERS?
What do we mean by ‘good’ performance or a ‘good’ outcome? The answer
matters because citizens who vote for parties with alternative economic
programs, and policymakers who attempt to improve those programs, will
need some concept of what is desirable—either for the individual, the
policymaker, or the nation.
As we saw in Unit 3, people value their free time as well as their access to
goods. We should include their reward per hour of work in our evaluation
of outcomes. In any given year, a ‘good’ performance is one in which
unemployment is low and real wages per hour are high. Putting this into a
dynamic setting, and evaluating an economy over many years, we judge
performance as ‘good’ if a country combines rapid growth of real wages per
worker hour with low unemployment.
There are of course other dimensions of long-run economic
performance that most people care about. We may care whether or not the
distribution of economic rewards is fair, whether or not the economy’s
relationship with the natural environment is sustainable, or about the
extent to which households are subjected to economic insecurity through
business cycle fluctuations. But here we focus solely on the growth in real
wages per hour and the unemployment rate.
We use the labour market model and the Beveridge curve to see that
achieving good performance requires an economy to have two capacities:
• To raise the price-setting curve and restrain the upward shift of the wage-
setting curve: So that both hourly wage growth and the long-run
employment rate are high.
• To adjust rapidly and fully: So that the entire economy can take advantage
of opportunities from technological change.
Technological change means jobs disappearing in firms in which new tech-
nology substitutes for workers. Jobs also disappear as new firms enter and
those unable to adapt to the new conditions shut down. The Beveridge
curve highlights the importance of matching workers and vacancies in the
labour market. In Figure 16.9b, we saw that the impact of new technology is
initially to displace workers: the Beveridge curve summarizes the eco-
nomy’s ability to rapidly redeploy displaced workers, shortening the period
the economy spends in the short-run situation (point D, Figure 16.9b).
Figure 16.12 shows long-run performance (over a 40-year period) for a
group of advanced economies. It uses the criteria of real wage growth and
unemployment rates. We study a long period because we do not want our
evaluation of long-term performance to be affected by the particular phase
of the business cycle in which a country finds itself (it will look much better
at the peak than at the trough). We use wages in manufacturing because
they are measured in ways that are more accurately comparable across
nations—although this is not ideal, because the share of employment in
manufacturing shrinks over time and varies across countries.
Good performance places a country in the top-left corner of Figure
16.12, with high wage growth and low unemployment; bad performance
places a country in the bottom-right corner. Since we value both high wage
growth and low unemployment, we may be prepared to tolerate low wage
growth if it is associated with a lower level of unemployment. This means
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
724
that we can represent a citizen’s indifference curve as a ray from the origin.
Steeper rays are better, and a country’s performance is measured by the
steepness of a ray from the origin to that country’s observation. If you look
at Figure 16.12, and take Belgium (BEL) as an example: a Belgian citizen
would prefer to be on a steeper ray, like that of Germany (GER), with lower
unemployment and higher wage growth.
The two rays in Figure 16.12 divide the countries into three groups. The
high performers over the 40-year period from 1970 to 2018 are Norway
and Japan. The low performers are Belgium, Italy, US, Canada, and Spain.
The poor performance of the US is in part due to the fact that it started
with higher wages in 1970, because it was the world’s technology leader
during this period (as we saw in Figure 16.3). This meant that other nations
could learn from it, rapidly raising their productivity. Similar arguments
apply to Canada. For this reason we do not take these two countries as
representative of the low performers, although real wages have grown
much more slowly than productivity in the US, so most US citizens did not
benefit very much from economic growth in this period.
Notice that successful countries used different combinations of policies
and institutions. Some of the best performers (on steeper rays from the
origin) like Norway, Finland, Sweden, and Germany have powerful unions,
while the Nordic countries (including Denmark) have some of the most
generous unemployment benefits in the world.
Figure 16.13 reproduces the unemployment data from Figure 16.1, but
with two of the high performers and two of the low performers from
Figure 16.12 highlighted. The differences between Japan and Norway on
one hand, and Italy and Spain on the other, centre on unemployment rather
than real wage growth. In Figure 16.13 you can see how unemployment
behaved differently following the oil shocks of the 1980s, and after the fin-
ancial crisis.
We shall see that the model in this unit provides a useful framework for
understanding the high and low performers of the labour market. We will
now show how to use the model to explain the way that institutions and
policies affect real wage growth and unemployment in the long run.
High performers
Low performers
JPN
NOR
SWE
NLD
DNK
GER
USA
UK
FRA
FIN
CAN
BEL ITA
SPA
0
1
2
3
4
0 5 10 15
Unemployment rate (average annual rate, 1970–2018)
Re
al
w
ag
e
gr
ow
th
(a
ve
ra
ge
an
nu
al
gr
ow
th
ra
te
,1
97
0–
20
18
)
Figure 16.12 Long-run unemployment and real wage growth across the OECD
(1970–2018).
View this data at OWiD https://tinyco.re/
9247646
OECD. 2021. OECD Statistics
(https://tinyco.re/9377362); BLS data for
Spanish real wages available only from
1979. Spanish real wage growth for
1970–1979 has therefore been
estimated using Tables 16.25 and 16.5
from Barciela López, Carlos, Albert
Carreras, and Xavier Tafunell.
2005. Estadísticas históricas de España:
Siglos XIX-XX. Bilbao: Fundación BBVA.
16.8 INSTITUTIONS AND POLICIES
725
EXERCISE 16.6 YOU ARE THE POLICYMAKER
Refer to Figure 16.12 (page 725) to answer the following questions:
1. Using the same axes, draw the indifference curves of a citizen or
policymaker who cares only about wage growth.
2. According to the data in the figure, which countries would be the high
performers and which would be the low performers?
3. Using the same axes, draw your indifference curves if you only cared
about the unemployment rate. Which countries would be the high and
low performers in this case?
4. Using the same axes, draw an indifference curve based on your own
personal preferences over wage growth and unemployment, and justify
your choice.
5. Now considering your preferences over other economic factors, which
country in the figure would you choose to live in, and why? Explain
which economic factors you included in your decision.
Divergent 1970s and 1980s Convergent 1990s and 2000s
1973 End of ‘golden age’
of capitalism
1973–74
First oil shock
1979–80
Second oil shock
2002–08 Third oil shock
2008 Start of global
financial crisis
Spain
Italy
Japan
Norway
0
8
15
23
30
19
60
–6
4
19
65
–6
9
19
70
–7
4
19
75
–7
9
19
80
–8
4
19
85
–8
9
19
90
–9
4
19
95
–9
9
20
00
–0
4
20
05
–0
9
20
10
–1
4
20
15
–1
9
Year
U
ne
m
pl
oy
m
en
tr
at
e
(%
)
Figure 16.13 Unemployment rates of two high and two low labour market
performers (1960–2019).
See more https://tinyco.re/0981244
Data from 1960–2004: David R. Howell,
Dean Baker, Andrew Glyn, and John
Schmitt. 2007. ‘Are Protective Labor
Market Institutions at the Root of
Unemployment? A Critical Review of the
Evidence’ (https://tinyco.re/
2000761). Capitalism and Society 2 (1)
(January). Data from 2005 to 2019: OECD
harmonized unemployment rates, OECD.
2021. OECD Statistics (https://tinyco.re/
9377362).
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
726
QUESTION 16.9 CHOOSE THE CORRECT ANSWER(S)
The following graph plots the real wage growth of different countries
against their unemployment rate, averaged over the period 1970–2011.
JPN
NOR
SWE
NLD
DNK
USA
GER
UK
FRA
FIN
CAN
BEL ITA
SPA
0
1.1
2.3
3.4
4.5
0 5 9 14 18
Unemployment rate (average annual rate, 1970–2011)
Re
al
w
ag
e
gr
ow
th
(a
ve
ra
ge
an
nu
al
gr
ow
th
ra
te
,1
97
0–
20
11
)
Based on this information, which of the following statements is correct?
If you only cared about unemployment, then Finland is the country
with the best performance.
If you only cared about wage growth, then European countries have
outperformed North American countries.
If you cared about both unemployment and wage growth, then
Spain is one of the best-performing countries.
If you cared about both unemployment and wage growth, then
Finland has unambiguously outperformed Norway.
•••••16.9 TECHNOLOGICAL CHANGE, LABOUR MARKETS,
AND TRADE UNIONS
Policies and institutions make a difference. The models shed light on the
experience of some of the best and worst performers. We take three coun-
tries as examples: Norway and Japan as good performers, and Spain as a
poor performer.
In Norway and Spain, unions are important, but not in Japan. In
Norway, more than half of all wage and salary workers are trade union
members, and union wage deals affect most workers in the economy. In
Spain, although union wage deals are important for the entire economy, less
than one-fifth of Spanish workers are in unions.
Figure 16.14 provides information on the importance of union wage
deals and unemployment. On the horizontal axis, we plot the percentage of
employees whose wages are determined by union wage deals. As you can
see, in some European countries, union wage deals cover almost all employ-
ees. And in the set of countries with coverage of more than 80%,
unemployment rates range from less than 4% (Iceland) to 16% (Spain).
Figure 16.14 suggests that there is no tendency for unemployment to be
higher in countries in which unions are more influential in wage-setting.
Low unemployment is found in countries extending across the whole range
16.9 TECHNOLOGICAL CHANGE, LABOUR MARKETS, AND TRADE UNIONS
727
medium run (model) The term
does not refer to a period of time,
but instead to what is exogenous. In
this case capital stock, technology,
and institutions are exogenous.
Output, employment, prices, and
wages are endogenous. See also:
capital goods, technology,
institution, short run (model), long
run (model).
inclusive trade union A union,
representing many firms and
sectors, which takes into account
the consequences of wage
increases for job creation in the
entire economy in the long run.
of union strength. Compare South Korea and the Netherlands, Japan and
Austria, or the US and Sweden.
Just as the employer does not offer the lowest wage possible, most
unions do not seek the highest wage they could win in bargaining.
Employers offer wages above the minimum because they cannot control
how hard the worker works. Unions do not bargain for the maximum
wage possible (the wage that would leave none of the pie for the owners)
because unions cannot control the firm’s decisions about hiring, firing, and
investment, and higher wages may reduce employment by reducing the
firm’s profits.
A union organized across many firms and sectors will not exploit all the
bargaining power it possesses. It knows that large wage gains will lead to:
• In the medium run: Restrictive aggregate demand policies, as the govern-
ment and central bank seek to keep inflation close to target (as we saw in
Unit 15).
• In the long run: The exit of firms and a smaller stock of capital goods,
which will slow the rate of productivity growth.
Unions that act this way are called inclusive trade unions. Non-
inclusive unions may bargain for high wages in their own corner of the
economy without regard for the effects on other firms or workers, both
employed and unemployed. Employers’ associations that take account of
the interests of all businesses, including those that might enter an
industry and compete with its incumbent firms, are called inclusive busi-
ness or employers’ associations. When unions and businesses act in an
inclusive manner there is also more likely to be a positive union voice
effect. As discussed in Unit 9, this lowers the disutility of work, helping to
push down the wage-setting curve.
TUR
KOR
USA
NZL
POL
JPN
HUN
SVK
CAN
UK
IRL
CZE
SWI
GER
LUX
AUS
NOR
ITA
SPA
GRC
DNK
NLD
PRT
ISL
FIN
SWE
BEL
AUT
0
2
4
6
8
10
12
14
16
0 20 40 60 80 100
Employees covered by union wage bargains
(latest available year in the ICTWSS database (2020))
U
ne
m
pl
oy
m
en
tr
at
e
(2
00
0–
20
av
er
ag
e,
%
)
Figure 16.14 Union wage bargaining coverage and unemployment across the OECD
(2000–2020).
View this data at OWiD https://tinyco.re/
2462743
OECD. 2021. OECD Statistics
(https://tinyco.re/9377362). Labour force
statistics. OECD and Amsterdam Institute
for Advanced Labour Studies (AIAS).
2021. ‘Institutional Characteristics of
Trade Unions, Wage Setting, State
Intervention and Social Pacts’
(https://tinyco.re/9834258) OECD
Publishing. Paris.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
728
The Nordic case: Inclusive unions and employers’ associations
This inclusive behaviour is exactly what the trade unions and employers’
associations of Norway (as well as in the other Nordic countries) did over
this period: their centralized wage bargaining insisted on a common wage
for a given kind of labour, depriving low-productivity firms of access to
inexpensive labour and driving many of them out of business. As workers
were quickly redeployed to employment in more productive firms, the
main impact was to raise average labour productivity, pushing up the price-
setting curve and allowing higher wages.
Inclusive trade unions also support generous income floors and high-
quality publicly provided healthcare, occupational retraining, and
educational services—all of which reduce the risk to which most indi-
viduals are exposed. This has the effect of making the creative destruction
of technological change less destructive for people’s personal lives and
allows them to be generally more open to change and to risk-taking. Both
of these attributes are essential for a technologically dynamic society.
These so-called ‘active labour market policies’ improve the matching
process between workers looking for work and job vacancies available for
workers. A result is that workers whose jobs are eliminated (for example, by
the failure of low-productivity firms under the pressure of centrally
bargained uniform wages) can find an alternative job more quickly. The
result is a Beveridge curve closer to the origin, superior to both the German
and US Beveridge curves (shown in Figure 16.6). It is far inside that of
Spain, as we see in Figure 16.15.
An inclusive union knows that the economy has to respect the two
major incentive problems of a capitalist economy: providing incentives for
workers to work and for employers to invest. In some cases—for example,
in Sweden with its highly centralized trade union federation—trade union
leaders knew and persuaded their members that in the long run, pushing
down the wage-setting curve will increase employment and will not
reduce wages.
Adrian Wooldridge.
2013. ‘Northern Lights’
(https://tinyco.re/2892712). The
Economist. Updated 2 February
2013.
Torben M Andersen, Bengt
Holmström, Seppo Honkapohja,
Sixten Korkman, Hans Tson
Söderström, and Juhana
Vartiainen. 2007. The Nordic
Model: Embracing Globalization
and Sharing Risks
(https://tinyco.re/2490148).
Helsinki: Taloustierto Oy.
Q1 2001
Q2 2021
Q1 2001
Q2 2021
Norway
Spain
0.2
0.5
0.7
1.0
1.2
1.4
0 5 10 15 20 25 30
Unemployment rate (%)
Va
ca
nc
y
ra
te
(%
)
Figure 16.15 Beveridge curves for Spain and Norway (2001 Q1 – 2021 Q2).
OECD Employment Outlook: OECD.
2021. OECD Statistics (https://tinyco.re/
9377362).
16.9 TECHNOLOGICAL CHANGE, LABOUR MARKETS, AND TRADE UNIONS
729
gross unemployment benefit
replacement rate The proportion
of a worker’s previous gross (pre-
tax) wage that is received (gross of
taxation) when unemployed.
As a result, the inclusive unions of the Nordic countries (Norway,
Sweden, Finland, and Denmark) set their wage demands in accordance with
the productivity of labour. When it rose they demanded a fair share. They
had bargaining power from low unemployment, high membership, and
their ability to implement wage agreements across the economy, but they
did not use this power to push the wage-setting curve up unless it was
warranted by productivity growth. These unions also supported legislation
and policies that make working less onerous, shifting downward the wage-
setting curve, and further expanding long-run employment.
The Japanese case: Inclusive employers’ associations
In contrast to the Nordic countries, Japanese unions are weak, but workers
are well organized in the large companies. Employers’ associations are
strong and work to coordinate wage-setting among the large firms. These
associations therefore operate in a similar way to the unions in Norway: the
impact of wage decisions on the economy as a whole is taken into account
when wages are set. Specifically, the corporations deliberately do not
compete in hiring workers, so as to avoid raising wages.
The Spanish case: Non-inclusive unions
Unions protect jobs in Spain, supported by government policy. Wage-
setters in Spain are strong enough to wield power, but are not inclusive.
A combination of non-inclusive unions and supportive government legis-
lation that protects jobs may help to account for the poor performance of
the Spanish labour market.
Based on the model, we would predict high unemployment in Spain, and
low unemployment in Norway and Japan. And that is what we see in the data.
Unemployment benefits and unemployment
The employment-enhancing effects of inclusive trade union and govern-
ment co-insurance policies may help to explain an apparent anomaly:
countries with generous unemployment benefits do not have higher rates of
unemployment (see Figure 16.16).
This is anomalous, because in our model an increase in the unemploy-
ment benefit would, ceteris paribus, reduce the workers’ cost of job loss, and
shift the wage-setting curve up.
The contrast between unemployment rates and benefits in the
Netherlands and Italy illustrates the point. An unemployed person gets a
benefit of over 70% of previous gross earnings in the Netherlands, and
unemployment is low; in contrast, benefits in Italy offer a 30% gross
replacement rate, and unemployment is much higher than in the
Netherlands. The implication is that countries that are able to implement
generous but well-designed unemployment insurance schemes, coordinated
with job placement services and other active labour market policies, can
achieve low rates of unemployment. Providing people with opportunities to
smooth consumption may make them readier to embrace new technology,
which will shift the price-setting curve upward.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
730
CZE
ITA
KOR SVK
TUR
GRC
HUN
POL
UK
JPN
USA
CAN
AUS
GER
LUX
AUT
NZL
SWI
ISL
SPA
FIN
IRL
FRA
BEL
SWE
PRT
NLD
NOR
DNK
0
2
4
6
8
10
12
14
16
0 10 20 30 40 50 60 70 80 90
Gross unemployment benefit replacement rate (2001–20 average, %)
U
ne
m
pl
oy
m
en
tr
at
e
(2
00
1–
20
av
er
ag
e,
%
)
Figure 16.16 Unemployment benefit generosity and unemployment rates across the
OECD (2001–2020).
View this data at OWiD https://tinyco.re/
2762873
OECD. 2021. OECD Statistics
(https://tinyco.re/9377362).
EXERCISE 16.7 UNEMPLOYMENT RATES AND LABOUR MARKET
INSTITUTIONS
Some people have argued that high unemployment in some European
countries relative to the US during the 1990s and 2000s was due to the
existence of rigid labour market institutions (for example, powerful unions,
generous unemployment benefits, and strong employment protection
legislation).
1. Using Figure 16.1 (page 695), check if the unemployment rate has
always been higher in most European countries compared to the US.
2. From what you have learned from this section, and by looking at
Figures 16.1, 16.14 (page 728), and 16.16, evaluate the claim that high
unemployment in Europe was due to the existence of rigid labour
market institutions.
QUESTION 16.10 CHOOSE THE CORRECT ANSWER(S)
The following is a plot of unemployment rate and trade union density
for the period 2000–2012. Trade union density is defined as the fraction
of employees who are union members.
You can read more about the role
of institutions in European
unemployment in these papers.
Olivier Blanchard and Justin
Wolfers. 2000. ‘The Role of Shocks
and Institutions in the Rise of
European Unemployment: The
Aggregate Evidence’. The Economic
Journal 110 (462) (March): pp. 1–33.
David R Howell, Dean Baker,
Andrew Glyn, and John Schmitt.
2007. ‘Are Protective Labor Market
Institutions at the Root of
Unemployment? A Critical Review
of the Evidence’ (https://tinyco.re/
2000761). Capitalism and Society
2 (1) (January).
16.9 TECHNOLOGICAL CHANGE, LABOUR MARKETS, AND TRADE UNIONS
731
SVK
TUR
FRA
KOR
USA
HUN
ESP
POL
CHE
JPN
CZE
NLD
AUS
NZL
DEU
PRT
GRC
CAN
GBR
AUT
ITA
IRL
LUX
NOR
BEL
DNK
FIN
SWE
ISL
0
2
4
6
8
10
12
14
16
0 10 20 30 40 50 60 70 80 90 100
Trade union density (2000–2012 average, %)
U
ne
m
pl
oy
m
en
tr
at
e
(2
00
0–
20
12
av
er
ag
e,
%
)
Country Unemployment (%) Trade union density (%)
AUS 5.5 19.2
AUT 4.8 29.5
BEL 7.8 54.6
CAN 7.1 27.4
CZE 7.1 16.3
DNK 5.4 67.7
FIN 8.3 69.5
FRA 8.3 7.7
DEU 7.9 19.2
GRC 13.4 23.1
HUN 8.1 13.3
ISL 4.2 87.1
IRL 8.3 32.4
ITA 9.0 34.9
JPN 4.5 18.4
KOR 3.5 10.1
LUX 4.5 36.7
NLD 4.1 18.9
NZL 5.3 20.7
NOR 3.6 53.7
POL 13.2 15.4
PRT 9.1 20.4
SVK 14.9 18.6
ESP 15.4 16.6
SWE 7.0 70.3
CHE 3.6 17.5
TUR 10.2 6.2
GBR 6.1 26.8
USA 6.4 11.5
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
732
Based on this information, which of the following statements is correct?
High trade union density is a necessary condition for a low
unemployment rate.
Low trade union density results in high unemployment.
Considering only the Nordic countries (Norway, Denmark, Sweden,
and Finland), it can be concluded that high trade union density
leads to a low unemployment rate.
Given the trade union density, the relative unemployment outcomes
indicate that inclusiveness of trade unions is higher in Norway than
in Belgium.
••16.10 CHANGES IN INSTITUTIONS AND POLICIES
We have seen that differences in institutions and policies make a big differ-
ence for employment and wage growth, and that citizens of Spain might wish
to have institutions like those of Japan or a Nordic country. But changing
institutions is difficult because it inevitably creates winners and losers.
Countries that changed their policies changed their fortunes. Both the UK
and the Netherlands suffered sharply increased unemployment rates in the
1970s and early 1980s due to the first and second oil shocks (which shifted
the price-setting curve down) and the increased bargaining power of labour
(which shifted the wage-setting curve up). These effects are illustrated in
Figure 16.17. But a change in policy eventually turned the bad news around.
In the UK, the unemployment rate fell from 11.6% in 1985 to 5.1% in 2002,
and in the Netherlands it fell from 9.2% to 2.8% over the same period.
1973 End of ‘golden age’
of capitalism
1973–74
First oil shock
1979–80
Second oil shock
2002–08 Third oil shock
2008 Start of global
financial crisis
Divergent 1970s and 1980s Convergent 1990s and 2000s
UK
Netherlands
0
8
15
23
30
19
60
–6
4
19
65
–6
9
19
70
–7
4
19
75
–7
9
19
80
–8
4
19
85
–8
9
19
90
–9
4
19
95
–9
9
20
00
–0
4
20
05
–0
9
20
10
–1
4
20
15
–1
9
Year
U
ne
m
pl
oy
m
en
tr
at
e
(%
)
Figure 16.17 Different ways of pushing down the wage-setting curve: The
Netherlands and the UK.
See more https://tinyco.re/9341009
David R. Howell, Dean Baker, Andrew
Glyn, and John Schmitt. 2007. ‘Are
Protective Labor Market Institutions at
the Root of Unemployment? A Critical
Review of the Evidence’
(https://tinyco.re/2000761). Capitalism
and Society 2 (1) (January). Data from
2005 to 2019: OECD harmonized
unemployment rates, OECD. 2021. OECD
Statistics (https://tinyco.re/9377362).
16.10 CHANGES IN INSTITUTIONS AND POLICIES
733
industry Goods-producing business
activity: agriculture, mining,
manufacturing, and construction.
Manufacturing is the most import-
ant component.
Both countries turned around their economies and shifted the wage-
setting curves down, but they used different institutions and policies:
• In the Dutch case: Institutions became more inclusive, moving in a
Nordic direction by common agreement.
• In the British case: Policy reduced the power of the non-inclusive unions
and increased competition in labour markets.
In the Netherlands, a key component was an agreement in 1982 between
employers and unions called the Wassenaar Accord. Unions offered wage
restraint (a downward shift in the wage-setting curve) and in exchange, the
employers agreed to a reduction in working hours. The union agreed that
the reduction in working hours would not increase labour costs (and hence
would not shift the price-setting curve down).
In the Dutch case, unions and employers’ associations were capable of
coordinating wage-setting to achieve a better macroeconomic outcome.
They were powerful enough that they could ensure their members stuck to
the agreement. The unions were exercising bargaining restraint in the
interests of improved performance of the labour market, and hence in the
economy as a whole.
In the UK, the wage-setting curve also shifted down but in this case, it
was because of a fall in union power brought about by changing industrial
relations legislation, which weakened the ability of the non-inclusive
unions to organize strike action.
EXERCISE 16.8 THE LABOUR MARKET MODEL
Explain how to use the labour market model (wage-setting curve and
price-setting curve) to show the changes in labour market performance of
the UK and the Netherlands from the early 1970s to the early 2000s, as
discussed in this section. The article by Nickell and van Ours (2000)
referenced above is a good research resource for this question.
•••16.11 SLOWER PRODUCTIVITY GROWTH IN SERVICES,
AND THE CHANGING NATURE OF WORK
The rise and fall of manufacturing employment
As discussed in Unit 1, before the Industrial Revolution most of the output
of the economy was made by family members. They were not employees
but instead were independent producers of the goods and services both for
their own use (called home production) and for sale to others. The Indus-
trial Revolution and the emergence of the capitalist economic system
shifted labour from the family and the farm to firms: independent
producers became employees.
Due to technological progress in machine-based production, manufac-
tured goods became cheaper. As a result, textiles and clothing once
produced in the home were now purchased and paid for with the wages
gained through industrial and other employment. The result was a
sustained increase in employment in the industrial sector of the economy.
Manufacturing makes up most of the employment in industry, and the
terms manufacturing and industry are often used interchangeably.
Stephen Nickell and Jan van Ours.
2000. ‘The Netherlands and the
United Kingdom: A European
Unemployment Miracle?’ Eco-
nomic Policy 15 (30): pp. 136–180.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
734
Labour-saving innovation also made farming more productive. And as
people became richer they spent less of their budget on food. Therefore the
fraction of the labour force engaged in farming fell.
For many, the shift out of farming and the rise of manufacturing
employment meant an improvement in economic opportunities, especially
when the trade unions and worker-based political parties forced employers
to improve industrial working conditions.
This did not last forever though. Figure 16.18 shows that for most of the
world’s large economies, the era of expanding manufacturing employment
ended sometime in the third quarter of the twentieth century. Just as
manufacturing had initially displaced agriculture as the main kind of
employment, the production of services rather than goods has replaced
manufacturing. Follow the steps in the analysis in Figure 16.18 to see how
major industrial economies passed through stages of rising and falling
manufacturing employment at different times.
The economics of slower productivity growth in services
The amount of labour devoted to agriculture has declined in all of the eco-
nomies shown in Figure 16.18. Fewer than one in 20 workers in rich
economies work in agriculture. The recent big shift in work has been from
the production of goods (manufacturing and agriculture) to the production
of services. We know that output per hour of labour (productivity) is
growing more slowly in the production of services than in manufacturing.
This has two effects:
• An employment shift: To produce the same mix of goods and services it
now takes relatively less labour devoted to goods and more to services.
• A consumption shift: The costs of producing goods have fallen relative to
the costs of producing services, and so the prices of goods have fallen
relative to the prices of services. This leads people to buy more goods
and fewer services than they otherwise would have done.
The first of these effects has been stronger than the second.
To see how this process works, let’s simplify by using a model in which
only the first effect occurs. So we assume that people consume a given ratio
of goods (shirts, for example) and services (haircuts). The examples illustrate
the reason for slower productivity growth in services: it takes about as long
today to cut someone’s hair as it did 100 or even 200 years ago, but to
produce a shirt it takes much less time than it did 200 years ago (probably
less than a fifth).
Figure 16.19 shows the model. The total amount of labour employed in
the economy is assumed to be 1 (it could be 1 million hours, for example). If
all of this labour is devoted to the production of goods, 1 unit of goods is
produced. And the same is true of services: if all the labour produces
services, then 1 unit of services is produced.
The solid red line is the feasible frontier, showing the amounts of goods
and services that are possible given the existing technologies and the
amount of labour employed. We assume that the same number of units of
goods and services are consumed, so in the figure the quantity of services
and the quantity of goods consumed both equal half a unit in the first
period. In the second period, productivity rises in manufacturing while
staying constant in services, meaning that the cost and hence the price of
16.11 SLOWER PRODUCTIVITY GROWTH IN SERVICES
735
goods declines relative to services. Follow the steps in the analysis to see the
effect on employment.
Labour has shifted from goods production to services production. This
model is designed to illustrate why the shift took place. Two things left out
of the model have, in reality, reduced the shift, and a third one has
increased it:
• Productivity increases in some services reduces the shift: We assumed that
there was no productivity increase in services. But think of the kinds of
services we have discussed in this unit, such as the sharing of music or
other forms of digital information, where the productivity advances
have been large. If productivity in services increased, then in our model
it would at least partially offset the shift in labour. We will see just below,
however, that much of the service sector of the economy is made up of
such things as personal care, which is more like haircuts than the
reproduction of music.
• Substitution of goods for services reduces the shift: We increase the
proportion of goods we consume if their relative price falls. By assuming
that the ratio of goods (shirts) to services (haircuts) did not change, we
ignored this process. It would partially offset the decline in goods
employment.
15
20
25
30
35
40
45
50
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
Year
In
du
st
ry
sh
ar
e
of
to
ta
le
m
pl
oy
m
en
t(
%
) UK US Germany Japan South Korea Taiwan China
Figure 16.18 The rise and fall of the share of employment in industry (1870–2019).
View this data at OWiD https://tinyco.re/
0246543
US Bureau of Labor Statistics. 2004.
International Labor Comparisons (ILC)
(https://tinyco.re/2780183). Updated 14
October; International Labour
Association. 2021. ILOSTAT Database
(https://tinyco.re/3625463); The
Conference Board. International
Comparisons of Annual Labor Force
Statistics, 2013 (https://tinyco.re/
2640734).
1. The shift of employment out of
industry
This was led by the UK and the US
around 1950, followed by Japan and
Germany about 20 years later.
2. South Korea’s rise to industrial
prominence
This began only in the last quarter of
the twentieth century, yet the share of
manufacturing employment in South
Korea was already falling by the end of
the century.
3. Manufacturing in Taiwan and
Germany
Taiwan now has a larger share of the
labour force in manufacturing than
Germany.
4. Manufacturing in China
Unlike the other economies in the
figure, in China labour continued to be
pulled into the manufacturing sector in
the first decade of the 21st century.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
736
• An increase in relative demand for services increases the shift: We also
ignored the possibility that as incomes rise, people choose to spend
more of their budget on services. Remember that services include
tourism and other forms of recreation, and also include health,
education, and care, which may not be paid directly out of the house-
hold’s disposable income. This would reinforce the shift of labour into
services. We have seen this before: it is equivalent to the earlier shift of
labour out of agriculture that occurred when the share of food in house-
hold budgets shrank.
However, in the countries showing a decline in goods employment relative
to services, the net effect of the things we have excluded from the model did
not completely offset the deindustrialization of the workforce.
Q
ua
nt
ity
o
f s
er
vi
ce
s
Quantity of goods
1
After: ⅔ of the
labour force
produces this
After: ⅓ of the
labour force
produces this
⅔
½ A
B
They consume equal
quantities of goods and
services both before and after
Feasible frontier after effect
of doubling labour productivity
in goods production
Feasible
frontier
before
⅔ 1½ 2
Figure 16.19 Increased productivity in goods production raises the fraction of
workers in services.
1. The feasible frontier
The solid red line is the feasible
frontier and shows the amounts of
goods and services that can be
produced given the existing technolo-
gies and labour available.
2. Equal split of goods and services
We assume equal amounts of goods
and services are consumed: at A, the
amount consumed of each equals 1/2.
3. Manufacturing productivity increases
The productivity of labour in the pro-
duction of goods doubles, but
productivity remains unchanged in
services. The new feasible frontier is
shown as the dashed line.
4. More goods, more services
If people continue to consume equal
amounts of goods and services, the
economy will be at point B with pro-
duction and consumption of 2/3 units
of each.
5. A shift in employment
At B, labour has shifted from the pro-
duction of goods to the production of
services: 1/3 of the labour produces
goods, and 2/3 produces services.
16.11 SLOWER PRODUCTIVITY GROWTH IN SERVICES
737
Another complicating factor is that some countries are net importers of
goods while others are net exporters, meaning that many goods are
purchased in a different country from where they were produced. This is
part of the explanation for why different countries have different patterns
for the hump-shaped relationship shown in Figure 16.18. International
trade and the opportunities for specialization that came with it accelerated
the decline in the goods-producing share of employment in some countries
(the US and the UK, for example), but slowed it down in others (Germany,
South Korea).
China’s growing share of employment in goods reflects the forces seen
elsewhere in the now-rich countries and its specialization in exporting
manufactured goods. The Einstein at the end of this section illustrates the
logic behind Figure 16.19 and analyses the result of a productivity increase
in goods production.
EINSTEIN
How faster productivity growth in goods production may shift
employment from goods to services
This Einstein explains the logic behind Figure 16.19 and explains why a
productivity increase in goods production shifts employment to firms
that produce services. We define λs as the productivity of labour in
services. Then λs = Qs/Ls, the quantity of services divided by the amount
of labour employed to produce it. In our model, the following equation
holds:
• λsLs = Qs: The productivity of labour in services multiplied by the
amount of labour in services is equal to the amount of services
produced.
• Qs = Qg: The output of goods must be the same as the output of
services. This isn’t always true, but we defined it that way in our
model.
• Qg = λgLg: The output of goods is equal to the productivity of labour
in the production of goods multiplied by the amount of labour
employed in producing goods.
We can now equate the first and last terms of the above equation to give
us an expression for the amount of labour that must be employed in the
two sectors, given the productivity levels in each sector, if they produce
an equal number of units of output:
We then rewrite this expression, using the fact that the total amount of
labour in the two sectors sums to one:
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
738
Then we rearrange the equation using the first and last terms to get an
expression for the amount of labour engaged in service production:
In the figure, productivity in both of the two sectors was 1, so the
amount of labour engaged in goods production was 1/2. When the pro-
ductivity of labour in goods production doubles:
This is the share of labour devoted to the production of services after the
increase in productivity of the labour used in the production of goods.
QUESTION 16.11 CHOOSE THE CORRECT ANSWER(S)
Figure 16.18 (page 736) is a graph of the share of employment in
manufacturing industry in different economies.
Based on this information, which of the following statements are
correct?
The share of employment in industry has been falling in all eco-
nomies shown.
The shift of employment out of industry was led by the UK and the
US around 1950.
The UK has consistently had a higher share of total employment in
industry than the US.
The Far East economies now all have higher shares in industry than
Germany, the UK, or the US.
••16.12 WAGES AND UNEMPLOYMENT IN THE LONG RUN
We have learned that national economies differ not only in how rapidly
they adjust to the opportunities offered by technological change and other
changes of circumstance, but also in the wages and employment that they
can sustain in the long run.
These depend on many of the characteristics of economies that we have
analysed in earlier units. Figure 16.20 summarizes the determinants of the
unemployment rate and the growth rate of real wages, and notes the units
where these concepts are discussed.
Figure 16.21 builds on Figure 16.20 by showing the institutions and
policies that can affect the growth of real wages and the unemployment
rate.
16.12 WAGES AND UNEMPLOYMENT IN THE LONG RUN
739
Technological change
U1, U2, U3
Conflict over work
and wages U6
Productivity growth
U1, U2, U3
Price-setting curve
U9, U15, U16
Beveridge curve
U16
Wage-setting curve
U6, U9, U15, U16
Job creation and
destruction; firm entry
and exit U16
Wage-setting by
firms and work effort
by workers U6, U9
Unemployment rate;
growth rate of
real wages
Figure 16.20 Determinants of the unemployment rate and the growth rate of real
wages in the long run.
Technological change
U1, U2, U3
• Competition policy
• R&D, Patents
Conflict over work
and wages U6
Productivity growth
U1, U2, U3
Price-setting curve
U9, U15, U16
Beveridge curve
U16
Wage-setting curve
U6, U9, U15, U16
Job creation and
destruction; firm entry
and exit U16
Wage-setting by
firms and work effort
by workers U6, U9
Unemployment rate;
growth rate of
real wages
• Education
• Active labour
market policy
• Employment
protection
legislation (EPL)
• Unions
• Industrial relations
legislation
• Tax policy
• Competition policy
• Environment for
doing business
• Oil shocks
• Unemployment
benefits
• Employment
protection
legislation (EPL)
Figure 16.21 The institutions, policies, and shocks that can influence unemployment
and real wages.
16.13 CONCLUSION
Unemployment is a market failure: it means that there are people willing to
work at the current market wage but cannot find a willing employer. Job
destruction is a constant feature of capitalist economies, in which technolo-
gical changes tend to raise productivity and put some workers out of their
jobs. But a well-functioning economy will also feature high levels of invest-
ment that ensure that jobs are created at least as fast as they are destroyed.
Ensuring that firms will invest both in technological progress and in job
creation is one of the fundamental incentive problems of a capitalist eco-
nomy. The other is ensuring that workers have the incentive to put in
sufficient effort to do their jobs. We have analysed these incentives using
the price-setting curve and the wage-setting curve, which show respectively
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
740
the maximum wage that firms can pay and still remain in the industry, and
the minimum wage that can be paid to get sufficient effort from workers.
The main difference between the high-performing economies and the
laggards is that in high-performing economies, institutions and policies
work so that the incentives of the main actors are to increase the size of the
pie, rather than wasting resources fighting over the size of the slice.
Concepts introduced in Unit 16
Before you move on, review these definitions:
• Creative destruction
• Marginal product of capital
• Job creation, job destruction
• Diminishing marginal product of capital
• Beveridge curve
• Labour market matching
• Long-run price-setting curve
• Equilibrium markup
• Diffusion gap, adjustment gap
16.14 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
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Korkman, Hans Tson Söderström, and Juhana Vartiainen. 2007. The
Nordic Model: Embracing Globalization and Sharing Risks
(https://tinyco.re/2490148). Helsinki: Taloustierto Oy.
Autor, David, and Gordon Hanson. NBER Reporter 2014 Number 2: Research
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(https://tinyco.re/2846538).
Bentolila, Samuel, Tito Boeri, and Pierre Cahuc. 2010. ‘Ending the Scourge
of Dual Markets in Europe’ (https://tinyco.re/2724010). VoxEU.org.
Updated 12 July 2010.
Blanchard, Olivier, and Justin Wolfers. 2000. ‘The Role of Shocks and Insti-
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Evidence’. The Economic Journal 110 (462): pp. 1–33.
Blanchflower, David G., and Andrew J. Oswald. 1995. ‘An Introduction to
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Burda, Michael, and Jennifer Hunt. 2011. ‘The German Labour-Market
Miracle’ (https://tinyco.re/2090811). VoxEU.org. Updated
2 November 2011.
Carlin, Wendy and David Soskice. 2015. Macroeconomics: Institutions,
Instability, and the Financial System. Oxford: Oxford University Press.
Chapters 8, 15.
EconTalk. 2016. ‘David Autor on Trade, China, and U.S. Labor Markets’
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Updated 26 December 2016.
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Century: The Search for Labour Saving Inventions. United Kingdom:
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741
Hobsbawm, Eric, and George Rudé. 1969. Captain Swing. London:
Lawrence and Wishart.
Howell, David R., Dean Baker, Andrew Glyn, and John Schmitt. 2007. ‘Are
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A Critical Review of the Evidence’ (https://tinyco.re/
2000761). Capitalism and Society 2 (1).
Keynes, John Maynard. 1923. A Tract on Monetary Reform. London,
Macmillan and Co.
Nelson, Richard R., and Gavin Wright. 1992. ‘The Rise and Fall of American
Technological Leadership: The Postwar Era in Historical Perspective’
(https://tinyco.re/2811203). Journal of Economic Literature 30 (4)
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Nickell, Stephen, and Jan van Ours. 2000. ‘The Netherlands and the United
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Rifkin, Jeremy. 1996. The End of Work: The Decline of the Global Labor Force
and the Dawn of the Post-Market Era. New York, NY: G. P. Putnam’s
Sons.
Singer, Natasha. 2014. ‘In the Sharing Economy, Workers Find Both
Freedom and Uncertainty’ (https://tinyco.re/2844216). The New York
Times. Updated 16 August 2014.
Sterk, Vincent. 2015. ‘Home Equity, Mobility, and Macroeconomic
Fluctuations’ (https://tinyco.re/2186300). Journal of Monetary Eco-
nomics 74 (September): pp. 16–32.
Wooldridge, Adrian. 2013. Northern Lights (https://tinyco.re/2892712).
Updated 2 February 2013.
UNIT 16 TECHNOLOGICAL PROGRESS, EMPLOYMENT, AND LIVING STANDARDS
742