Welcome back my fellow Earth economists! Today we will take a closer look at the supply side of Earth. We will distinguish between the short-run and long-run supply, and we investigate how reforms can be designed to make the Earth economy more efficient. At the end of the session, you will be able to critically analyze the interaction of Earth supply and Earth demand. That means that we have completed the Earth economic model. Earth economic supply involves combining labor and capital in the production process. People work with tools, machines, and infrastructures. In this lecture, the stock of capital simply exists, and the question is how and to what extent this stock is used in combination with the available amount of labor? The production function Q in this formula describes how we can use combinations of production factors. Machines can replace workers to some extent. More employees can sometimes achieve similar production as could be produced with more capital. In the case of substitution, different quantities of labor and capital can be combined to reach a particular level of production. A firm decides on the mix of production factors based on their contribution to production. For instance, if wages increase, firms will invest in labor saving technologies, reducing the amount of labor and increasing the amount of capital used in production. Typically, substitution implies relocation of factors of production and that requires time. So often in the short-term, the possibilities for substitution are limited. For that reason, a mismatch can occur for short-run supply. The short run Earth economic supply curve slopes upward because at lower prices, production will be reduced. While higher prices will induce firms to hire more labor, and stretch production, and move towards long-run supply. It is, however, difficult to maintain such high levels of production. So the price level increases steeper when production gets near its maximum. Earth short-term supply function can shift down, for example, when wages are moderated or when subsidies reduce the price level. It will shift up due to cost-push inflation when prices increase for intermediate inputs and production. Also increases in direct taxes such as value-added tax and border tariffs shift the curve up. Long-run Earth economics supply is vertical line. The location of the supply function is determined by the quality and quantity of the production factors. The long-run production function is price insensitive. Professor Peter, why is a supply curve price insensitive in the long run? I think that you can see this best when you consider that long-run supply is the production level at which you use all the factors of production that are available. Yes. I understand that price increase won't necessarily boost production, while a price decrease most likely will reduce it. So the price doesn't matter, right? Well, you make a good point. But now it's also important to see that this means that you are no longer on the long-run supply function. Indeed, because of the fact that price matters, you must be on the short run supply curve. The supply curve shifts down and to the left when the quality and/or quantities of the production factors decrease. Likewise, outwards shifts occur if the quantity and/or quality of Earth's production factors increases. For example, when natural resources are discovered. In the next session, we will study investment as one of the key drivers of long-run supply. Also policy shifts can exert a positive or negative influence. Fighting corruption would increase supply. Privatization, deregulation, and liberalization are often assumed to stimulate competition, and thereby enhance efficiency. This is the mantra of the OECD's Structural Reform agenda and of the Washington Consensus that both were extremely influential in framing and shaping structural reform policies around the globe. You may wish to look these terms up in Google if you're not familiar with them. Let's look at how these policies spread. We start in 1980. The jurisdictions in red with a competition law are in the minority. But that has changed dramatically by 2005. In 25 years, Earth experienced structural reform, and in 2005 the world was pro competition. This is yet another illustration of the point that while we have different governments in our analysis, we can treat Earth as if it has one government when the vast majority of countries move into the same direction. Now, structural reform does not always and unambiguously have a positive impact on key economic variables. For example, the finance minister may like highly profitable monopolies with lots of tax revenues. Let's investigate one of the often overlooked consequences of structural reform, namely the ambiguous impact on the labor market. I start with a diagram with GPP on the vertical axis and the Earth price level on the horizontal axis. Pay extra attention if you are an economist, because then you would expect price vertically and quantity horizontally. Earth supply slopes upward, Earth demand slopes downward. The economy is below the full employment equilibrium, because distortions in the economy create a wedge between demand and supply. For example, because there is no competition authority. Now, let us investigate what happens if more vigorous competition policies are applied worldwide. Undoubtedly, this is beneficial for it. Production increases and the price level decreases, because market prices move towards competitive levels. Now I need an extra panel to see what happens with labor demand. We have labor demand horizontally and vertically, GPP. The purple line shows how much can be produced with labor. I used that to see how much labor I need for a level of GPP. Since production increases, that would seem to increase demand for labor, but the story may be different. Structural reform increases efficiency, and that means that labor can produce more. Therefore, the curve shifts up. Now you can see that the higher GPP in a more efficient world can be achieved with less labor. Of course, we have two options. Option 1, the increase in Earth economic demand is stronger than the increase in labor productivity, so that labor demand increases. Or second option, the increase in labor productivity exceeds the increase in Earth economic demand so that labor demand actually falls. The implication is that a policy of structural reform can ignite growth, but its impact on employment and unemployment is uncertain. The stronger the increase in productivity, the lower the probability that jobs will be created. This is something that we need to investigate further when we take a look next time on production and the long run.
