Question

Suppose an economy experiences an increase in productivity. Explain both the short-run and medium-run effects of this increase in productivity on output, employment, and the unemployment rate.

Answer 1

Productivity of an economy is a measure which tells us how efficiently an economy can translate input into output. Low productivity would mean that for producing a certain amount of output it requires higher amount of input as compared to the economy where productivity is high.

Let's understand the implication of increased productivity in short run and medium run on output, employment and unemployment rate.

Let's first understand the effects of increased productivity in short run. In short run increased productivity would mean that the output that country was producing would now require less amount of input. In short run the output doesn't adjust since it takes time for firms and economic actor to change their future production plans and consumers take time to change their consumption pattern. So in short run output doesn't change. Given that output doesn't change, the increased productivity would require less amount of labor to produce the certain amount of output. This would mean the employment rate would decrease and unemployment rate would increase.

Now let's see what happens in medium run. Once the firms owner understand that productivity of labors has increased, their cost of production decreases since now they have to employ less labors. Consequently their profits increases, as result they change their future production plan, and starts employing more labors. And when they employ more labors their income goes up, which in turn means that the demand in the economy goes up. And this virtuous cycle continues, higher demand would mean more production and more employment.

So in medium run, the output rate would increase, employment rate also increases while unemployment rate decreases.