Monday, October 25, 2010

Capacity Utilization, Aggregate Supply and The Production Possiblities Frontier---Your future is contained within these Graphs--How is the view?

     I believe one of the most important connections I try to make with students is the link between our economy's productive capacity and students future careers and aspirations.  A mantra familiar to my students: "If politicians, policy-makers, and business leaders are NOT working TODAY to make the necessary investments to ensure future increased productive capacity, then students will find their career prospects limited when that future arrives.  Your job is not created when you are ready to go to work. The preparation for that career/job to exist (or not) is, taking place TODAY".  Keep this in mind as I illustrate how productive capacity affects the economy in the short and long run.
      We need to link three familiar AP Macro concepts together: Capacity Utilization, The Production Possibilities Frontier, and the Aggregate Demand/Aggregate Supply Model of the Economy.  First, lets look at Capacity Utilization:
""Capacity utilization is a concept in economics which refers to the extent to which an enterprise or a nation actually uses its installed productive capacity. Thus, it refers to the relationship between actual output that 'is' produced with the installed equipment and the potential output which 'could' be produced with it, if capacity was fully used.""
     In other words, it is a measure of how efficiently and effectively (aka "productive efficiency") we employ our societal resources (Land, Labor, Capital, Entrepreneurship) to produce goods and services.  It is impossible to fully employ all of our resources and it is not necessarily desirable to do so.  It seems it would be a prudent policy to conserve resources for future use by subsequent generations.  There will always be some amount of resources that are not employed at any given time.  The consensus in the economics community is that if an economy can achieve approx. 83% of Capacity Utilization (resource employment) then it is theoretically at "Full-Employment". I repeat,  this does not mean 100% resource employment but if you reach 83% of capacity then that should be the best you can expect to do in the long run. 
     The two graphs below show the economy at full-employment in two different ways, but each are linked.  The first is the PPF, which shows the potential production of goods an economy can achieve if it is fully employing all of its resources in the least costly way ("Productive Efficiency").  More simply, it is the measure of raw production of capital goods and consumer goods.  The second graph on the right shows the dollar value, denoted by "FE RGDP" (Read that "Full-Employment Real GDP"), of that raw production of consumer and capital goods.  When Aggregate Demand (AD) intersects our short-run ability (SRAS) to produce goods AND our long-run ability (LRAS) to produce goods, then we are said to be at "Long-Run Equilibrium".  Point "A" on both graphs represents this nirvana.  Presidents easily get re-elected and the TEA Party's and's of the world go away. 

     Where are we today in terms of Capacity Utilization? This graph shows capacity utilization for an extended time period.  Note the ebbs and flows from the full-employment baseline of 83%---anything below is under-utilizing capacity and anything over is producing beyond our capacity.  The blue vertical bars represent recessions.  You can see there is always a dip during recessions and a rise during periods of recovery.
     The last bar to the right represents the most recent recession.  Notice how capacity utilization has recovered somewhat from its nadir in 2009, however it is still near its lowest point in 40 years. How do we relate this situation to the PPF and the AD/AS Model of the Economy?  See the next two graphs below:

     We are obviously under-utilizing resources in our economy. We see it everywhere--closed stores, friends or family members losing jobs.  The actual unemployment rate is close to 10%, which is double the Natural Rate of Unemployment, roughly 5%.  Other resources, land, capital, entrepreneurship, are standing idle as well.  Currently our capacity utilization is at 75%.  This can be represented by point "B" in the PPF graph and in the AD/AS Model of the Economy.  We know we COULD be producing at point "A" but currently we are not.  Why?
     One explanation is that there is not enough demand for those under-utilized resources.  As the financial crisis took hold in early 2007, people started losing their jobs.  Unemployed people don't buy as much as they did before; businesses don't sell as much as they did before and either lay people off or close stores altogether; manufacturers produce less because retailers don't reorder, so they lay people off or close factories... Do you see the idle capacity being created before your eyes as the situation ripples across the economy!! The productive capacity STILL exists (store-fronts, factories, skilled workers, etc, have not gone away), but the demand for them is not currently there.  This is shown in the graph above on the right.  Aggregate Demand for goods and services DECREASES and shifts to the left (Point "B").  We have high unemployment and potential deflation, both not desirable to have in an economy. 
     What happens, if and when, the economy recovers and Aggregate Demand picks up? Hopefully we get back to the situation in the very first set of graphs---Full-employment at a stable price level.  However, there is potential for Aggregate Demand to shoot past FE RGDP and into inflation territory. Why? Because we will start to use that under-utilized capacity and IF the recovery in Aggregate Demand is so strong that is uses up all that under-utilized capacity and then demands MORE, we hit a new problem--Inflation!  This is illustrated in these two graphs below:

     Capacity utilization moves above 83% and our productive capacity becomes over-employed and stresses start to appear.  Factories operate at a level they were not designed for and employees are working overtime and/or extra shifts.  Something has to give!! We are wearing out existing productive capacity! During the downturn businesses may not have  replaced capital equipment, purchased new capital or technology, or built new facilities and the productive capacity is not there to meet the new demand.  The ability to supply goods lags behind the demand for those goods---Too few goods are being produced relative to the money flowing though the economy from (1) fiscal stimulus and (2) Federal Reserve monetary policies. This is the classical definition of inflation.   Now Congress, the President and the Federal Reserve have a new problem on their hands!
   So, during a downturn do the powers-that-be focus just on the demand-side to get the economy moving forward (Aggregate Demand shifting to the Right) to absorb excess/under-utilized capacity (mainly people) and put them back to productive work making goods, or do they focus on the supply-side, so when the inevitable(?) pick-up in the economy occurs the productive capacity (SRAS and LRAS) has increased sufficiently to absorb the new demand without igniting inflation? Hmmm...Feed demand, starve supply OR Feed Supply, starve demand? What would YOU do??  I am glad I have no additional responsibility other than to write this blog entry...Not sure I could take the pressure of answering the question....
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