Module 12 Potential Output

Introduction

Simple model classify resources as:

Capitol Goods	Land Capital
Labour Force	Labour Enterprise

In the short run (a year) supply of factors of production and state of technical knowledge are given or fixed. Result in fixed upper limit of total output known as the ‘production potential’

Producing a fixed quantity of inputs means forgoing alternative compilations, dilemma encounter: how to allocate scarce resources.

Potential Output in the Long Run

Short run the most important question is whether a society attains its given production possibility frontier, thus making full use of the existing supply of the factors of production and the given stock of technical knowledge.

Longer periods of time production possibility frontier is not fixed

Net investment

=

Gross investment

-

Replacement Investment

72 divided by growth rate = number of years to double investment

Measure Potential Output

Unemployment rate (U) x capacity utilization (as measured in industry surveys)

Degree of capacity utilization Ý increase the rate of unemployment ßfalls.

• Unemployment rate never falls to zero and
• Capacity utilization never reaches 100 %

Full employment is not defined in terms of zero rate unemployment, but as a target rate of unemployment.

The unemployment rate is determined by the difference between actual and potential output. Thus if potential output and the unemployment rate both increase the potential output rate must, by definition, have increased at a faster rate than actual output.

Types of Unemployment

Frictional	Job search
Structural	Industrial Change – mismatch between unemployed and characteristics of the job vacancies
Seasonal	Dependent on weather or the calendar
Demand Deficient	Actual Output (Y) < Potential Output (Q) Insufficient Demand for Labour

Most important factors determine the amount of frictional, structural, and seasonal unemployment are:

a) Level of economic activity

b) Transmission of information

c) Rate of structural change

d) Ease of changing occupation and home

e) Institutional restrictions and barriers;

f) Dependence on seasonal industries

Unemployment affected by general level of economic activity.

Actual Output	Close	Potential Output	Ý Employment	Strong competition among employers to hire labour
Actual Output	Below	Potential Output	ß Employment	Less competition among employers to hire labour – frictional & structural unemployment will increase
Unemployment	affected by quality of transmission of job information
Structural Change – tastes change, new products emerge
Seasonal industries

In a perfectly competitive labour market wages would fall if the supply of labour exceeded the demand for labour. For a variety of reasons in many labour markets this does not occur, e.g. collective bargaining agreements, employers wishing to retain employee goodwill and it is said ‘wages are sticky downwards’, i.e. downward wage rigidity

The Relation Between the unemployment Rate (U), Potential Output (Q) and Actual Output (Y)

Policy makers are more confident about eradicating demand-deficient unemployment than they are about frictional, structural, and seasonal unemployment

Main category of unemployment

Demand Deficient

Actual Output (Y) < Potential Output (Q) Insufficient Demand for Labour

Output and Inflation

Inflation Rate

% increase per year in the average price level from one time period to another.

Price level is the Consumer Price Index. This measures the average level of prices of the goods and services consumed by the typical household. Calculated monthly. Several hundreds goods and services regularly purchased each month by average households are selected, initially to establish a base period,

Index that includes all goods and services produced in the economy is known as the GNP deflator.

Ý Aggregate demand (D)	ß Unemployment (U)	Ý Inflation Rate (INF)
ß Aggregate demand (D)	ÝUnemployment (U)	ß Inflation Rate (INF)

Philips Curve

Philips Curve is a short-run relationship. It simply shows the consequence for inflation and unemployment would be in any given short-run period for various levels of aggregate demand.

1) Slopes downward from left to right- any short-run period, lower unemployment will be associated with higher inflation, depend on the level of aggregate demand,

Inverse relationship between unemployment and inflations referred to as the trade-off between unemployment and inflation

Lower unemployment can only be achieved at the expense of higher inflation

2) Historically it has usually been in a position such that the inflation rate that occurs at full employment is positive. Inflationary bias of the economy.

Full employment does not mean zero unemployment it means that there are enough jobs available for all those who are in the labour force, but there is still an imperfect match between jobs and workers, In other words, even though there is full employment, there is frictional and structural unemployment

Unemployment and inflation depends on where the economy is on the curve. At high rates of unemployment, the curve is relatively flat.

The Philips Curve shifts up or down over time

Ý Shifts Up

Ý Full employment inflation rate

Unemployment rate where inflation is zero will be Ý

The rate of inflation that results in any period depends not only where the economy is along the Philips curve, but also the position of the Phillips Curve itself.

High aggregate demand means a low unemployment rate; the ‘high’ in aggregate demand refers to actual GNP being close to, equal to or greater than potential output which by definition means almost full employment, full employment or excess demand for labour.

Policy Makers must decide where along the inflation-unemployment trade-off the economy should be.

How decided depends in part on the position of the Phillips Curve.

When relatively low and to the left tend to choose target close to full employment

When high and to the right choose low inflation even though this will mean higher unemployment.

The Phillips Curve shows a relationship between unemployment rates and inflation rates for a given level of aggregate demand. The inverse relationship observed between inflation and unemployment rates (the trade off) is in one sense like the inverse relationship between prices and quantities; for a given income, on a demand curve, i.e. if income were to increase dramatically a ‘large’ quantity might be purchased at a high price, i.e. large compared to what was purchased previously at a low income. Thus if aggregate demand were to change dramatically (a shifting Phillips Curve) relationship between low unemployment and high inflation may not be observed empirically.

Okun’s Law

A relationship between an economy's GDP gap and the actual unemployment rate.

The relationship is represented by a ratio of 1 to 3.

Thus, for every 1% excess of the natural unemployment rate, a 3% GDP gap is predicted.

Based on empirical data, associated a 1% unemployment rate (above the full employment unemployment rate) with a 3% reduction in real output.

Review

Scarcity and choice

It is the dual existence of insatiable wants and limited resources that produces, what economists call, the fundamental fact of scarcity. Economics is the study of how individuals and nations use resources under their command to satisfy their wants as fully as possible; economics is concerned with scarcity and choice; scarcity because there are insufficient resources to produce the goods and services to satisfy all wants fully, choice because resources used to produce one set of goods and services are, by definition, not available to produce a different set of goods and services.

There are three different methods of solving the scarcity-choice problem in the world today; by tradition by command and by market. All nations today utilise each of the methods albeit in differing degrees. The traditional method relies upon social custom and habit; the command method relies upon the decision of a central ruling body; the market method relies upon the interactions of willing buyers and willing sellers negotiating prices and quantities exchanged.

Economic efficiency

Technological efficiency means producing goods and services using a minimum amount of resources. Economic efficiency subsumes technological efficiency but also requires that the collection of goods and services produced, compared to all other possible collections of goods and services, is that collection which satisfies society’s wants as fully as possible.

Economic equity

Economic equity does not mean economic equality but rather a fair or equitable method of allocating the goods and services produced in an economy. In traditional economic systems custom determines the allocative process with the important members of the society being ‘first served’. In planned economies wages and salaries are fixed by the central committee for different types of workers and the prices of goods and services are also determined centrally. What the authorities cannot guarantee is that the goods and services produced will be bought or that the goods and services desired will be produced in sufficient quantities for all who wish to purchase them.

In market economies competition for resources to produce goods and services determines the prices of these resources and consequently the distribution of income among resource owners. People with meagre/zero resources have to rely on the charity of upper income groups to survive, normally through government tax/transfer schemes.

i. Potential output

Potential output (Q) is the output that would be produced if all resources were fully employed. Actual output (Y) is the output of goods and services which is produced and it may equal potential, exceed potential or be less than potential. When Q = Y the economy is at full employment, i.e. the only unemployment which exists is composed of frictional and structural elements. When Q > Y, unemployment exists; this unemployment is due to lack of aggregate demand, i.e. the sum of consumer demand (C), investment demand (I), government demand (G) and net international demand (X-Z) is insufficient for Y to equal Q. When Q < Y, possible in the short-run because of the way full employment is defined, inflationary forces come into play.The government by using monetary and fiscal policy can regulate aggregate demand. Increasing G, cutting taxes and increasing the money supply to reduce interest rates are stimulatory policies whereas the reverse are deflationary policies. Enacting policies to keep Y close to Q, a moving target because of increases in the quality and quantity of the labour force and the capital stock, is a difficult task compounded by the constraints of attempting to achieve other desirable macroeconomic goals.

Explain why the existence of monopolies in market economies can prevent economic efficiency being achieved, why society may still wish to have monopolies and what regulations can be put in place to attempt to achieve economic efficiency when monopolies are present.

Monopoly

Economic efficiency prevails when the marginal efficiency conditions (MEC) are met, i.e. when

The MEC comprise two elements.

Consumer maximising equilibrium

and perfectly competitive firm equilibrium.

In a monopoly (m), profit will be maximised at the output at which marginal revenue (MR) equals marginal cost (MC). The profit maximising price which clears the market is greater than MC.

and as a consequence

and economic efficiency will not prevail in the presence of monopoly; too little of the monopolistically produced goods and too much of the competitively produced goods will exist.

The reason society may wish to preserve monopolies is because of economies of scale. To take advantage of these economies of scale and in an attempt to establish the MEC monopolies may be permitted but have their output/pricing strategy determined by government in an attempt to equalise P_m with MC_m thus achieve economic efficiency. Monopoly profit can be taxed and monopoly loss subsidised.

How useful might policy makers find Okun’s Law and the Phillips Curve to be if the economy is suffering from a high rate of unemployment?

Okun’s Law states by how much actual output has to increase to decrease the unemployment rate by say 1%.

The equation is

Q = potential output

Y = actual output

U_F = natural rate of unemployment

For this equation an increase in Y of 3% is required to decrease U by 1% assuming U > U_F. Thus if U_F were 5% and U were 7% then to bring about full employment policies would have to be enacted to increase Y by 6%.

The Phillips Curve shows for a short-run period the associated unemployment and inflation rates. This trade off between inflation and unemployment can pose a dilemma for policy makers, i.e. which is the lesser of two evils in the short-run and how might a given set of policies affect variables such as unemployment and inflation in a longer time period.