4.1 The Production
output or supply
(GDP) depends on the production function of a
country. In symbolic logic,
Ys = f (K, L, N, .....) where:
Ys = aggregate supply;
some function of technology
Natural Resources; and,
... = all other imaginable factors
of production or inputs.
Taken together, available Capital, Labour and Natural Resources constitute
a Nation-State's 'factor endowment'. This endowment varies dramatically. Consider Canada and Singapore. While Canada has a
highly educated population it relies on its Natural Resources to make
its way in the world. Singapore, on the other hand, has virtually no
Natural Resources yet prospers. Accordingly
before deriving the Aggregate Supply Curve in the short and long run it is
appropriate to consider the primary factors of production: Capital, Labour &
Natural Resources as well as Technological Change. For those interested in
a more detailed historical and philosophical understanding of these factors of
production, please see:
Observation #3: Capital, Labour & Natural Resources and
i - Capital (K)
definition of capital is an unresolved problem in economics. To
Marxists, it is theft. To the mainstream, its definition remains
problematic as noted by T.K. Rymes of Carleton University in
conversation with the author in the early 1970s: “If there is no theory
of capital, there is no economics. And there is no theory of
capital!” Actually there are many.
Today, when economists
speak of Capital, they may refer to cultural, financial, human, legal,
physical, social or other forms expressed as a stock, e.g.,
the physical plant and equipment existing at a given moment in time.
For our purposes Capital is so defined: physical plant and equipment
existing at a given moment in time. Financial capital is treated,
for our purposes, as money acting as a unit of account for this physical
ii - Labour (L)
three forms of Labour: Productive, Managerial & Entrepreneurial. All three embody personal knowledge.
Productive workers are those on the shop floor actually producing goods
& services. They are concerned with output. Their knowledge is technical
and specialized to a given industry or firm. In this sense the competitiveness of a firm or
nation “depends not only on sensible decisions about what to do, but on
the availability of the skills that are required to do it” (Loasby
other things, means “a governing body of an organization or business,
regarded collectively; the group of employees which administers and
controls a business or industry, as opposed to the labour force”. The role of management is to make
available the means (inputs) so production workers can perform
their tasks and then market and distribute the output. One crucial
characteristic of the firm is custom including tacit understandings of
entitlements and obligations between productive, managerial and
entrepreneurial workers. This constitutes part of ‘corporate culture’.
With the notable
exception of firms like Microsoft (Bill Gates) and Walmart (Sam Walton),
most major corporations do not follow an original founder/owner but
rather a ‘hired gun’, or business entrepreneur. The word ‘entrepreneur’
comes from the French entre meaning ‘between’ and prendre
meaning ‘to take’. The English ‘middleman’ retains this original
sense. Today the term usually refers to someone
who sees and seizes an economic opportunity or a market opening or gap.
This may take the form of a new product or of servicing an existing
market in a new way. In both cases a high degree of creativity and
risk-taking is implicit. Entrepreneurial
knowledge is intuitive in seeing and taking advantage of invariants and
affordances in a market that others do not see. It involves seeing and
realizing a vision of future markets, products and opportunities and
leads the organization in realizing that vision.
iii - Natural Resources
definition of a natural resources is constantly evolving.
At first glance, natural resources have no relationship to knowledge. By
definition, they exist as John Locke said in “the State that Nature hath
provided”. They are just part of the environment until the knowing mind
recognizes them as useful. Thus oil lay in the ground virtually untapped
until invention of the internal combustion engine. Just as we recognize
a tool by its purpose, we similarly identify
natural resources by the human ends we attribute to them. At a given
point in time a naturally occurring substance is seen as nothing but an
environmental feature. Take a pathway through the jungle one day and you
see a large rock outcrop. The next day, with new knowledge, the same
path leads not to an environmental feature but to a bauxite deposit that
can be converted into aluminum. It has become a toolable natural
resource. Yet it itself has not changed, one day to the next, rather new
knowledge allows us to see it in a different light.
What do we mean by
technology? The word ‘technology’ entered the English language only in
1859 according to the Merriam Webster Dictionary deriving from
the Greek techne meaning Art and logos meaning Reason,
i.e., reasoned art. Physical technology, to paraphrase Heidegger, is the enframing and
enabling of Nature to serve human purpose. Technological change
in the Standard Model of Market Economics refers to the impact of new
knowledge on the production function of a firm or nation. The content
and source of that knowledge is not a theoretical concern; what matters
is its mathematical impact on the production function.
In Economics, measurable
technological change only entered the mainstream in 1957
when Robert Solow published "Technical
Change and the Aggregate Production Function". In it he presented what is known as
the Solow Residual. It begins with a symbolic
equation for the production function: Y = f (K, L, T)
which reads: national income (Y) is some function (f)
of capital (K), labour (L) and technological change (T). Over the last
hundred years, depending on the study, something like 25% of growth in
national income is attributable to changes in the quantity
and quality of Capital and Labour while 75% is attributable to technological change. Yet we have no idea of why some
things are invented and others not; and, why some things are
successfully innovated and brought to market and others are not. The
Solow Residual is known in the profession as the measure of our
economic ignorance. The economic effects of this residual was
destruction' by economist Joseph Schumpeter. For
those interested in further information
please see my:
The Economic Meaning of Technological Change, especially
Exhibit 1: Evolution of
the Production Function.
models can be
by technological change, e.g., information technology in the
1980s reduced the need for middle management and resulted in significant
'downsizing' of large firms. In response to
technological change, the production function may shift
upwards or downwards, i.e., technology can be lost as well as
found, e.g., after the fall of Roman Empire. The quantity and/or cost per unit output may
increase or decrease. Alternatively, an entirely new production
function may emerge with innovation of new and/or elimination of old
products, processes and techniques. Technological knowledge thus does not
only accumulate; it also withers away if not transmitted to subsequent
generations. The later is most apparent with respect to traditional
craft methods (White & Hart 1990) and arguably with
deindustrialization of many parts of the developed world. The process has been compared by
Kaufmann to speciation and extinction in biology (Kauffman
Short Run Aggregate Supply (SAS)
C14/352-6: 329-33; 338-341)
We will derive both
Aggregate Supply Curves - Short Run (SAS) and Long Run (LAS) - using
what Keynes called "diagrammatic illustrations of economic problems"
1924, 329). As with Aggregate Expenditure and Demand there
are, on the supply side of the macroeconomic equation, two supply curves
- the short-run aggregate supply (SAS) and the long-run or potential
aggregate supply (LAS) . This results in the 'Keynesian double
cross'. In Microeconomics, X marks the spot of market equilibrium of
Supply and Demand. In
Macroeconomics there are two Supply and two Demand curves and
equilibrium is defined with respect to both the current (short run) and
potential (long run) equilibrium of a national economy.
SAS is plotted using
the schedule of increasing price levels (Y axis) and real GDP (X axis)
7th Ed Fig. 26.1;
R&L 13th Ed
MKM Fig. 14.7) assuming nominal factor prices remain
constant. This means that if the overall price level rises then real
factor prices decline resulting in increased production.
goes up (P x Q) while cost (factor prices) remains the same, i.e.,
profits increase. Because real production grows as prices rise SAS
is upward sloping, that is, it has a positive slope. To repeat, higher
prices for goods and services with lower real factor cost in production
increases profits and encourages firms to supply more. Shifts in SAS
can occur due to change in any factor costs and from technological
7th Ed 26.11;
R&L Fig. 23-4 13th Ed). One way of thinking about SAS is that it is the
summation of the supply curves of all producing enterprise in an economy
and reacts the same way to changes in final and factor prices.
There is, however,
within the economics profession, controversy about SAS's slope.
Thus in the Classical Model it is assumed that money wages and prices
are perfectly flexible. This means any increase in demand simply
raises prices rather than expand output. SAS is inelastic or even
vertical. It is with this assumption that Keynes took exception.
He believed that the money wage was not perfectly flexible.
Rather, it was subject to at least four rigidities .
wage bargaining tends to focus not just on the wage rate but also on the
wage differential between different types of workers, i.e., there
is no an homogenous unit of Labour but rather many different forms and
types. A given group of workers resist wage cuts not just because of
the financial cost but also the status implications relative to other
workers. A case in point is the wage differential between police
officers and fire fighters. Over time a wage differential develops
reflecting the relative worth of each group. Any attempt to alter that
balance tends to be resisted.
unions negotiate contracts for specific time periods, e.g., two
or three years. During that period the money wage cannot be changed by
even when there is no formal contract between unions and firms there is
a tendency – a convention - to maintain the money wage for a given time
Labour exhibits 'backward looking expectations' about price changes,
a.k.a., inflation. Thus they expect the future to be a projection
of past experience. Business, on the other hand, exhibits 'forward
looking expectations' given its day-to-day experience of the changing
prices of inputs, outputs and competitors.
Taken together these
four factors make the money wage ‘sticky’ rather than perfectly flexible
as assumed in the Classical Model and in the New Classical Model known
as the School of Rational Expectations. Under the Keynesian Model
'sticky' wages results in a SAS curve with a relatively gentle upward
slope. In the Classical and New Classical Models, flexible wages and
prices result in a very inelastic or even vertical SAS. The difference
in the slope of the SAS curve has significant implications for fiscal
and monetary policy.
4.3 Long Run/Potential Aggregate Supply (LAS)
The Long Run
Aggregate Supply Curve (LAS) is found when all available factors of
production (K, L, N, T, etc.) are fully employed (P&B
7th Ed Fig. 26.1;
MKM Fig. 14.5). LAS is vertical meaning there can be no increase in
output given that factors of production are fully employed. LAS
corresponds to potential real GDP of a national economy, that is, the
maximum output attainable given the existing supply of factors of
Movement up or down LAS curve is caused by changes in two
sets of prices: (i) the overall or aggregate price level for final goods
and services; and, (ii) factor prices. If final prices go up then factor
prices will rise at the same rate meaning that 'real' wage rates and
other factor prices remain constant as does real GDP.
LAS can shift, left
or right, if there are increases or decreases in available factors of
production, e.g. the quantity of labour grows or shrinks, changes
in the quantity of capital (investment) or technological progress (P&B
7th Ed 26.2; R&L 13th Ed
MKM Fig. 14.6). In this regard it is important to realize that
technological knowledge can be lost as well as found. Take the case of
the Roman Empire after the barbarian conquest.
The key for movement
along SAS is the labour market. Movement up along the curve means real
GDP rises as the price level rises because unemployment falls as the
real wage rate falls with nominal or money wages fixed. This will
continue until SAS measured by real GDP attains LAS or potential GDP at
which point the natural rate of Ue or 'full employment' is achieved.
This 'natural rate of Ue' is not zero but rather reflects 'frictional'
and structural Ue (P&B
7th Ed 26.1).
If one moves along
the SAS beyond LAS or potential GDP, i.e., after full employment
has been achieved, factor prices including the real wage rate will
increase due to competition for fully employed factors. That is while
in the short run output may exceed potential for example due to overtime
and extra shifts it cannot be maintained because competition for fully
employed factors of production raises their cost causing production to
drop shifting SAS to the left. Thus rather than increased real GDP
(which has reached its limit), money factor prices will rise and
movement will shift up along the LAS curve reflecting rising final
prices for goods and services rather than up SAS (P&B
3rd Ed Fig 24.2).
Shifts in SAS occur
because of changes in real factor prices thereby affecting a firm’s
costs of production. LAS does not shift with changing factor prices
because factors or inputs are fully employed. However, changes in the
quantity of Capital and/or Labour as well as advances in technology
cause shifts in both SAS and LAS (P&B
7th Ed Fig. 26.2;
R&L 13th Ed
In conclusion, I ask
you, after class, as a thought experiment, to consider the impact on SAS
and LAS of a change in a national production function and its related
factor endowment of Capital, Labour and Natural Resources as well as
Technological Change in a field or industry of personal interest and
4.4 AD-AS Equilibrium (MKM
The purpose of
the AD/AS model is to understand and predict changes in real GDP and the
price level. It represents another application of the Marshallian
scissors of microeconomics. There are both short-run (SR) and long-run
(LR) points of equilibrium, that is points to which the model will
return after any short-term changes in the underlying variables of the
i -SR Real GDP & Prices
occurs when SAD = SAS. If the economy is not in equilibrium forces will
tend to bring the economy back into equilibrium (P&B
7th Ed Fig. 26.6;
R&L 13th Ed
For example, if real GDP is higher than equilibrium, final and factor
prices tend to be higher than consumers are willing to pay and firms
will cut production, lower prices and factor prices will tend to fall.
If, on the other hand, real GDP is less than equilibrium, the quantity
of final goods producers supply is less than consumer demand forcing up
all prices until equilibrium is achieved.
SR Equilibrium & Full Employment (FE)
SR equilibrium is
not necessarily at potential real GDP or full employment. If it is less
there is a recessionary gap; if it is more there is an inflationary gap
(P&B 7th Ed
Fig. 26.6 &
R&L 13th Ed
MKM Fig. 14.8). Overtime the economy will tend to adjust in response to
the forces at play and return the economy to LR equilibrium. For
example in a recession, factor prices are depressed causing the cost of
production to fall and output to increase over time. During inflation,
factor prices are elevated causing the cost of production to rise and
output to fall.
LR Growth & Inflation
growth shifts LAS to the right, i.e., increased potential. The
rate at which LAS shifts is measured by the growth rate of potential GDP.
Inflation results when the rate of growth of AD is greater than LAS.
As will be seen, a major factor affecting the rate of growth of AD is the quantity of
money. If the money supply grows faster then LAS inflation results. If
the money supply grows slowly, so does inflation. None of these
growth rates are steady but rather there is persistent fluctuation
around an ever growing potential GDP.
AD & AS Fluctuations
Let us assume that the world economy grows faster than the domestic
economy. Demand for exports increases shifting the AD curve (P&B
7th Ed Fig. 26.10;
R&L 13th Ed
Fig. 23-7 &
This shifts the domestic economy out of equilibrium with LAS. Initially
movement occurs along the SAS curve on which it is assumed that money
factor costs are constant. Eventually, however, factor prices must rise
as firms compete for a fixed quantity of factors of production. This
raises costs and causes the SAS curve to shift to the left back to LR
equilibrium at full employment but at a higher price level.
Similarly, let us
assume that the price of a significant factor of production like oil
increases. This will cause the SAS curve to shift as production costs
rise to the left out of equilibrium with potential GDP (P&B
7th Ed. Fig. 26.11;
R&L 13th Ed
Fig. 23-10 &
recessionary gap is created but at a higher level of prices. This
combination of recession and inflation is called stagflation. The final
outcome depends on what happens to AD. If AD does not increase
demand for oil is decreased and production falls and other factor prices
fall eventually returning the SAS curve to its starting point and
the economy returns to LR equilibrium
v - Equilibrium Real
GDP & Price Level
The economy can
be in three possible states: a recessionary gap, full employment or an
inflationary gap (P&B 7th Ed Fig.
Automatic forces will tend to eliminate an inflationary gap and restore
full employment. There are, however, no automatic forces which will
eliminate a recessionary gap.
Assume, in the
short-run, potential real GDP of $750 billion is greater than actual
$600 billion (P&B 7th Ed Fig.
If autonomous spending increases by $100 billion then AE0
shifts to AE1 and AE increases more than $100 billion due to
the multiplier. However, prices increase as AE rises eating into the
shift and AE1 drops to AE2. The effect of the
price increase is visible in P&B 7th Ed Fig.
R&L 13th Ed
If instead we
assume the economy is at long run potential and autonomous expenditure
increases AE0 will shift up to AE1 by more than the increase in
autonomous spending due to the multiplier (P&B
However, because the economy is at full potential this increase in AE
will be translated as a shift in AD to the right and in a price increase
shifting the SAS to the left (P&B 7th Ed Fig.
The result is a return to equilibrium potential GDP but at a higher
The shifting from
below long-run equilibrium to equilibrium and then above characterizes
the business cycle (P&B
7th Ed Fig. 26.9:
(R&L 13th Ed
Design for Evolution, Braziller, NY, 1975.
White, B. &
Hart A-M, (eds), Living Traditions in Art: First International
Symposium, Dept. of Education in the Arts, Faculty of Education,
McGill University, Montreal, 1990.