If we could
take a snapshot of the economy at a specific point in time, it would be
possible to enumerate all available resources, both capital and labor, and
calculate the maximum possible output if all resources were put to their most
productive use. This is the potential output of the economy.
If
sufficient time, energy and resources were applied, the available human and
capital resources of a nation can always be increased. In addition, more
productive uses of resources can be devised (technological advancement).
However, in the short run, it is reasonable to assume that these factors are
fixed; i.e. potential ouptut is constant. Thus it follows that there must be a
fixed upper limit to the amount of production possible. This leaves open the
question of which products compose the potential output. In a two-good economy
producing guns and butter (where guns symbolize military spending and butter
symbolizes peaceful spending), if the economy is operating at potential output,
it is only possible to produce more guns by producing less butter and vice
versa. This creates a range of production possibilities at potential output.
Any combination lower than potential output is possible, so this curve is a
‘frontier’ that shows the boundary above which additional production is not
possible.
This graph
can be shown to illustrate the microeconomic question of what to produce. At
the point X on the graph, the production of B2-B1 additional butter requires
the sacrifice (opportunity cost) of the production of G1-G2 additional guns.
The opportunity cost is determined by the slope of the production possibility
frontier. When society is operating at some point within but not on the
frontier, it is possible to produce additional units of one or both goods with
no sacrifice to production of the other good; ie, no opportunity cost. An
economically rational society will therefore always desire to operate on the
frontier.
The
situation when attempting to decide if more of one good should be produced is
different depending on whether society is on the production possibilities
frontier. If the economy is currently operating below the frontier, then any
decision to produce more of one good can be taken in the absence of information
about other goods. However, if the economy is at the frontier, the decision
must also include the opportinity cost of output foregone in the other good.
The first major macroeconomic question is therefore whether or not the economy
is operating on the frontier.
A point like
Z represents a situation that has been experienced from time to time by all
major capitalist economies, for example during the Great Depression of the
1930s. Clearly it would be preferable to operate at point X or Y than at Z.
There must be highly compelling reasons if a government enacts policies
designed to keep the economy at point Z.
Potential Output in the Long Run
In the long
run, the quantity and quality of labor and capital stock is not fixed; neither
is the state of technological advancement. Certain items are relatively fixed
over time, such as the amount of land area available. The supply of labor is
heavily dependent on the population and its age structure, and by social
customs like the common retirement age, the number of hours worked per week,
the extent to which people participate in the labor force, and so forth. These
are demographic features that change only slowly. Other items can change
relatively rapidly in the long run, such as the number and type of factories
operational, improvements in technology, and the training of particular
segments of the workforce.
The second
major macroeconomic question is: What determines the rate of growth of
potential output through time?
The ultimate
objective of economic activity is consumption, which is the present enjoyment
of material goods and services. If a society uses all available resources to
satisfy present consumption, then no further resources will be available to
countract the inevitable decline in productivity of existing capital and labor
as machinery gets older and requires more maintenance, as training is not
renewed so professional skills diminish, etc. Some level of expenditure on
capital goods is required simply to maintain the current level of potential
output. If more than this is spent, then potential output will increase. Net
investment is equal to the total spent on capital goods, less the amount
required simply to maintain current levels. A production possibilities frontier
exists between capital formation and current consumption, similar to the one
shown above with guns and butter. In order to maintain or increase productive capacity,
society must operate at a point on the graph (presumably on the frontier) which
is above the replacement investment level on the vertical axis. The vertical
distance between this line and the actual operating level will determine the
net gain or loss in potential output over time.
Small
differences in growth rate are of substantial importance to the material
standards of living. At a growth rate of 2%, standards of living double every
35 years, but at 4% they double every 18 years. The rule of thumb to get the
number of years between doublings is to divide 70 by the growth rate.
