Two Blades of the Scissors Supply, Demand and Changing Industry Structures

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1 1 Ronald Schettkat November 2004 Two Blades of the Scissors Supply, Demand and Changing Industry Structures 6.1 Potential and Actual Growth: Relaxing the Full-Employment Assumption 6.2 Summary 6.1 Potential and Actual Income Growth: Relaxing the Full-Employment Assumption In traditional growth theories (both old and new), it is implicitly assumed that demand is unsaturated, and thus, that the growth process only needs to be analyzed from the supply side. Because of technological progress, the more output can be produced using the same input, meaning that a rise in productivity enhances the production possibilities of given resources. Technological progress improves the supply-side, it expands an economy s production capacity, and it potentially allows for a higher income. But it depends on the reaction of demand, whether this potential for economic growth will actually be realized. If Say s law would hold, the demand side of the market would never be an impediment to economic growth, and an increase in productivity would both expand the capacity to produce, and would, by assumption, raise production, and thus, incomes. To keep employment constant, the direct labor-saving effect of productivity growth will need to be compensated for by an expansion of demand. With an income elasticity of demand equal to one, which is basically what Say s law boils down to, demand expansions would be proportional to productivity growth. This situation is described in Figure 6.1 by the convex-shaped iso-employment curve. The inverse of

2 2 productivity is plotted along the horizontal axis, which means that an increase in productivity would be represented by an inward movement along the horizontal axis. Product demand is plotted along the vertical axis and hence an increase in product demand will be represented by an upward movement along the vertical axis. To keep employment constant, product demand must rise in line with productivity growth. The function underlying the iso-employment curve is one of unit elasticity, which means that every rise in productivity will be met by a proportional rise in demand. If every industry would have such a balanced growth path, the economy would have constant employment levels and a static industry structure. In reality, however, such growth paths are unlikely to occur, because some industries may produce goods with an income or price elasticity smaller than one (food, some manufacturing products) 1. In such industries, the labor-saving effect of productivity growth will never be fully compensated for by the expansion of demand and employment will shrink. There may be also industries that produce goods with a demand elasticity greater than one (many services). In such industries, demand expands more than proportionally. In Figure 6.1, industries with low demand elasticities will lie below the unit-elasticity curve; those with high demand elasticities will lie above this curve. 1 Price elasticity is usually negative but we will follow the Marshallian tradition and refer to the absolute values of elasticity.

3 3 Figure 6.1: Productivity, Demand, and Employment product demand/ capita [d] Say's law [demand = supply] productivity product innovation increase in income decrease in price rising net exports employment s * d = constant saturation (lack of innovation) labor demand / output [s]

4 4 Although in some industries, productivity growth will outperform the expansion of demand, at the aggregate level, employment will remain constant, or will increase, as long as employment losses in one industry are compensated by employment gains in industries with strong demand reactions. In other words, it will be possible to maintain full employment, as long as the negative and positive effects that occur at the industry level, balance out at the macro level. This generalized version of Say s law would, by assumption, guarantee full employment. Whether this guarantee also holds in reality, can only be tested empirically, but, since it will always be the case that the aggregate employment effects are determined by industry-specific effects, it will nevertheless be useful to take a closer look at the mechanisms that determine demand responses. Rising incomes, product innovations, and declining prices will all stimulate domestic product demand. In addition, world demand may rise (in response to the above mentioned variables). Leaving product innovations aside, and focusing on the domestic economy, it becomes clear that demand can only rise if income is growing and /or prices are falling. If, for example, an increase in productivity would partly, or totally, be absorbed by higher profits or higher wages, then prices would remain unchanged, and product demand would not expand, unless there would be some other incentives. In such a situation, demand is likely to remain constant, and the direct labor-saving effect of productivity growth will dominate. This effect may be compensated for by declining prices, which may work as a second round effect, as a compensatory mechanism for the direct laborsaving effect of productivity growth. But if the product market is saturated, and price elasticity is less than -1, employment will decline, even with falling prices.

5 5 Figure 6. 2: Labor Demand Derived from Product Demand; A Simple Diagrammatic Presentation I price setting function Prices (P) II product market Pe' Pe'' η>1 η=1 wages (W) η<1 a' Pu' a'' W' W'' Pu'' (Q) Qe' Qe'' Qu' Qu'' quantity Le' a'' Le'' a' Lu'' Lu' π' π'' IV labor demand function III production function labor demand (L) Definitions: Product demand Q = a bp Price setting function P = W/π * k W = wage, π = labor productivity, k = mark-up Production function Q = L * π L = labor Labor demand L = a/π - bk/π 2 *W Productivity π = tan α = Q/L

6 6 The impact of process innovations (productivity gains) and price reductions on the demand for products and labor can be illustrated by a simple model (see Figure 6.2), which can be thought of as a vertically integrated sector. In the top-right quadrant (II) the product market is represented by a negatively-sloping, linear demand function. 2 At high price levels, this demand function is elastic (η > 1); at low prices, demand is inelastic (η < 1). This means that in a situation in which prices are high and demand is low (that is, in an unsaturated market (see Chapter 7)), price reductions will lead to a more than proportional rise in the quantity demanded. In the reverse situation, that is when prices are low and the market is saturated, price reductions will lead to a less than proportional quantity reaction. How product demand translates into employment depends on the production function (quadrant III in Figure 6.2). In Figure 6.2, the level of employment depends on the demand for products at given productivity levels. Possible substitution effects between capital and labor have not been taken into account since capital-labor substitution in vertically integrated sectors is no more than a shift of labor from one stage of production to another (Kromphardt 1987), although these shifts may result in technological progress. 3 As shown in the bottom-left quadrant of Figure 6.2, at given product demand, labor productivity determines employment. Ignoring profits, whose effects would in this model be similar to those of wages, prices are determined by wages and productivity, as shown by the price-setting function in the top- left quadrant of Figure 6.2. Prices then feed back into the demand function. Put more specifically, at wage W, the price will be according to the initial price-setting function (the solid line in quadrant I) P e, which will result in product demand Q e. Given the production function, which is depicted by the solid line in quadrant III, it would require labor input L e to satisfy product demand Q e. 2 For the sake of simplicity, a linear demand function is used here. However, any demand function with both a price elastic, and a price inelastic section would produce similar results. Only the special case of unit elasticity will price reductions lead to a proportional expansion of demand, and will the direct labor-saving effect of productivity growth be compensated completely. 3 Here only labor productivity is considered, i.e. variation in capital deepening with results in variations of the production function (the angle a in Figure 6.2).

7 7 An increase in productivity will shift the production function from π (the solid line in the bottom-right quadrant) to π'' (the dotted line in the bottom-right quadrant). If demand would remain constant, the amount of labor necessary to satisfy this demand would be smaller than the initial amount of employment. This would allow the wages of the remaining workers, or profits, to rise. The rise in productivity could, however, also be used to lower prices. The labor market impact of such a price reduction would depend on the reaction of demand, which, in turn, would depend on the price elasticity of demand. There are three possible responses, each corresponding to a different price elasticity. If the price elasticity of demand were equal to one, then an increase in productivity would translate into a price reduction, would cause demand to expand by exactly that amount and would leave employment unchanged. In that case, the direct labor-saving effect of productivity growth would fully be compensated for by the secondary market expansionary effect. In the case of unit price elasticity, adjustments would follow a specific path, as has already been discussed above. If elasticity would be greater than one, the price reduction from P e ' to P e '' would result in a demand expansion from Q e ' to Q e '', meaning that demand would expand more than proportionally. The direct labor-saving effect of the growth in productivity would be more than compensated for by the secondary market expansion effect and the productivity increase would lead to a rise in employment from L e to L e. A situation characterized by high demand elasticities in response to falling prices typifies the early stages of the product-life cycle (for a more detailed discussion see Chapters 7 and 8). If the elasticity of demand were price inelastic (η < 1), then the same relative price reduction in response to the same productivity gains would result in the exact opposite employment reaction. If prices would fall from P u ' to P u '', then the quantity demanded would rise from Q u ' to Q u '', which would be insufficient to keep employment at its initial level L u, and employment would consequently fall to L u. Thus, although the productivity gains would in both cases be translated into falling prices, differences in demand reactions would produce opposite employment effects.

8 8 Box 6.1: Principle Employment Effects of Productivity Growth The Direct Effect The direct effect of an increase in productivity will be labor-saving, because the same output can be produced with fewer inputs. The Indirect effects (depend on a number of variables) 1) If prices decline in line with productivity, that is, if wages and profits remain constant, the employment effect of productivity growth in a particular industry will depend on the price elasticity of demand. If price elasticity is high, employment will expand; if demand elasticity is low, employment will decline. 2) If prices remain unchanged, that is, if wage and/ or profits increase, the employment effect of a rise in productivity in a particular industry islikely to be negative. This means that, if the demand for that industry s products remains constant, employment will decrease. 3) Higher productivity will only translate into higher incomes if the employment effect of a productivity increase is sufficiently delayed, or 4) If the share of exports increases. If a reduction in labor demand is anticipated, or if reactions are very quick, a rise in productivity will not result in higher incomes (value added). Income arguments are therefore dependent on the delayed reaction from labor inputs. A multitude of variables other than price reductions could stimulate demand at the product level such as, for example, product innovation, the variation of products in order to extend their life cycle, the linking of products to other unsaturated desires through advertisements. In advertisements for Bacardi, for example, the consumption of rum is associated with a vacation in the Caribbean, with beautiful girls, a yacht, in short with the Barcardi feeling. Rising incomes can stimulate product demand, and the development of new markets (exports) will also raise demand. Creating new markets was one of the tasks that Schumpeter assigned to his entrepreneur (see above). However, although individual countries or regions can improve demand for their products through exports, this is most likely not a viable strategy for all

9 9 countries especially in saturated markets. Thus, even though there are ways by which the demand for products in saturated markets could be stimulated, they would most likely have only a limited effect. Consequently, at the end of the product-life cycle, when markets have become saturated, and price elasticity is low, but productivity continues to increase employment will no longer be sustainable and will begin to decline. Under the full-employment assumption, workers that have been dismissed in one industry can always be transferred to another industry. Thus, although the gains of productivity growth may not materialize in the particular industry experiencing the productivity growth, society will ensure that the freed capacity will be put to fruitful uses elsewhere. And although the demand for certain products may be inelastic, this will never be the case for the demand of all products simultaneously. One specific market may perhaps become saturated, but human desires will always be insatiable (for a discussion of saturation phenomena see Chapter 8). In the words of Allyn Young, to begin by inquiring into the operations of reciprocal demand when the commodities exchanged are produced competitively under conditions of increasing returns and when the demand for each commodity is elastic, in the special sense that a small increase in its supply will be attended by an increase in the amounts of other commodities which can be had in exchange for it. Under such conditions the increase in the supply of one commodity is an increase in the demand for other commodities, and it must be supposed that every increase in demand will evoke an increase in supply (Young 1928: 533/ 534). In other words, Young believes that at the aggregate the full-employment assumption holds, which is dependent both on the saturation of desires and on the perfect functioning of markets. An analysis that starts from a perfect market system abstracts from time and frictions. In the real economy, however, such abstractions are not possible, since there are frictions and adjustments take time. If time is an important variable, the sequence of events also becomes important. In discrete time, in which there is a time lag between two successive events, demand responses in technologically progressive industries may have tremendous consequences for the economy as a whole. If demand in the technologically progressive industry responds elastically, that is, if prices fall in

10 10 response to productivity gains 4, then potential income gains will be realized and a rise in productivity will immediately be transformed into additional value added, that is into additional income. However, if demand in the technologically progressive industry does not respond elastically, or if prices remain unchanged, then the occurrence of frictions may prevent the potential gain in value added from being realized. To get an idea of what happens, it will be important to go through the entire sequence of events. Firstly, productivity will rise and prices will decrease in accordance, though probably after a short time lag. Secondly, in response to these price reductions, demand will expand, though less than expected - or less than needed to absorb the increase in production capacity. As a consequence, value added will increase less than productivity, too many workers will be in employment, and hence, some of them will be dismissed. Thus, additional income will be created but only to the amount that product demand will actually expand. True, in theory, dismissed workers could, of course, be employed elsewhere, but in reality the economy s value added may not rise enough, and the resulting increase in demand may not be sufficient to generate jobs in other industries. Consequently, in the absence of any corrective measures, unemployment will rise, instead of incomes. What would happen if a rise in productivity in the technologically progressive industry would not result in lower prices, but in rising wages and/ or profits. In that case, the industry s price position would remain unchanged, and there would be no direct mechanism to raise the demand for that industry s product. If demand would remain unchanged, the wages of individual workers may still rise, but this would occur with a reduction of the workforce. Consequently, the wage sum would remain the same. And because the amount of demanded products would remain constant, 4 When Allyn Young wrote of competitively produced commodities, he obviously had in mind a perfectly functioning price mechanism, meaning that the industries or firms experiencing technological progress would accordingly reduce their prices. Under less competitive conditions, which are likely to occur in industries with increasing returns to scale, prices may be sticky.

11 11 valued added would not increase. If profits increased, instead of wages, the result would be the same: demand would remain constant and some workers would be dismissed. However, the wage sum would decline, which would allow profits to rise, with unchanged value added. Although the distribution of wages and profits would be different, the industry s value added would be the same, a situation roughly observed in many industrialized countries where the wage share declined. In other words, relaxing the full-employment assumption will have tremendous consequences for the amount of income created in an economy.

12 Summary Increasing returns to scale, like technological progress, may increase an economy s production capacity and may initiate a virtuous cycle of efficiency gains, production expansion, an increase in purchasing power, and a demand expansion, which may, in turn, stimulate even larger returns to scale and/ or investments and learning. Higher economic activity may facilitate innovations, and may serve as another channel for efficiency gains. Most importantly, if positive feedback effects and increasing economies of scale occur, some part of economic growth will itself be the result of economic growth. If the fullemployment assumption would hold, supply would find its demand and the virtuous circle of supply and demand would be very powerful. However, the full-employment assumption is merely a theoretical concept helping to abstract from demand-side frictions. In reality, supply-side improvements (productivity increases) will only result in income growth, if the demand for additional goods is elastic. If demand is inelastic, the virtuous circle of supply and demand runs the risk of becoming a vicious circle. Professor Jan Tinbergen described economic development as a race between productivity gains and demand expansions, thereby indicating that the direct labor-saving effect of productivity growth may dominate compensatory effects from the demand side. This means that the initial employment level will only be 'sustainable' if demand expands at the same rate as productivity; if demand expands less than productivity, employment will shrink. Since it is this interplay between supply and demand in product markets that determines employment, it can be concluded that product markets and labor markets are, of course, mutually dependent. Hence productivity gains alone will not be sufficient to raise employment; they must be met by unsatisfied potential and effective demand. The increasingly more efficient

13 13 production of 'old' products, which every household already owns, will not be sufficient to sustain or expand demand and eventually new products and new markets will need to be developed, as Schumpeter (1937) already explained in his innovation theory. Economic growth and productivity growth are twins, but not identical twins. The structure of production must meet the structure of demand. Value will only be created, if supply finds its demand.