Economic Output

How large total output could possibly be for an economy is determined by the quantity and quality of capital stock and labor force. Capital stock includes natural and man-made resources such as rivers, factories, mineral deposits, etc. The labor force includes that portion of the population willing and able to work. The quality and quantity of capital stock and labor force available varies widely across different nations. The maximum output possible given these resources is called potential output.

If some portion of the available capital stock or labor force is idle (unemployed), then acutal output will be lower than potential output. When resources are idle, some amount of output is lost and gone forever. Actual output will equal potential output when full employment occurs. However, there will always be some amount of unavoidable “frictional” unemployment. Since this level of unemployment is unavoidabe, it is taken into account in potential output as the “full employment level of unemployment” and corresponding full employment rate of downtime of equipment, tools, factories, etc.

Potential employment grows over time. This expansion is caused  by:

·         Growth in the quality and quantity of labor available

·         Growth in the quality and quantity of capital stock available

·         Technological advances

In any given period, some amount of output will be dedicated to the production of new capital goods such as new factories. This will increase the level of output in subsequent periods. In addition, the newly produced capital goods will embody the latest technological advantages. So a nation which devotes a high percentage of current output to the production of new capital goods will win on two counts. Similarly, the higher the proportion of current output applied to the training and improvement of labor, the higher output will be in future periods.

The cruel dilemma facing impoverished nations is that current output already fails to provide adequately for the existing population, so diverting some resources to investment rather than current consumption will create even more widespread problems of starvation and poverty.

In the short run there is little or nothing a government can do to affect a nation’s potential output. Changes in potential output are long-run occurrences. However, actual output can certainly be affected in the short run. The actual output or GNP is the sum of the values of all final goods and services produced in the economy in a year. There is also a corresponding flow of income to resource owners matching the value of all final goods and services produced. In a simple model, ignoring the government and international sectors, all resources are owned by households and all goods are produced by firms. The firms hire resources owned by households, and produce goods and services, which are then sold to the households. This results in a circular flow of income.

GNP is the value of all final goods and services produced. GNE (Gross National Expenditure) is the value of total spending by the households. GNI (Gross National Income) is the value of the factors of production used by all firms. Since these are all measuring the same thing, they must all be equal. The symbol Y is used for the value of GNP/GNE/GNI.

In this simple model, firms can only produce two kinds of goods, consumption goods and investment goods: GNP = C_F + I. Households can also only spend their money in two ways, consumption and spending: GNI = C_H + S. C_F is the amount of consumption goods that firms plan to produce, while C_H is the amount of consumption goods that households plan to buy. When these are equal, I=S—the resources devoted to the production of new capital goods are equal to the savings rate of households. The propensity of households to save, rather than spend, their money will have long term implications for economic growth.

However, C_F and C_H are not always equal. Firms might produce more consumption goods than households plan to buy, in which case goods will be left unsold. Retailers will place smaller orders, and manufacturers will reduce production. Taking all firms together, this results in a reduced GNP. Since firms are producing less goods, they will require less resources, resulting in a reduction of GNI. This will result in lower income for households and will cause C_H to fall even lower. A recession will occur. GNI and GNP will continue to fall until inventories fall below desired levels, at which point the process will reverse. However, the recession will have been a period of wasted productivity, where actual output fell below potential output, unemployment was in evidence, and society was less well off than it could have been.

On the other hand, if households want to buy more than firms are producing, retailers will experience shrinking inventories as goods are sold faster to meet demand. They will increase the size of their orders and manufacturers will increase production. More resources will be required, resulting in higher household income, which in turn results in even more demand. GNP and GNI will rise and a ‘boom’ will result. The increase in GNP and GNI will be constrained only by potential output. As this point is reached, demand continues to rise despite an inability to increase supply to match, resulting in higher prices, which cause households to buy less goods. Orders will decrease and the ‘business cyce’ will be repeated.