Measuring Potential Output

Potential output is a supply concept. It is achieved only when the economy reaches full employment of all factors of production. Should there be under-employement of any of the factors of production, actual output will be less than it could have been. Potential national income and output cannot be directly observed. To estimate potential output, some measure of the utilization of factors of production is required. The two most widely used are the unemployment rate (the number of people unemployed as a percentage of the number of people willing and able to work), and the extent of capacity underutilization as measured in industrial surveys. There is a clear direct relationship between the two.

For the economy as a whole, the unemployment rate never falls to zero and capacity utilization never reaches 100% due to ‘frictional’ unemployment. This leads to the question of what unemployment rate should be chosen to signify full employment. If this were chosen to be zero, the concept of full employment would be functionally meaningless. The definition of potential output is the maximum attainable output; therefore ‘full employment’ must be attainable in some periods. There is a logical basis for defining full employment to include some unemployment, since some types of unemployment are unavoidable and will exist even in an economy operating at its full potential.

Types of ‘full employment’ unemployment:

Frictional – At any given moment, there are always people changing jobs or entering the job market from school. The job search process takes time, because information is imperfect. Movement within the job market is impeded by this imperfection, just as movement along a surface is impeded by the roughness of the surface. Hence the term ‘frictional’ unemployment.

Structural – Where frictional unemployment is related to people changing jobs without changing their profession or geographic location, structural unemployment is related to people retraining to work in a different profession or moving to a different location. It can come about due to technical progress making some types of job obsolete and creating new types of job; or due to business closures in one area resulting in a surplus of particular skills, who if they do not choose to retrain must relocate. Structural unemployment can be seen as a mismatch between the types and locations of jobs offered and the types and locations of workers looking for jobs. It is not the result of a lack of jobs overall, but it takes more effort to correct than does frictional unemployment. As a result, it can persist for long periods.

Seasonal – Certain types of employment, notably in agriculture, require more workers at one time of year than another. This will result in unemployment during the ‘off’ season—for this not to be so, all workers in the seasonal industry would also need to have a second skill that is seasonal in the precisely opposite pattern