Potential Output in the Long Run and short run

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.