Wed Dec 9th, 2009 at 01:55:51 AM EST
In this diary I introduced a frame of discussion about economics that I labelled the full world (by contrast with current economic thought which I claim is largely developed in and adapted to the empty world). In that diary, I looked at the different kinds of resources and the kinds of price shocks that could be expected when our non-negotiable way of life runs head first into the even less negotiable laws of physics.
This time, I'll look at a slightly different issue:
If economic activity is the process of converting raw materials to consumer goods and services, what happens when the capacity of one's industrial plant to convert raw materials into goods and services outstrips one's capacity to acquire raw materials?
To explore this, I'm going to go back to a fairly basic analytical tool: The production possibility frontier (PPF). The production possibility frontier represents the possible configurations of an economy when its labour and capital are fully deployed in the conversion of raw materials into consumer goods. The points that fall inside the PPF represent configurations that do not fully employ the capital and/or labour of the economy. The points that fall outside the PPF are unachievable given the available plant and labour force.
In the empty world, this is the entire story. There is, of course, always a theoretical upper limit to production (given by the laws of physics and the accidents of geography and geology). But in the empty world (see figure on the right) it lies beyond the PPF. Which means that even if the empty-world economy stretches its capital plant and labour force to the breaking point, the supply of raw materials will never be an interesting constraint.
In the empty world, idle plant and labour can be put to productive use through an expansion of demand - an insight normally attributed to John Maynard Keynes. It is therefore, in principle, possible to ensure full employment by using only fiscal and monetary policy.
In the full world, this is no longer true. In the full world (shown below on the left), possible configurations of capital, labour and aggregate demand exist in which part of the labour force and capital plant is idle not because of insufficient purchasing power, but because of insufficient access to raw materials. This can happen either because the resources they depend upon for production have been depleted or because our capital plant now permits us to convert raw materials to consumer goods faster than it permits us to recover said raw materials.
In the full world you can, in other words, have involuntary unemployment that cannot be cured by fiscal or monetary policy, because attempts to expand demand sufficiently to force the deployment of the entire productive apparatus will run into non-negotiable resource constraints. Attempting to force the economy into a state of full employment by expanding demand will then run into ruinous cost-push inflation, as increasing demand strains against unexpanding availability of raw materials.
But this is not all. The goods that I have chosen to for the illustrations in this diary are picked with malice aforethought: Gasoline and automobiles are complementary goods - demand for automobiles depends on the availability of gasoline. If consumers are not reasonably confident that they will be able to procure the fuel necessary to run their automobiles, no amount of government handouts will induce them to demand automobiles.
The figure below on the right shows the effect of such demand constraints. The dashed line represents the theoretical maximum demand (i.e. the demand if all consumers had as much money as they could possibly desire to spend) for automobiles, given a certain production of gasoline. The astute reader will notice that the dashed line intersects the line representing the resource constraint before it intersects with the production possibility frontier.
Two conclusions may be drawn from this: First, that resource constraints can and will reach into industries where the resources concerned do not enter into the supply line, by virtue of those resources being in the supply line of complementary goods. Second, that the economy in this example will never reach full employment. (Barring outright make-work schemes. And make-work is not, in my book, about full employment - it's about camouflaging unemployment subsidies in a way that sufficiently appeases reactionaries to prevent outright obstructionism.)
Clearly, the economics of the full world will need serious reconsideration of the definition and desirability of "full employment."