Production Possibilities in the Macro Economy

Study Questions

n 1. What fosters long-run economic growth?

n 2. What can a society do to get the economy to grow faster?

n 3. What conditions could lead to long-run economic decline?

n 4. Why is society’s institutional PPC at lower output levels than its physical PPC?

n 5. What is the principal economic problem in an underperforming economy?

n 6. What is the principal economic problem in an overheated economy?

n 7. What is the main objection to a self-correcting economy?

Society and the PPC

n Which combination of capital goods and consumer goods best suits its current and future wants and needs of society?

Society’s Trade-off

n If society increases production of capital goods, it must decrease production of consumer goods, and vice versa.

n Capital goods are resources, so the economy grows faster if it emphasizes capital goods over consumer goods.

Long-Run Economic Growth

n Society’s PPC pushes outward.

¨ Increased resource availability.

¨ Technological advancement.

n Standard of living improves.

Long-Run Economic Decline

n Society’s PPC pushes inward.

¨ Decreased resource availability.

n War

n Natural disaster

n Resource quality degradation.

¨ Technological backwardness.

n Standard of living declines.

Short-Run Economic Problems

n The business cycle has periods of growth at faster rates than the trend – recovery and prosperity – and periods of growth at slower (or even negative) rates than the trend – recessions.

Fine Tuning Society’s PPC

n Society does not desire to make all out (100%) use of its resources and technology:

¨ restricts the work week

¨ prohibits child and slave labor

¨ sets minimum wage requirements

¨ preserves natural resources

¨ bans the use of some resources and processes

n Society is willing to make this trade-off of less production to get a better quality of life.

The Institutional PPC

n The Institutional PPC is what society uses to measure its full-employment goal.

n The Institutional PPC, therefore, is inside (below) the Physical PPC – the output it could reach if it really went all out in production.

Full-Employment Goal

n At full-employment, society has no cyclical unemployment.

¨ At or near the peak of the business cycle.

¨ Operating at its Institutional PPC

Going into Recession

n Society moves away from its Institutional PPC into the area of inefficiency.

n Idle resources, particularly idle workers, increase.

n The economy is underperforming.

Going into Recession

n Sales decrease.

n Inventory increases.

n Retailers cut back on orders.

n Production begins to fall (Real GDP decreases).

n Salespersons and factory workers are laid off.

n Unemployment rises.

Figure 10-7. Going into An Underperforming Economy

Self-Correction in an Underperforming Economy

n Correction occurs when:

¨ In the product market, prices are marked down to move unsold goods.

¨ Need for salespersons increases.

¨ When overstock is gone, retailers put in new factory orders.

¨ Production increases.

¨ People laid off go back to work.

¨ Unemployment falls.

Self-Correction in an Underperforming Economy

n Correction occurs when:

¨ In the labor market, a surplus of labor causes a downward pressure on wages

¨ Lower wages prompt hiring increases..

¨ Unemployment begins to fall, but very slowly.

¨ Businesses reorganize and structural unemployment replaces cyclical unemployment.

¨ As the outlook brightens, production increases.

¨ GDP increases.

¨ Hiring speeds up.

¨ Unemployment falls.

Figure 10-8. Self-Correction out of an Underperforming economy

Going into an Overheated Economy

n Society wants to buy more than the Institutional PPC can provide.

n Society attempts to produce beyond its Institutional PPC.

n Resources, particularly workers, become hard to find.

n Wages are bid up.

n Goods and services are in shortage and their prices rise.

n The economy overheats

n Inflation becomes a big problem.

Going into an Overheated Economy

n Sales increase too fast.

n Inventory is depleted.

n Retailers increase factory orders.

n Production reaches maximum capacity

n More skilled factory workers are needed, but none are available.

n Firms outbid each other for existing skilled workers.

n Wages, prices, and inflation rise.

n Unemployment falls abnormally low.

Figure 10-10. Going into an Overheated Economy

Self-Correction in an Overheated Economy

n Correction occurs when:

¨ Rising wages of workers and prices of resources increase operating costs and shrink profits.

¨ Hiring decreases.

¨ Firms begin to cut back on production.

¨ As product prices rise, previously overeager buyers leave the market.

¨ Sales fall.

¨ GDP falls.

¨ Society retreats back to its Institutional PPC.

¨ Unemployment rises to the full-employment level.

Figure 10-11. Self-correction out of an Overheated Economy

An Economic Role for Government?

n It takes a long time for self-correction to cure the economy’s problems.

n Modern society becomes impatient. It wants results now.

n Society petitions government to step in and “fix” the economy….to solve the problem.

n Government responds by formulating policies to hurry the correction along.