Sunday, December 5, 2010

A Principle of Macroeconomics: Consumption is the Purpose of Production

I have always said that the most important principle of macroeconomics is scarcity. There are not enough resources (land, labor, and capital) to produce enough goods and services (consumer goods and services, capital goods, and government goods and services,) to achieve everyone's goals.

Scarcity is important because it implies that "overproduction" is not a plausible explanation for recession, and that overproduction of some goods should always be understood as implying the under production of other, more valuable goods. While there may be a "general glut" of goods, the problem is some kind of coordination failure rather than too much production of everything. Increasing the productive capacity of the economy--the supplies of resources like land, labor, and capital and the enhancement of resource productivity--is a "good" thing, and the key issue is the allocation of resources to produce the most valuable goods and services.

However, a more fundamental principle of macroeconomics is that the purpose of production is consumption. This principle is worth emphasizing because some criticisms of Keynesian economics by free market economists go too far in dismissing the importance of consumer expenditure for the economy. Production by firms in consumer goods industries is driven by expectations of consumer expenditures in the near future. And the production of many intermediate goods--materials and partially finished goods--while directly driven by expectations of purchases by other firms in the near future, are indirectly driven by expected future consumer expenditures. Since firms will not produce what they do not expect sell, expected consumer expenditures are important in determining both output and employment.

It is not only productive capacity, or "supply" that drives production, employment, and income, it is also expenditure on that productive capacity, or "demand." Both supply and demand are important.

Consider, then, the principle that the purpose of production is consumption. It is not a fact about the world, but rather a judgement about what economic activity should be about. For Robinson Crusoe, alone on this island, the reason he catches fish in the lagoon is to eat the fish. He produces in order to consume. In a social order, including a market order, people produce goods and services for other people to consume, and they consume goods and services that other people produce. If Robinson Crusoe isn't alone, but rather there is a group of people on the desert island, working as a team, it still is clear. They divide up various tasks necessary for survival (produce) in order to obtain the goods and services (food, and shelter) they want (consume.)

However, in a market system, people directly provide resources for sale to others, who use those resources to produce goods and services, in order to sell products to others. They sell these resources and products for money, and then use that money to purchase goods and services. What appears so obvious with Robinson Crusoe alone on his island, or even an isolated team working together, can become muddied in a market economic system. But still, the purpose of production is consumption.

Adam Smith's metaphor of the invisible hand suggests even if the people in a market economic order fail to see that the purpose of their production is consumption, prices should create signals and incentives that coordinate their activities so that their production is directed towards consumption. For example, someone may think that they work to accumulate wealth, but some prices will adjust to a level where their efforts to accumulate wealth become consistent with the purpose of production--the consumption of goods and services.

For the most part, there is no problem at all. People provide resources to others, selling those resources to earn incomes like rents, wages, and interest. Firms use those resources to produce consumer goods and services, capital goods, or government goods and services, to sell them, and receive a revenue that covers their expenses and generates a profit. The profit is income to the owners of the firms, and so the value of the output produced generates a matching income to those providing resources, including the owners of the firms.

For the most part, the reason households want to earn income is consumption, buying consumer goods and services. So while people directly provide resources to firms is to earn income, and the reason firms use the resources to produce goods and services is to pay for the resources and earn profit, people do this mostly to spend the income they earn on consumer goods and services. The provision of resources and the production of goods and services is mostly being directed towards consumption. For the most part, the market economic system creates a flow of employment of resources, production of goods and services, and expenditures on those goods and services consistent with the basic principle that the purpose of production is consumption.

Usually, I think about the economy without government, but explaining how production gets directed towards the provision of government goods and services rather than consumer goods and services is simple. For the most part, governments fund their purchases of resources (like labor) and government goods and services by taxation. Those earning incomes pay taxes to the government. This reduces their disposable income (after tax income) and so their ability to purchase consumer goods and services. The government hires workers and purchases various goods and services. Sadly, this reduces the capacity of the private sector to produce goods and services, which matches the reduction in the ability of households to buy consumer goods and services. (What about budget deficits and budget surpluses? That must wait a bit. )

What about saving? Saving is disposable income less consumption. It is that part of income not paid in taxes or spent on consumer goods and services. If the purpose of production is consumption, does that make saving "bad?"

And what about investment? Firms purchase capital goods--machines buildings and equipment. And, the resources provided by households to firms--the land, labor, and capital--are partly used to produce capital goods. Is the production of capital goods inconsistent with the principle that the purpose of production is consumption? Is investment "bad?"

Saving and investment are consistent with the principle that the purpose of production is consumption to the degree that households save in order to fund future consumption and firms invest in order to produce consumer goods in the future. The key question then, is how (or if) the market process generates prices that create the signals and incentives that cause households to save in order to consume in the future and firms to invest in order to produce consumer goods in the future.

If those prices are not at the right level to provide the correct signals and incentives, it is possible that consumption is too low. If consumption is expected to remain too low in the near future, then the production of consumer goods will likely be too low as well. In that situation, recovery requires expectations of increased consumer expenditure and an increase in the production of consumer goods.

Free market economists who denigrate the need to expand consumption expenditure and insist that somehow, all problems will be solved by an increase in the productive capacity of the economy--greater supplies of land, labor, and capital--are failing to take into account this key principle of macroeconomics--the purpose of production is consumption.


  1. Free marketers wouldn't "insist that somehow, all problems will be solved by an increase in the productive capacity," they would let the markets clear by the price mechanism. That's what is happening in the housing market. It's just "too slow" for Keynesians, who want everything right now. Markets clear if you give them a chance, which includes time.

  2. I am a free market economist, and so,you should be sure to say "some." You need to get beyond generalities like "markets clear by the price mechanism." Looking at a single market, like housing, and assuming, that just like a lower price for houses will clear that market through a lower quantity supplied and a higher quantity demanded, the same process works for all markets at once is an error. As houses get cheaper relative to other things, people buy more of them and less of other things. As less money can be made from houses compared to other things, resources are shifted to produce other things.

    Now, let's think of the other things now. You have just said that people are buying less of them (and more houses) but more resources will be devoted to producing them (and less to houses.) This process cannot work for everything at once.

    That isn't to say that the market mechanism cannot lead to all markets clearing. But some other market forces must be at work than what clears a single market like housing. And one characteristic of any such process will be that real consumer expenditure in the near or distant future must be expected to match the productive capacity of the economy. How exactly does some market process (say, lower prices and wages across the board) result in such an expectation? That is what needs to be explained. I am more and more convinced that the price that should adjust is interest rates.

  3. Hi Bill,

    I still don't know why you're not allowing the price mechanism to work. You gave a very nice overview of how general equilibrium works and then assume it somehow fails. Why? If prices are 'not correct to provide the proper signals,' then either a price mechanism really doesn't work, or it works but it needs time to allow for lags in decision making - which can involve changing expectations - and implementation. I think it's the latter.
    And because interest rates are just one more price signal, again, what's the problem?
    I still think timing of price adjustments is the issue, not expectations of consumers having some more income.
    Why are the prices and wages not changing as theory suggests they should? And why wouldn't firms simply lower prices and expectations of profits to meet real rather than nominal goals?
    It seems you are saying that the price and wage signals can be read properly by consumers but not by firms (?); not sure, but why make it worse with some possibly spurious signals of "demand"?
    You may be onto something but it's not necessarily merely interest rate adjustments that will simultaneously clear the markets. Somewhere you've introduced a friction and as far as I can tell it's solely expectations. But I can't tell why some are not on the ball (more than usual, of course), while others are.

    Pete Bias

    BTW, I don't want to sound negative; I really like the blog and look to you for wisdom. I just want to know what I'm missing here.

  4. "Scarcity is important because it implies that "overproduction" is not a plausible explanation for recession, and that overproduction of some goods should always be understood as implying the under production of other, more valuable goods. While there may be a "general glut" of goods, the problem is some kind of coordination failure rather than too much production of everything"

    Absolutely! This is one of the many flaws at the heart of the IS-LM style Keynesian-influenced macro.

  5. I liked your post, but I had some difficulties with it.

    You write that "if the demand for new homes falls 50 percent and new homes make up 10 percent of the economy, then the demand for other products in the economy should grow more than otherwise." I'm not sure how you're measuring demand; my guess is that you mean the demand for new homes falls in such a way that the economically rational response from builders is to produce new homes at half the rate they had been doing. Provided consumers have not suddenly increased their desire to hoard money, they must have increased their desire to buy things other than new house (but not necessarily other consumer-durables: perhaps goods and services immediately consumed, perhaps physical investment goods or financial assets). This sudden change in consumer desires will throw the economy into (greater) disequilibrium. Many of those employed in new homes construction will lose their jobs (especially if the change in consumer desires is expected to be permanent), and will have to take jobs in which they are less productive than they had been; GNP will tend to decline, and so "the real volume of demand for the other products of the economy should grow" at [but this should be "increase" rather than "grow at"] *less than* "approximately 5 percent." A shock to the economy, requiring greater-than-normal "recalculation," should be expected to reduce the normal growth rate.

    In your gold-standard scenario you might have mentioned that the rate of gold production is assumed not to increase, in spite of the increased demand for gold. Then, in the statement, "Everyone who holds money earns a real capital gain," you might tell us how you are using the term 'real'. You evidently have in mind some unit of account *other than ounces of gold* (in spite of the fact that in this scenario gold *is* money); what is it? Later you refer to "[t]he real volume of expenditures on various goods" and "the real quantity of money." Obviously this "real volume" or "real quantity" is not being measured in ounces of gold; what *is* the numeraire?

    I still seem to detect some stock/flow confusion in your discussion. You write: "if the former home buyers [I think this should be: "those who formerly would have bought a new home or homes"] still have no [increased] desire to buy anything [else], they just have higher real money balances." No, they just continue to *increase* their money balances: instead of accumulating a new home or new homes, they accumulate (rather than just "hold") more money. The topic is their flow of spending (or the lack thereof) rather than the stock of their holdings.

    In the subsequent helicopter-drop scenario, are we supposed to have abandoned the gold regime and moved to fiat money?

    I found the discussion of "inside money" confusing. I thought we were discussing various scenarios brought on by a shock to the system in the form of a sudden decrease in consumers' willingness to buy new homes and a corresponding increase in their desire to *accumulate currency*. But in the "inside money" discussion, it seems the topic has shifted: the consumers now want to hold more "money" in some broader sense, and in fact what they want to hold more of are *bank deposits*, which are really *loans to banks*. It's not more currency that people suddenly want (along with fewer new houses): it's more *savings* (of a super-safe, short-term variety). The banks then relend the funds deposited with them--but they have trouble finding borrowers, since people in general are more determined to *save*. So interest rates have to fall, etc. But the original scenarios, involving *currency*, had nothing to do with interest rates.

    Thanks for whatever clarifications or comments you care to offer.