MACRO MATERIAL

[The man of system] seems to imagine that he can arrange the different

members of a great society with as much ease as the hand arranges the

different pieces upon a chess-board. He does not consider that the pieces

upon the chess-board have no other principle of motion besides that which

the hand impresses upon them; but that, in the great chess-board of human

society, every single piece has a principle of motion of its own, altogether

different from that which the legislature might chuse to impress upon it.

If those two principles coincide and act in the same direction, the game of

human society will go on easily and harmoniously, and is very likely to be

happy and successful. If they are opposite or different, the game will go

on miserably, and the society must be at all times in the highest degree of

disorder. — Adam Smith, The Theory of Moral Sentiments

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Total Production in the Economy

What determines total production in the economy?

If we had a function (indicating cause and effect), what would the arguments of

the function be (the causes) that led to the total production of the economy?

Total Production = F (?, ?, ?, ...)

Economists have been thinking about the answer to this question for more than

two centuries. What’s the conclusion? Notice first that when we were talking about

supply in an individual market, the price of the good was part of the supply function.

At higher prices, it becomes more worthwhile for firms to reallocate available resources

from some other use in the economy to this particular market’s output.

But when it comes to the whole economy... that doesn’t immediately make sense.

We should already be using all available resources to produce something. The general

price level doesn’t seem to matter for the economy as a whole as relative prices mean

for individual markets.

And this is our first observation with respect to total production. Money and

prices don’t seem immediately relevant.

Real vs Nominal

Your nominal income is the dollar amount of your income. This might feel like a

“real” thing, but suppose you woke up tomorrow, and your nominal income (the dollar

amount of your income) was ten times as high. Your bank account had ten times the

balance, the coins in your couch had ten times the numbers written on them. But

simultaneously, the price of everything — including your current debts! — were also

ten times the amount.

Does having ten times the nominal income mean anything for you personally, when

prices are ten times as high?

Your nominal income is just some numbers written on paper. But your real

income is about the Story of Stuff. Two nominals make a real. The numbers on

the money in your wallet is nominal. The numbers of the prices in a store are nominal.

But the comparison between the two gives a real variable: how much real stuff your

money can buy.

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Why doesn’t the government just print money to pay off the national debt

and pay for public services?

At irregular but reliably recurring intervals, someone will inevitably offer the idea they

just thought up to pay the government’s bills. Their idea will be for the government

to just make more money to finance everything.

The problem with making more money is that money is nominal, not real.

More money by itself does not produce more farms. It does not produce more

factories. It does not create more oil reserves. It does not manufacture more contain-

erships, lay down train tracks, or pave interstate highways. It does not produce more

houses. Human beings can do work and create things, but money by itself does not

do anything besides being green and attracting dust. Money can be used to buy any

of the above items, but it does not produce those items.

If the government hires workers with new money, that does not necessarily mean

more work will be done: the government might simply be reallocating work from one

previous end to another. Instead of working on Project A, the workers hired by the

government will now work on Project B. This means different stuff, not necessarily

more stuff.

What we produce does not depend directly on money!

What we produce depends directly on our real resources. People working is a

real resource, and would continue to be a real resource even without money. Wheat

fields are a real resource, along with the wheat they produce, and wheat would still

be valuable even in a world without money. Transportation infrastructure is a real

resource. We can imagine a working economy that had fecund fields and humming

factories, even if it didn’t have money. But an economy that had only money, and no

real resources (like food!) would not be an economy at all. There is no point to money

if there is literally no real resource for money to buy.

The Determinants of Total Production

Total production does not (at first) seem to depend on money at all. Looking beyond

the veil of money, we can see that total production in the economy depends on the

productive capacity of the economy: what resources do we have, that allow us to create

more stuff?

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Labor

The amount of available labor in the economy is a determinant of total production.

More workers mean a higher productive capacity, all else equal.

Capital

By “capital”, we mean capital goods. Capital is stuff that we have built that helps

us make more stuff. A factory and its equipment are capital. Capital comes from

our past productive capacity, in order to increase our future productive capacity. The

more capital available to an economy, all else equal, the larger the productive capacity

of that economy. When we have more tools available that is specifically built to help

us make more stuff, then we can make more stuff. Pretty simple.

Regarding the word “capital”: Remember that this is an macroeconomics class, not

finance or accounting. In this class, “capital” does not mean the funding a company

is trying to raise, nor is it another word for owner’s equity. In macro-speak, unless

otherwise noted, capital is a real tangible thing, a kind of stuff that was created to help

us make more stuff. A dishwasher is capital (it is stuff, a machine, that helps wash

dishes). Assets minus liabilities is equity or net worth, not capital. Raising money

from financial markets is funding, not capital.

You don’t have to speak this way outside of this class. In fact, you probably

shouldn’t. Just remember that a big issue in learning about a new topic is learning the

language we have developed for trying to speak precisely about that topic. Accountants

and financiers and economists have developed different languages. Be prepared to be

polylingual in this business school! Accountant-speak and economist-speak are subtly

different languages.

Natural Resources

Readily available land, oil, timber, iron ore, and other natural resources are also nec-

essary for production. These resource are not considered capital (human beings did

not create them) but they are still necessary for total production in an economy.

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Risk

This idea is sometimes collapsed into “capital”. Sometimes it is called entrepreneurial

talent. Production is not just determined by moving around already-existing factories

and equipment in order to produce different things.

Someone must decide what to make. The cold universe gives us no guarantees

that our choices will prove correct. There is risk involved in any enterprise, in any

allocation of capital, and without some person or institution taking that risk to decide

what risks to take, there will be no production.

“Technology”

In advanced macroeconomic production functions, another variable in the production

function is often “technology”, or “total factor production”. This term is essentially a

catch-all to encompass everything we don’t understand. “A measure of our ignorance”,

as Moses Abramovitz called it.1

Returning to the Production Function

We want the cause and effect for total production, and so we want a function that

demonstrates causality. What are the arguments of this function?

Total Production = F (labor, capital, natural resources, ...)

Money and prices are not on the list. (Yet...) We’re going to be introducing a new

graph here.

1“Total factor production” is one of the most ill-advised terms of all of economics. Dressing up our ignorance in fancy terminology does not make us any less ignorant. “Unexplained Residual” would be a much better label.

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The space of this graph looks, at first blush, exactly like the space we were looking

at for our previous supply and demand curves! Despite the similarity, it is not the

same space. These variables are different!

That P on the vertical axis is not the price of a single good. It is the general

price level, or an index of all prices of all goods. And the Q/t on the horizontal axis

is not the quantity of a single good, but the quantity of all goods created in the entire

economy. It represents total real production. When we graph our production function

in this space, with the recognition that prices and money don’t matter, we have to

realize that we’re not graphing a direct relationship, or an inverse relationship, but

rather no relationship.

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Regardless of what the general price level P is, total production is the same. We

can measure our input in dollars, or in cents, or in yen, or in euros, and it shouldn’t

matter to measure how much we produce. This is the argument that total production

relies only on real resources (like labor and capital), and not on the price level based

on the kind of money being used. We have already noticed that this space looks

very similar to the space of a standard supply and demand graph, even though it is

very different. Next we’re going to relabel that total production curve that shows no

relationship with prices. We’re going to call this curve aggregate supply.

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Aggregate supply is not the same thing as supply.

Supply slopes up in a single market because at higher prices, resources in the

economy are reallocated from other uses to production within this single market. This

is why supply has a direct relationship with the price in a single market: at higher

prices, it becomes worthwhile to reallocate those productive resources in the economy

toward this one market. But we’re talking here about the economy as a whole, which is

to say, every market combined. Resources can be allocated from one kind of production

to another, but in the entire economy, available resources should be used for something.

Higher prices in the entire economy should not affect total production. Supply has a

direct relationship with price within a single market, but aggregate supply (right now)

has no relationship with prices.

A Different Perspective on Total Production

One of the problems with the previous aggregate supply graph is that literally all

production in the economy is combined into a single Q/t.

Luxury automobiles? They’re in that Q. Streaming download services? They’re

in the Q, too. Same as legal advice given, factory robots built, fishes caught and sold,

McDonald’s Happy Meal toys handed out, computer chips manufactured, new houses

built, and literally everything else that an economy produces that can be measured

inside a time interval. All part of the same Q. But it’s worth remembering that there

is still a limited amount of productive capacity in an economy, a limited amount of

stuff that we can produce, and that the more of our productive resources (including

capital and labor) that are devoted to building automobiles leaves those same resources

unavailable for the production of Happy Meal toys.

Life is about Trade-Offs

The more of one kind of good we produce leaves fewer productive resources available

to create other goods. We as a society face a trade-off with what we desire to produce.

The next graphical space we will look at is going to have a Q on both axes. These two

different Q’s represent two different kinds of goods that we can make.

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So what kind of trade-offs do societies commonly make? One of the classical ways

to understand a macroeconomic trade-off is the choice between “guns and butter”

— a metaphor for the difference between military goods and consumer goods.

This graph gives the possibilities for production. The line represents the fron-

tier at which production is possible. Beyond the frontier is impossible, out of reach:

the red dot represents a production combination that is simply not possible for this

economy.

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The area inside the frontier is possible, but inefficient: to produce at the green dot

is possible, but why stop there? It is silly to produce within the frontier, when it is

possible to produce more. It is the blue dot that represents production that is at the

very limit of what is possible: efficient production right on the frontier itself.

The United States military spends approximately 90 million dollars for a single

F-35 fighter jet. Or for bigger numbers, they spend approximately 600 billion dollars

every year on total military purchases. More than 3% of the US economy is devoted to

military spending. Those productive resources cannot be used for other purposes. We

have less production available for houses, medical care, fancy gadgets, engineering con-

sulting, and everything else. (“Butter”.) There is a trade-off involved. Whether this

is a good trade-off depends on what might happen in the future if the US government

were to spend less (or more) on military goods and services.

That is a political science question which we will not try to answer here.

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