Unit 3- Supply Side Economic Growth and Applications

A look at Economic Growth in Terms of the PPF

A look at Economic Growth in Terms of the PPF

Every year the economy's productive capacity increases. Typically, the labor force grows by about 1% annually as new workers emerge from schools and other sources, looking for work. In addition, improvements in technology and growth in the capital stock increase worker productivity (output per worker) roughly 2.0% annually. The sum of labor force growth and worker productivity leads to an estimate of 3.0% annual growth in the entire economy's productive capacity. This is considered to be a steady year-to-year growth rate that only changes slowly over the decades.

The 3.0% annual growth in productive capacity is known as supply side growth and can be illustrated by a rightward shift in an economy's production possibilities frontier (PPF). In other words, we can expect the PPF for the U.S. to shift out at a constant annual rate of 3.0%. Each year the U.S. economy can produce 3.0% more goods and services than in the prior year.

fig31.gif (7160 bytes)In Figure 3-1 we break annual supply side economic into its two components. Our economy's current capacity to produce goods and services is represented by the inner production possibilities frontier, and production is at point A in an efficient economy. Economic growth over a one-year duration is represented by the expansion of the PPF to the far right, and to point B2. The annual contribution of an increased labor force to economic growth is shown by the economic expansion from A to a point such as B1. The remainder of annual economic growth is due to increases in worker productivity, or the PPF expansion from B1 to B2. The greater the annual increase in worker productivity or labor force growth, the more the PPF shifts outward from one year to the next.

The actual rate of worker productivity growth in the U.S. economy is a source of significant debate. From 1973 through 1995, annual labor productivity growth averaged 1.0%, the same rate of labor force growth. Since 1996, productivity growth has accelerated to a 2% annual rate, and combined with a steady 1% labor force growth rate, annual supply side growth has increased to 3%.

The question, posed by economists, is the 2% annual increase in worker productivity an established trend or a temporary blip? For if worker productivity reverts back to 1% annually, then supply side economic growth will also fall back to 2%. As we will see later in the course, the rate of supply side economic growth is a critical determinant of how fast the economy can grow without an increase in inflationary pressures.

Measured productivity growth picked up starting in 1996, after five years of an economic expansion. That has drawn attention because past upward swings in productivity typically occurred early in a recovery (in the first couple of years) as economic activity rebounded. Once companies increased hiring, it slowed again.

The evidence indicates that the higher rate of productivity growth is here to stay. The nation's steadily rising investment in computers and communications is finally paying off. as businesses are finally reaping the benefits of information technology

Federal Reserve Chairman Alan Greenspan believes a fundamental change is under way. He told Congress early in 1999 that the economy was enjoying "higher, technology-driven productivity growth."

Investment in information technology -- computing and telecommunications gear -- has quadrupled over the last decade, rising as a share of all business spending on equipment from 29 percent to 53 percent, according to the Commerce Department. There have been similar surges in corporate spending on software, consulting, technical support and training related to the field.

More and more companies are streamlining the routine chores of back office business like invoicing, purchasing and inventory control - the wholesale automation of corporate transactions. This business-to-business commerce over the Internet is projected to jump from $48 billion in 1998 to $1.5 trillion by 2003, according to Forrester Research Inc. During the same period, the research firm estimates that consumer sales over Internet will rise from $3.9 billion to $108 billion.

Applications of Supply Side Economic Growth: Supply-sider Economics

Politicians love to promise voters a utopian world of minimal taxes combined with generous government programs and a balanced federal budget. In reality, tax cuts need to be accompanied by offsetting reductions in government expenditures or the budget deficit will skyrocket. In the U.S., the 1980s was a case in point (see the table below). During this time, large income tax cuts were combined with dramatic increases in defense expenditures and mostly unspecified and unrealized spending reductions. The budget deficit soared and so did the national debt.

Even if sharp reductions in non-defense expenditures had been accomplished during the early 1980s, the budget deficit would have increased dramatically. The reason was the requirement of gains in worker productivity and increased supply side growth that would occur due to the tax cuts. Supply-siders believe that tax cuts increase the incentive to work and output per worker. So far evidence has proven them completely wrong. After the 1980s tax cuts, there was no resulting jump in worker productivity or an increase in the rate of economic growth which could be attributed simply to supply side factors.

And the opposite is also not true: tax increases imposed by Reagan (1986), Bush (1990) and Clinton (1993) had no adverse effect on worker productivity and thus supply side economic growth.

Believers in the supply-side effects of reduced taxes hypothesize that tax cuts will increase the annual increase in worker productivity beyond the typical level found today, leading to higher average annual growth rates in the economy's PPF. For example, in the early 1980s, supply-siders argued that with a cut in the federal income tax rate, annual increases in worker productivity would jump from 1.0% to 2.5% as employees and businesses work longer and harder due to higher after-tax pay and profits. Combined with the 1% annual increase in the labor force, the new 2.5% worker productivity growth would lead to a 3.5% average annual supply side economic growth. The PPF shifts further outward each year than prior to the tax reduction, further increasing the economy's productive capacity.

We conclude this section with a look at some of the numbers. We begin with the 1980 election of Ronald Reagan, who took office in January 1981. He appointed congressman David Stockman to head the Office of Management and Budget (OMB). Stockman, along with Congressman Jack Kemp devised a plan to encourage economic growth and balance the budget. The key was a 25% cut in marginal income tax rates, strong increases in government spending on defense and a balanced budget through the miracle of assuming an increase in the supply side economic growth rate. Stockman, who rejected the deficit projections of his OMB staffers as too pessimistic, found a supply-side forecasting model that gave him the desired results. Stockman would later admit in a controversial book that he had used the supply-side numbers of economic growth to make the program acceptable to Congress. As the table below shows, the supply-side model linking higher economic growth rates to tax cuts would lead to a balanced budget by 1984. In contrast, the non-partisan Congressional Budget Office forecast continued budget deficits when leaving out the supply-side economic assumptions. (2).

 

Reagan's Budget Projections
(1981)
In billions of dollars
Year Fiscal Year
Projected Deficit
or Surplus		 Actual Deficit
1980   -73.8
1981 -54.5 -78.9
1982 -45.0 -127.9
1983 -23.0 -207.8
1984 +0.5 -185.3
1985 +7.0 -212.3
1986 +30.0 -221.1
(2) Projections of the budget deficit or surplus are taken from: A White House Report, "America's New Beginning: A Program for Economic Recovery," Feb. 18, 1981.

Looking on the revenue side, the graph to the left shows that collections were about $100 billion less after the income tax cut than if none had taken place.
A Brooking Institute study looked at the effects of the tax cuts on worker behavior. The study found that the number of hours spent working for the majority of workers was unaffected by lower taxes. Only two groups showed substantial increases in working hours. First were high-income women. This group may have responded to lower taxes, but probably the most important contribution to greater working hours was the increasing presence of women moving up the corporate ladders during the 1980s. The group with the greatest increase in work effort was low-income wage earners whose marginal tax rates actually increased overall when Social Security taxes were raised in 1983. They needed to put in more hours just to maintain a constant income.

Importantly, annual increases in worker productivity remained constant during the 1980s and are significantly smaller than they are today, providing no evidence of a boost in supply side economic growth due to the 1981 tax cut. In conclusion, the net result of tax cuts that are not fully offset by reductions in government spending are easily predicted by traditional economic theory. Stronger demand side economic growth due to higher levels of consumer spending, greater deficits, and little empirical change in the behavior of the average worker.

Applications of Comparative Advantage: Exchange Rates

The idea of comparative advantage is used to relate trade between different countries or regions. Factors such as labor skills, resources, and technology determine the competitive relationship between two countries. When describing comparative advantage in this light, changes in competitive relations evolve slowly. For example, comparative advantage changes with the adaptation of workers to new technology, a process that may take years or decades.

In contrast to the stately pace of change described above is the rapid transformation caused by movements in exchange rates. Fluctuating exchange rates can have a significant impact on the relative prices of imports and exports between two trading countries. Consider two recent events:

Until late 1994 Mexico had encouraged trade with the United States by fixing the peso-dollar exchange rate at 3.5 pesos to the dollar. However, throughout 1994 a persistent trade deficit with the U.S. and the flight of savings put tremendous downward pressure on the peso's value. Finally, in December 1994 the peso was allowed to float and immediately underwent a sharp devaluation against the dollar.

The effect of the peso depreciation (dollar appreciation) was to significantly lower the prices of Mexican exports to the United States. In contrast, the prices of U.S. imports increased dramatically for Mexican consumers. The impact on the Mexican economy was especially severe because over 70% of Mexican imports came from the United States.

Trade relations between the U.S. and Mexico were based on comparative advantages that developed when the peso was fixed at 3.5 to a dollar. Due to the substantial impact of the peso devaluation (today a dollar buys 6.2 pesos worth of goods produced in Mexico) and the severe Mexican recession that began in 1995, the trade relationship between the two countries has changed considerably. Not surprisingly, the Mexican trade deficit with the United States became a surplus by early 1995.

During the first six months of 1995, U.S. exports to Mexico fell 11.9% from the comparable period during 1994, while exports from Mexico to the U.S. increased 29%.

The peso devaluation increased the comparative advantage of goods produced in Mexico by lowering their relative price to U.S. consumers. For certain items, U.S. consumers found Mexican substitutes less expensive and thus increased their demands for these goods. Mexican consumers found that market prices of U.S.-made goods increased substantially. In some cases Mexican consumers would substitute in favor of Mexican-made goods, or if no substitutes in consumption were available, the purchasing power (and disposable income) of Mexican consumers was reduced as prices for U.S. imports increased.

More recently, the dollar has appreciated against many Asian currencies. As we would expect, the devaluation of the Japanese yen, the South Korean won, the Thai bhat and other currencies has lowered the prices of imports into the United States and increased the price of U.S. exports to these Asian countries. The consequence has been a significant jump in the U.S. trade deficit that measures the value of goods exported from the U.S. in comparison to the value of goods imported into the United States.

As imports fall in price, American consumers buy more imports as a substitute for domestically produced goods that maintain a constant price. A trade deficit implies that the value of exports leaving the U.S. is less than the value of goods imported into the United States.

Comparative advantage changes business in other, less obvious ways. To slow price increases and diminished market share, Japanese producers look for lower cost substitute inputs when the yen appreciates. For example, a Japanese computer manufacturer may buy more computer chips made in Malaysia and disk drives made in Taiwan, and fewer made in Japan. The substitution occurs because the components imported from Taiwan and Malaysia are now relatively inexpensive. Japanese computer manufacturers may go so far as to import an entire computer from Taiwan, change the label, and export it to the United States as a Japanese computer. These practices allow Japanese producers to maintain appealing prices in a highly competitive market with low profit margins. Changes in exchange rates and thus changes in comparative advantage have forced Japanese producers to rely on more foreign components in the goods they manufacture.

In summary, the evolution of comparative advantage is often described by the slow metamorphosis of labor skills, resources, and changes in technology. While these are critical components, factors such as floating exchange rates make comparative advantage a highly dynamic concept that may affect trade patterns very quickly.

Applications of Comparative Advantage: Cisco Systems and the Internet

We have created a simple model of an economy in order to facilitate our discussion of the production possibilities frontier and comparative advantage. By dealing with a single country and two goods we looked at the PPF and allowing for two countries and two goods we analyzed how comparative advantage leads to specialization and trade. Now let us use our knowledge of the PPF and comparative advantage to make a more realistic application to a single company. For the purposes of this discussion, we will consider a fast-growing U.S. corporation called Cisco Systems. Cisco is in the business of producing the hardware used in computer networking: allowing computers to communicate with each other. Since you are reading this material on the World Wide Web, your access to the Web from your personal computer probably involves some of Cisco's equipment. However, unlike the PC and printer that you are using, you won't see any off Cisco's actual equipment.

The application of the PPF and comparative advantage to Cisco will be appropriate for many other businesses. Any company that produces a specific product in a competitive environment will follow the same guidelines discussed here.

By focusing on the production of networking equipment, Cisco is a company that specializes. Cisco only produces a few parts of a computer network, rather than trying to supply the entire network. Cisco does not manufacture personal computers, servers, modems or microprocessors. By specializing in networking equipment, Cisco focuses on producing high quality products in a very competitive and innovative industry. We can think of this as an efficient use of resources. Cisco hires and trains engineers and computer scientists that have education and skills specific to developing networking products. For Cisco to divert resources (labor) towards the production of personal computers would be inefficient. There are many other companies such as Compaq and Dell that specialize in the production of personal computers.

We can see Cisco as attaining a point along its corporate PPF by using its resources efficiently. Cisco also must satisfy the assumption of using the best available technology at any given time. This is required in order for Cisco to supply the highest quality products to its customers. Failure to incorporate the best available technology into its product line would result in a rapid loss in Cisco's customer base to more technologically proficient competitors.

For a company to succeed in the field of high technology it must constantly innovate in the development of improved products. We can look at Cisco's corporate PPF as shown in Figure 3-3 to illustrate this point. Cisco is a publicly owned corporation, implying that it has sold shares of stock or ownership of the corporation to the public (1). The axes for Cisco's PPF are labeled capital investment (horizontal) and profit distribution (vertical).
A publicly owned company can do one of several things with profits that it has earned:

The PPF shown here shows a tradeoff between profit distribution and capital investment/R&D. As a corporation increases the amount of profits paid as dividends to shareholders and bonuses to employees, it reduces the amount available for capital investment and R&D.

As we have seen earlier, the key to future economic growth or the expansion of the corporate PPF is capital investment. The less of total profits a corporation distributes and the more it retains, the greater is the potential future enlargement of the company's production possibilities frontier.

(1) To be more specific, private sector companies that sell stock are considered to be publicly (by the general public) owned. This should not be confused with the public sector, that refers to the government sector. By selling equity (stock) shares a company is selling ownership. If there is a company that you would like to be a part of and it is listed on a stock exchange, you can buy some of its stock and own a (very small) part of the company. If the company does well, the monetary value of your shares will rise. Finally, note that the term privatization refers to the conversion of a public sector company to the private sector, usually by opening up ownership and selling stocks to the public.

Finally, we should emphasize the need for a company in a competitive environment to constantly cut production costs in order to maintain profits for products where the opportunity for price increases are minimal. Furthermore, companies like Cisco need to attract and maintain a highly skilled and educated workforce by providing good salaries and providing constant training and education for its employees.

Cisco and Comparative Advantage

Cisco System sells its products throughout the world, as do most of its competitors, both foreign and domestic. This global view requires that Cisco develop strategic partnerships with foreign companies and distributors. Cisco applies the concept of comparative advantage in its business practices. It specializes in the production of the products in which it has a comparative advantage and works with other global companies that have a comparative advantage in specific products and market access.

As Cisco expands production and output, it will locate factories outside its home country of the United States. By locating production abroad, Cisco enhances its access to foreign markets, reduces transportation and distribution costs and may even protect itself against adverse changes in exchange rates.

Applications of the Production Possibilities Frontier: The 1995 United Nations Women's Conference

The fourth U.N. Women's Conference took place in Beijing, China. An update of the current gap between men and women shows the following:

·          Between 1970 and 1990 the difference in adult literacy between men and women has been halved. The same goes for school enrollment.

·          Of the estimated 900 million illiterate adults in poor countries, twice as many women are illiterate as men.

·          Of the 130 million children with no access to even basic education, 60% are female.

·          A typical women's wage is somewhere between 60%-70% of men, for roughly equal work.

In a new report issued by the World Bank entitled "Toward Gender Equality: The Role of Public Policy," the relation between economic growth and gender inequality is examined. The report examines ways in which improving the economic welfare and opportunities of women can contribute to economic growth, thus improving living standards for men as well.

Consider education. Education improves what is known as human capital; our skills, knowledge and abilities. A better-educated population is more productive and output per worker increases. Economic theory suggests that as output per worker increases, so does economic growth and living standards.

In many developing countries, population pressures keep many citizens at a poverty level. As better education allows women to enter the labor force in developing countries, evidence shows that fertility rates decline. In addition, for a given amount of investment, lower rates of population growth will eventually increase the capital per worker, increasing productivity and economic growth.

Improved education allows women greater opportunities outside the home and better knowledge of the alternatives available. Studies have tried to quantify the correlation between female education and population growth. One simulation shows that if female secondary-school enrollments were doubled in 1975 in developing countries, the number of births would have fallen 30% by 1985.

Furthermore, there is a direct correlation between a women's education and the health and education levels of her children. Better-educated women tend to have healthier children, who also are likely to be better educated.

Although education is the number one economic priority for women in developing countries, women also need better access to the credit system to take out loans. In many developing countries, no more than 10% of all loans are made to women. This prevents women from obtaining the money needed to start their own businesses.

Concluding from the above, the World Bank emphasizes that governments should try to change laws and regulations in favor of promoting equal opportunities for women. By doing so, governments will be promoting economic growth and improved living standards for both men and women.

Applications of Comparative Advantage:  The U.S. Auto Industry

Thus far, we have considered a simple economic model of two countries and two goods to discuss the concept of comparative advantage. From the model we can conclude that when each country specializes in the production of the good in which they have a comparative advantage and engage in (1) free trade with the other country for the other good, both countries end up on a consumption possibilities frontier that is greater than their respective production possibilities frontiers. Specialization and trade allows for higher levels of consumption beyond the domestic production possibilities frontier (PPF). Holding all of the (2) assumptions of the PPF constant, the consumption possibilities frontier that arises from the presence of trade, creates higher levels of consumption than the domestic PPF would permit by itself.

(1) By free trade we are referring to the absence of tariffs (a tax on imported goods) and quotas (limits on the number of imports).

(2) The three assumptions are:

In reality, there are many more than two countries, with a nearly infinite number of different goods produced. While the model of comparative advantage explains the benefits arising from free trade, it does little to explain how the world actually works. An accurate explanation would be impossible, given the complex combination of economic, political and social forces that are active. We will consider however, the increasing role of the global economy in determining the fortunes of an individual industry.

For an example, take the automobile. At the end of World War II, the United States turned its industrial might from armaments to consumer goods, with the automobile industry leading the way. Centered in Detroit, the big three of General Motors (GM), Ford and Chrysler, built ever-larger cars for Americans to cruise their new interstate highway system in luxury. Many models of cars were called "boats", closer to a luxury yacht than basic four-wheeled transportation.

The industrial might of Detroit became so tremendous that by the 1960s there was a common phrase: what is good for GM, is good for America. Consider the implications of such a statement; General Motors, Ford and Chrysler had such a significant influence on the economy, that when business was good for the big three, so were conditions for the entire U.S. economy. The auto industry became the barometer for the U.S. economy as a whole.

At the same time, America was awash in cheap gasoline from both domestic and foreign sources. Fuel economy was of little concern for Detroit automakers, as consumers increasingly satisfied their insatiable desires for greater horsepower and larger engines. Although it had formed into a cartel of oil producing nations during the early 1960s, most Americans had never heard of OPEC.

By the early 1970s, over 50% of the petroleum consumed in the United States was imported, primarily from OPEC member countries. With the first OPEC oil embargo in 1973, suddenly gasoline became a scare commodity. During the height of the embargo, long lines formed at gasoline stations throughout the country resulting in typical waits of over two hours for a tank full of gas. The American muscle car, often obtaining less than 10 miles per gallon of gas, went the way of the dinosaur. And how did Detroit respond to the need for fuel-efficient automobiles? Ford rolled out the Pinto, featuring exploding gas tanks. A rear end collision could result in a fireball, occasionally incinerating slow-footed occupants. Not to be outdone, Chevrolet built the Vega, with an engine so poorly designed that it would often quit after accumulating around 20,000 miles. No wondered American consumers embraced the alternative choices offered by the Japanese auto producers.

Across the Pacific

During the glory years of Detroit, the Japanese auto industry was struggling to its feet. Japan is a country with insubstantial domestic oil production, relying almost completely on imported oil. Not surprisingly, fuel economy was required in Japanese automobiles since gasoline was relatively scare and expensive. For the most part, Japanese cars produced in the 1950s and 60s were extremely spartan in their features and did little more than provide basic transportation. A few Toyota's and Datsun's (pre-Nissan) made their way across the ocean and onto the driveway of some eccentric Americans. For the most part, lacking many of the comfortable features of their American counterparts, few consumers in the United States considered a Japanese built auto when buying a car.

This situation changed completely during the 1970s. Gasoline prices surged, and U.S. consumers demanded greater fuel efficiency or they would go broke buying gasoline. When considering the Pinto's and Vega's dumped on them by Detroit, consumers increasingly purchased reliable, safe and durable Japanese imports. Japanese auto manufacturers took advantage of their increasing market share and the income generated, by continuously increasing the quality and the number of models available. Meanwhile, the big three mostly made excuses and demanded tariffs and quotas on Japanese imports to protect their falling market share. By the mid-1980s, Chrysler was bankrupt and required a federal bailout to avoid closing down.

The 1980s was a dismal period for U.S. automakers. Japanese producers gained increasing chunks of market share and the U.S. automakers failed to make the necessary sacrifices and long-term investments needed to match the Japanese manufacturers in quality. Many consumers felt the quality of U.S. autos was so poor, that they would have a life span of less than five years. However, by the 1990s, aided by a strong yen and a commitment to quality, the big three of Detroit began to come back.

The rapid depreciation of the U.S. dollar in relation to the Japanese yen during the last part of the 1980s gave the Detroit automakers a window of opportunity. When the dollar depreciated, or fell in value against the yen, the effect was to increase the prices of Japanese imports. At first, Japanese producers were able to reduce their profit margins in order to maintain prices, but as the yen continued to appreciate (and the dollar depreciate), eventually prices began to rise modestly in relation to the U.S. made cars.

Conclusions

From the above example we can gain a better picture of comparative advantage. Critical to understanding the evolution of comparative advantage in the production of a good is understanding the role of:

Putting all of this together into a complex economy helps to understand the gradual forces shaping a company's, an industry's or a country's future in a global marketplace that is becoming increasingly competitive over time.

Copyright © 2002, Jay Kaplan
All rights reserved
Last updated June 1, 2002