The existence of capacity constraints in the economy has implications both for business and for the optimization of economic policy, because failure to properly account for its effects on the supply of goods and services to the market threatens excessive inflation and/or suboptimal levels of output.
When capacity is constrained in the short-run, meaning that some individual firms/industries face difficulties keeping up with demand for their products, it leads to faster and faster increases in prices for those products. This has important implications for the shape of the short-run Phillips curve i.e., the tradeoff between inflation and unemployment, and the long-run average level of national income.
As I will explain in this article, capacity constraints on business are an important determinant of the shape of the short-run Phillips curve, which has implications for the proper role of short-run stabilization policy i.e., monetary policy. Before that, however, I'll give some explanation of what type of capacity constraint a firm might face.
At the level of the individual firm, the significant constraint on increasing production levels occurs as a sort of 'weakest link' in the production process. There are many elements that flow together in the production process to create goods and services, and whichever of those elements is the most limited will form the weakest link.
Recent examples of this sort of constraint have occurred in the automotive industry, where a global shortage in semiconductors has ground car manufacturing to a halt.
Different industries are more or less vulnerable to this sort of constraint, but modern production techniques such as just-in-time lean manufacturing often entail holding very limited inventories of stock, and thereby leave themselves vulnerable to supply chain issues when economic circumstances take an unexpected turn.
For most industries, the main constraints on short-run capacity include:
The list of potential capacity limiting factors is a very long one, but you get the idea. The main point is that while there is usually some spare capacity to increase production in the short-run, it is limited and will almost certainly incur additional costs that then force up prices in the economy i.e., inflation.
The extent to which this happens in any given industry is unique to that industry's particular supply and demand dynamics, but sooner or later the emergence of 'bottlenecks' in productive capacity will cause inflation to increase at a faster and faster rate until no further increase in economic output is possible in the short run. This constraint is described in my article about aggregate supply.
There is no easy way to fix capacity constraints other than to avoid mismanagement of the economy in such a way that we reach these constraints in the first place. To the extent that we do find ourselves in such a position, the most efficient way out is simply to allow the price mechanism to operate more efficiently, i.e., to avoid excessive government interference in the functioning of the free-market.
Recent examples of excessive stimulus packages, that keep employees at home rather than going to work where they can produce goods & services, represent an economic folly of indescribable magnitude. To have adopted such policies at a time of such enormous preexisting national debt levels, budget deficits, and trade deficits only serves to highlight just how far we have deviated from the sustainable economic growth path, and history is unlikely to look kindly on the politicians who steered our economies in this unfortunate direction.
The next few years are likely to demand major changes in how business is conducted across the world. It is not just specific firms or industries that will be affected, the capacity of entire economies to produce enough goods and services will face the biggest constraint of them all i.e., rising inflation.
Some of the capacity solutions that may be promoted in the near future as a response to global supply chain problems, and the probable restructuring of the global monetary system, include:
The short-run shape, or slope, of the Phillips curve is a matter of some controversy in modern economics and many standard treatments of it just assume a simple linear curve i.e., a straight line tradeoff between unemployment and inflation in the short run. The ideas and opinions here are fundamental to much of Keynesian theory, and the details do matter. For more information, see my article:
A linear short-run curve would suggest that, when the economy is overheating, inflation will go higher in fixed proportion to some reduced amount of unemployment. Conversely, when the economy is under-performing, that same proportional relationship holds with unemployment higher and inflation lower.
The important point here is that the economic boom periods should create as much extra output as recessionary periods create shortfalls in output. Overall the two fluctuations should even out with no overall gain/loss.
However, what we have just learned about capacity constraints should enable us to deduce that the short run Phillips curve is unlikely to be linear.
The fact is that output cannot be expanded beyond its long-run capacity at some constant, or linear, increment in costs of production. Such costs rise exponentially and cause ever increasing rates of inflation, meaning that the Phillips curve must be non-linear. The important point here is that long run economic output is reduced by the boom bust business cycle, because recessionary periods cause more lost output than the boom periods create extra output.
The implications of capacity constraints, and their role in shaping the short run tradeoff between inflation and unemployment, highlights the importance of keeping inflation out of the economy by management of appropriate fiscal and monetary policy - and it also highlights the total ineptitude of successive western governments on either side of the political divide in recent decades since they have uniformly failed to adopt such policies.
Such failures in planning will cause mayhem in the future, but free markets do have the power to reinvent themselves if allowed to do so, and the capacity to overcome most problems. The biggest potential constraint going forward relates to how free those business operations will be in future i.e., will the electorate blame the free-market or embrace it?
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