Understanding Effective Demand with Edward Lambert
A few people have asked me to provide a quick introduction to Edward Lambert’s recent work on Effective Demand, which work I’ve mentioned a few times. That’s ironic, because I made those mentions in hopes that more-accomplished others would do the same for me.
That help hasn’t been forthcoming, because quite a bit of work and thinking is required to plumb the depths of Edward’s model. So I’ve asked Ed to help me put together a basic introduction. Hopefully I’ll benefit from the blowback of ensuing discussions.
In Chapter 3 of General Theory, Keynes bruits the notion of effective demand. It’s very much the centerpiece of his thinking, but it is almost uniformly ignored in textbooks. He describes it as the intersection of the aggregate demand and aggregate supply curves. Edward adheres to that notion.
While I grasp that thinking in an abstract way, Keynes fails to provide what I need; he’s neither general nor specific enough for me to really grok it. (Dictionary.com: “to understand thoroughly and intuitively.”)
In a general sense, I want to understand what effective demand is, in narrative, descriptive terms explaining human incentives: why people and groups act as they do.
In a specific sense, I want to know the formula to calculate effective demand, so I can plug in publicly available measures (or watch others do so), plot changes in this measure over time, and see what happens.
Edward’s work particularly stands out for me in providing that formula. Whether his formula is “right” or useful remains to be seen. But it’s important; to my knowledge (and Edward’s), no effective-demand theorist, including Keynes, has provided a workable formula. It seems to be the very thing Paul Krugman was asking for four years ago in his lecture on effective demand.
Here’s the formula:
Effective Demand = Real GDP x Labor Share of Income / Capacity Utilization x (1 – Unemployment Rate)
I’ll unpack that below. But first my explanation and understanding.
First: Effective Demand is not a straightforward accounting measurement like Personal Consumption Expenditures or Corporate Profits. It’s much more like estimates of the non-accelerating inflation rate of unemployment (NAIRU) or Potential GDP. It’s an analytical construct, an economic concept that’s useful for sussing out what’s happening in the economy.
With that as background, here’s a shot at providing what Keynes and Edward don’t: an explanation of what effective demand is, at least in this construct. (Note that throughout, here, “capital” means real capital, not “financial capital.” I’m talking about drill presses and such.)
Effective Demand is a measure of how much the economy at a given point in time can, could, increase utilization of labor and capital from current levels, before that increase in utilization (and new real-capital creation) slows or stops due to insufficient demand.
It gives us a measure of the extent to which an economy can use more of its raw production capacity (its labor and capital, working full tilt) — before that increase slows due to the disincentives of insufficient demand/sales.
Effective demand helps us determine the “potential” production in the economy — its potential to employ and create capacity within that demand constraint – the extent to which producers seeking profits will 1.) employ unused and available capacity (mostly by employing more workers, perhaps bidding up wages to do so), and 2.) create new capital/capacity.
Note that “capacity” and “potential” are very different here.
Edward has said that effective demand could be called “opportunity demand.” The concept characterizes the magnitude of the sales and profit upside that producers see ahead when considering whether to expand production by utilizing more capital (by hiring more workers) and creating new capital (also hiring in the process).
Normally in the “good” parts of the business cycle, effective demand does not constrain the utilization of labor and capital. Businesses in aggregate can employ (and create) more resources at the margin, producing more output that they can sell at a profit. But there comes a point at the end of a business cycle where effective demand sets a limit upon the profitable utilization rates of labor and capital, and (hence) restricts the incentives to create and employ new capital.
So let’s go back to the formula, and the terms therein. What story can we tell about effective demand?
Real GDP. When this goes up, effective demand goes up. This seems intuitively obvious.
Labor Share. This is at the heart of the model. Labor share determines the relative power of labor to purchase finished goods. The sale of finished goods determines production and investment in capital capacity. So, when labor share rises, effective demand increases due to more relative power for household consumption demand. Producers see more upside potential, expressed in sales.
Capacity Utilization. This is somewhat counterintuitive. When capacity utilization increases, it decreases effective demand. This is because effective demand is a measure of the demand-incentives for producers to increase utilization. When capacity is already heavily utilized, it’s more expensive (less profitable) for producers to utilize more.
Unemployment Rate. This is even more counterintuitive. When unemployment declines (employment increases), effective demand also declines. Why? Because as the economy reaches the full-employment limit, it’s harder for the whole economy to increase output to the full-tilt limit. And it’s that potential increase that incentivizes producers. The decline in unemployment eventually constrains the potential future rate of that very decline, and the future rate of economic growth. See Edward’s post on this here.
Effective Demand Limit. Real GDP will tend to increase as more capital and labor is utilized. However, there is a limit set by the relative power of labor’s share of income to purchase production. Reductions in that buying power reduce producers’ incentives. The concept here goes back to Keynes’ original statement that employment of the factors of production will be limited at the point of effective demand where “the entrepreneurs’ expectation of profits will be maximised.”
The intuition behind this, in particular the key privileging of labor share in the equation: ultimately, economic activity is directed to producing goods that humans can consume. The desire for that consumption is the ultimate source of demand, hence the driving force behind economic activity (including capital production). Labor income — a very large proportion of which is devoted to consumption spending — is at least a good measure or index of that final demand, and at most the driving force of that demand.
I want to keep this post short (oops, too late), but before leaving I want to return to the key virtue of Edward’s work: the ability to plot this explicitly formulated measure of effective demand over time, and see how it has moved in relation to other measures. The graphs below, from this post, show how it has moved over several business cycles, plotted relative to 1. real GDP and 2. utilization of capital and labor.
As you can see, the ends of business cycles (beginnings of recessions), are characterized in this model by a stylized fact: real GDP approaching or exceeding this measure of effective demand. Capacity utilization increases quite smoothly up to that point (the “good” part of the business cycle), then declines (often after a chaotic period that can last quite a while; see 1995-2000).
These graphs seem to tell a very consistent and compelling story. I’ll leave it to Edward’s post to explain the individual dynamics of these periods in more detail.
Leading up to the Recession of 1974
Leading up to the Recession of 1980
Leading up to the Recession of 1991
The almost Recession of 1994 and the Recession of 2001
Leading up to the 2008 Recession
Leading up to the next Recession
Engineers and others with similar bent might find it useful to think of the intersecting aggregate supply and aggregate demand curves as the X and Y arms of a 2D plotter. The effective demand paths you see above are the lines that plotter draws over time.
Another physical metaphor, characterizing the lines/measures as pulling and pushing on each other: effective demand as portrayed here seems to act like an attractor, pulling up both real GDP and capacity utilization. But unlike a magnet, for instance, the attraction effect gets weaker as the lines converge. And when real GDP exceeds effective demand, we see a very strong attraction effect pulling those two measures back down again.
Cross-posted at Asymtposis.
Thank you for this interesting summary. As a non-economist, I find this fascinating but it’s not easy for me to work out its broader repercussions.
The labor share as an important component is straightforward. With the percentage of GDP now going to wages at (I believe) a 60 year low, it’s clear how is going to pull down effective demand.
But I’m especially interested in seeing how it is related to broader economic trends. In particular, how does it track the shift from capital accumulation to financial profits as a crucial feature of the neoliberal growth model?
My untrained eye way also struck by the fact that the line for ED is far steeper in the last two graphs. My question is: does this graph show us the consequences of the long-term shift away from capital accumulation and towards financial profits (i.e. the search for short-term profits through ownership of assets instead of investment in production)? I’d be interested to see that argument made.
@Frank Stain:
On steepness, note the different Y axis scales on the graphs. I think hard to compare the graphs, as presented, that way. The horizontal distance between the points (quarterly measurement) is perhaps more interesting.
re: trends, try out this post from Edward:
http://effectivedemand.typepad.com/ed/2013/04/when-labor-share-does-not-rise-in-the-growth-model.html
And more generally, I went after this question in a somewhat different way here:
For an economy to keep moving toward greater prosperity, labor share must increase. Through redistribution or changes in market power.
Allow me add to this:
“Capacity Utilization. This is somewhat counterintuitive. When capacity utilization increases, it decreases effective demand. This is because effective demand is a measure of the demand-incentives for producers to increase utilization. When capacity is already heavily utilized, it’s more expensive (less profitable) for producers to utilize more.”
Practically, you want to use capacity up to a certain point as to when it becomes more expensive to do so. That measure depends upon the industry. For example a process industry would have a higher utilization then other industries such as Batch/Lot or MTO industry. I would suspect you could run oil refining at a much higher capacity (90+% – historically) than one could run a 4 cavity injection molding tool. Capacity for a four (or whatever) cavity tool molding tool is 80 to 85% and you will not increase cost at that point. If you were to run the tool for 90-95% for short periods of time, you would not cause cost to increase.
The problem arises when you have to do maintenance, you fail to do so, and the tool breaks (a push pin breaks and ends up in a cavity damaging it, etc). This usually happens when demand exceeds or equals or comes close to capacity Maintenance then requires a longer time to repair the tool. If the tool is already at practical capacity, then you lose production and potetial sales/profits. It is wise to run at practical capacity than theorectical capacity for obvious reasons.
Goldratt did a book called “The Goal” in which he suggested the addition of capacity to satisfy orders even though less efficient was necessary as the end result was a lost order. You might add a one cavity tool which produces less; but, it still adds to total capacity. The idea was to satisfy orders if you can by adding inefficient capacity or do not except them as it costs more to have an unsatisfied customer. I suspect Apple does something similar with pricing adjustments where some customers settle for a Samsung instead.
There is a percentage for capcity.
My two cents.
In this model, higher labor share and also higher unemployment are associated with a more prosperous economy. This is presented as countejrintuitive, but to me, it appears that the two are associated in this way – when there is a higher labor share, there is income available to the working families sufficient to support those who are not, cannot, or do not wish to work.
And who are these nonworking people? Adult children, stay-at-home spouses, people pursuing higher education, or unhealthy or unlucky family and friends of those who are working.
It seems to me intuitively that the higher unemployment rate, or if you like the lower employment rate, is the result of the excess labor share going to workers, not counterintuitive at all.
Up until the 1970s,, the norm was to have at least one nonworking spouse, and often a family would be supporting other family members, such as grandparents, an uncle or aunt, or the children of other relatives. Earlier still, the norm was to have one or more servants, even in homes with modest means. Though technically employees, they were actually dependants of their employers, who provided food, clothing, shelter and a modest recompense.
Simply put, a high labor share of income is needed in order for an extended family to exist. Also keep in mind that these “nonworking” people were not generally layabouts. Rather, they would often be involved in child care, housekeeping, and community volunteer activities, to the benefit of all. Requiring a high percentage of adults to work in order to survive merely robs the community of the reserves of human energy so useful in meeting the needs of the community as they arise.
Noni:
This:
“a high labor share of income is needed in order for an extended family to exist.”
is what he is saying.
Noni,
Higher unemployment will raise effective demand, but that does not represent a more prosperous economy. Higher unemployment will signal a lower utilization of the factors of production.
As you say, higher labor share will represent a more prosperous economy, because labor share is the top limit upon the utilization of labor and capital. When an economy is able to raise labor share as it develops, there is more space for the utilization of labor and capital. It is a sign of a mature and prosperous economy built upon the capital investments of past generations. It is great how you tied that to taking care of our grandparents.
The problem now is that advanced countries should have continued to raise labor share, but the business profit motive reached a level to become a poison.
In Tibet, the doctors have a principle that all things are medicine or poison depending on the dose taken. Corporate profits are a medicine that makes society stronger, when they are balanced with the cost of taking care of people. But corporate profits can reach a level where they become poisonous to society…. like now.
@Edward: “Higher unemployment will raise effective demand, but that does not represent a more prosperous economy. Higher unemployment will signal a lower utilization of the factors of production.”
Makes sense to me. Higher unemployment means the potential to become more prosperous than we are at that unemployment level — by employing unused labor resources.
Related: I’m trying to find your great little recent example in comments of massive ED if all income went to one capitalist. Where is it?
My only question with this is where does increasing productivity fit? Labor share I get, but increasing productivity also contributes to demand in that the consumer price comes down.
It is my issue when people talk about machines and the declining need for labor. As I understand it, the more work put out per worker do to technology allows ever more people to “demand” the item do to the declining consumer price. We would not have seen the rise in labor utilization in China with the rise in the applicaiton of technology/science in manufacturing if this were not the case. Unless so much of the worlds manufacturing has been consolidated to this one region of the world that it sqews the image of labor demand?
Though I don’t believe there is a sqewing of labor demand unless creativity is stiffiled such that new products are not generated off of existing science that is utilized in current manufacturing. I do believe we are seeing some what of this effect as it relates to monopoly power, captured government and financialization.
“…where does increasing productivity fit? Labor share I get, but increasing productivity also contributes to demand in that the consumer price comes down. …”
If I understand correctly, productivity rises when fewer people are needed to make or do the same amount of stuff. In theory, productivity would skyrocket if a mere 1000 people could do all the work (with the help of machines.) And labour share could be very high, close to 100%, if those 1000 got all the benefits of that productivity, because ‘labour share” is restricted to income earned by actual workers, not the unemployed. If the 1000 worker/owners were the only people in the country, such a society would look like Asimov’s Solaria. https://en.wikipedia.org/wiki/Solaria
But such a country can’t (currently) exist. You cannot run a nation on 1000 rich people, be they ever so industrious. If nothing else, a nation like that would be terribly vulnerable to invasion, plague, and crazy feuds and such. Nations need lots of people, not to do stuff but to be a society, to offer padding and stability, to be a reservoir of memories, to be (crudely) a very large breeding population.
I worry that what’s left out of the modern neo-con equation are the “extras.” Whether workers or non-workers, they are needed.
Noni,
I a closed system you would be correct. However, productivity has increased do to applied technology/science and thus made any given item less expensive such that more people of the world can afford it. This requires more people to run more machines.
This is the reality of productivity. It is what has driven China’s growing “middle class”. That we think demand is being met with ever fewer workers is incorrect in part I believe. The demand is no where near what it could be for any given product do to global income inequality. Thus, people fall for the concept that fewer workers are needed. It is the “new normal” argument. But that argument is dependent on keeping income inequality.
Now, maybe someday in the far future we will have to figure out a way to provide for everyone do to the ability to produce/manufacture with almost no human labor, but then we all might just find that we can put all that productivity gain into humanity actually living to work instead of working to live.
Until then, the issue is income inequality. Of course as Coberly often notes we are on a planet with limited resources. Thus recycling has to become in time the prime source of raw material.