Conceptualizing Effective Demand with Productive Capacity

“… the fundamental law of capitalism must be: If workers have more money, businesses have more customers.” Nick Hanauer

Keynes wrote that insufficient effective demand could “bring the increase of employment to a standstill before a level of full employment has been reached”. We may have this problem. So… What is effective demand?

I base effective demand upon labor share. How could labor share determine an effective demand limit upon the employment of labor?

In the graph, real GDP rises with the utilization of labor and capital. I showed previously that the up-sloping blue line is a stable attractor path that real GDP follows. (link) The point where the blue line meets the 100% limit on the x-axis gives the productive capacity of the economy. This point tends to be stable for a period during the expansionary phase of a business cycle. In this hypothetical graph, $20 trillion is the stable productive capacity. Real GDP rises up the blue line toward $20 trillion as more labor and capital is utilized.

If we assume an effective labor share of 80%, a principle of effective demand would say that real GDP has a natural limit at $16 trillion and will not want to rise above this level. ($20 trillion productive capacity * 80%). This limit on real GDP has been the pattern since at least the 1960’s for various levels of labor share. What mechanism might we conceptualize to explain this?

Take the extreme case where the economy is producing at full productive capacity, $20 trillion. 100% of labor and capital is being utilized. With an effective labor share of 80%, labor income would have a top limit of $16 trillion. Who would consume the other $4 trillion of value-added output? Capital income would have to be the final consumer of $4 trillion of its own production. Ultimately that is not profitable for firms. Production itself would unavoidably deteriorate shareholder dividends.

In the aggregate, profit rates would be incredibly terrible if the economy was producing at 100% productive capacity. We know that profit rates rise up to the effective demand limit. Then as Keynes said, profit rates maximize at the effective demand limit. Once real GDP goes above the effective demand limit, a process begins toward those incredibly terrible profit rates at full productive capacity. Therefore real GDP stays within the lower red zone where aggregate capital can generate revenues within the limits of potential labor demand. Production there is justifiable and profitable.

As real GDP rises above the effective demand limit, production goes beyond what labor demand would ultimately be capable of consuming. Production in this zone is only justified if capital is willing to commit to consuming its own production. Yet that is increasingly unprofitable. Firms do not want to send such a signal to the market. Still a blend of signals would show firms and their investors that aggregate capital is separating from its customer base.

Ultimately, production and the utilization of labor & capital stay below the effective demand limit line. This has been the consistent historic pattern. In effect, effective demand has always been limiting full employment. Apparently we just never realized it.

Real GDP is now very close to the effective demand limit.

Footnote: Loose monetary policy is trying to push firms to utilize labor & capital beyond the natural effective demand limit, but they really can’t go there according to the explanation above.