Friday, October 19, 2012

Thoughts on "potential output"

"Potential output" is a probably harmless, but really dumb phrase. When people talk about "potential output" they're not actually talking about the output potential of the economy. They're not even really talking about the sustainable output potential of the economy.

We could not let children play, only teach them things essential to production in school, and have them work part time through their childhood and into adulthood. We could cut all higher education not relevant to production and put those people to work too. And we could make paying someone for childcare mandatory and force all parents to works.

We would produce a lot more than we do now. What's more, it's not like we'd be working people all that hard. It would be a dreary life, but it wouldn't be anywhere near subsistence living in the way Malthus envisioned it.

What we mean when we say "potential output" isn't equilibrium output either, because we know there can be high unemployment equilibrium (doubt it? google "employment to population ratio" or "NGDP").

So its certainly not a term you ought to take with a literal mindset. It's also not a term that you ought to take with a Walrasian mindset.

When we talk about "potential output" we're really taking a Keynes/Nussbaum/Sen approach to things. We're talking about macro relations but we're also making a general statement about human capabilities and the good life. What we mean is that at a particular employment rate that we feel comfortable and a particular level of leisure and pleasurable consumption that we think is reasonable, the economy could consistently produce X level, and we're going to call that "potential output".

It's a hugely value-laden concept. I only think that's interesting because it's often discussed as a technologically determined magnitude. Long run aggregate supply is often treated as a question of engineering - it's aggregate demand that's supposed to be all about hopes and dreams.

But that's really not true - even in the more circumscribed Walrasian sense.

This is not a mark against it, of course. It's just important that we restrict potential output to equations describing peoples' decisions, and keep it out of production functions, budget constraints, etc.


  1. I dunno, I think you are ignoring the role of the capital stock in determining potential output. While you could put everyone to work at gunpoint we have a relatively fixed capital/technology stock and that's the real limiting factor to potential.

    I also think that the behavior of prices when one is above "potential" also lends the phrase some credibility becuase it implies that above potential all adjustments take place in prices and not in output (in theory at least)

    1. Right - I'm not saying that productive capacity is unlimited. The capital stock is a limit (although it's a soft limit, and we can augment it and could have had a different capital stock than we have today potentially, if we had made different decisions in the past).

      Think about what potential output is. It's not "given capital stock, maximize output". It's something more vague like "given capital stock and preferences, maximize utility under full employment conditions, and then look at whatever output is associated with that optimization process". That's not a technical limit, although we often talk like it is. That's not to say - of course - that the technical capacities are irrelevant or that they're limitless.

  2. I dont really think about potential output as utility maximizing. I think of it as noninflationary full employment which does imply a technical limit.

    1. Well right, but those NAIRU type limits are inherently subjective. They're based on labor supply preferences and social decisions about what the good life is (NAIRU is higher elsewhere in part because they've made other decisions). I'm not sure "technical" is the right word for that limit.

  3. I think you are confusing cross country variation with subjectivity. I mean, I agree that it is extremely difficult or impossible to calculate potential output in the same way its impossible to calculate a Philips curve and that the concept should be thought of as "abstract".

    But that is different than saying that you cant even talk about potential output in principle becuase all the parameters are subjectively determined.

    That having been said, I think there is a more interesting discussion about what potential output is if you believe in stochastic trends as opposed to deterministic trends.

    1. Sorry, I wrote this too fast becuase I am supposed to be doing something else (I suppose I always am supposed to be doing something else).

      What I meant to say is that you are taking structural difference between countries and sort of over defining them as "subjective". Give a countries institutional structure there will be a point at which adjustments stop taking place in output and start taking place solely through prices. Institutions are probably even more fixed than capital so I don't see how variety between institutions means that (again, in principle) one cannot talk about a give countries potential output.

      Also, I'm not sure the last paragraph points to a more interesting discussion/I am not interested in hijacking this post.

    2. I agree, but I don't think I said you can't talk about potential output in principle because the parameters are subjectively determined.

      We can and do talk about potential output quite fruitfully all the time. The funny thing is we often think of it as an engineering concept (the limit of what our economy can sustainably produce) and not as the subjective concept it actually is.

      Clearly the fact that something is subjective doesn't mean you can't talk about it... otherwise we wouldn't have much to talk about!

      The reason I talk about institutions across countries is that institutions don't grow on trees. They're a direct result of a political process that produces an institutional output from the input of citizens' preferences and views on the good life and the role of government.

    3. Well, then I'm not quite sure what you are arguing. I guess I am already taking institutions as given (as well as technology and capital) to the when discussing potential while you do not think we should? You seem to be suggesting that everything (technology, institutions, capital, the labor supply) is flexible (with the labor supply infinitely so). Anyway, for me--by definition--potential output assumes fixed, or relatively unresponsive variables. Not to say they don't change and you cant have (very) long run trends in potential.

      In fact, you kind of seem to be arguing a strong version of stochastic trends in GDP assuming that we equate technology (solows A) with institutions, which is how it should be thought about.

    4. I have these vague thoughts and perhaps post them without enough context. Nothing's wrong with potential output.

      Your point here is kind of a short-run adjustment vs. long-run adjustment point. Yes, today we have a lot fixed that feeds into potential output. I'd agree with that. And institutions are among those fixed factors.

      I'm just thinking a lot more broadly about how we think about concepts like this. I at least instinctively think about (and I feel like I hear about) potential output as a technical magnitude. That's the technical limit. That's classical stuff. All the state of confidence, swings in preference kind of stuff operates with reference to this fixed star of "potential output" which is really just how much widgets we can produce in a particular period of time.

      But at a conceptual level that's the wrong way to look at it. It's not a technical limit at all. We could produce a lot more than X widgets this year if we wanted to. Presumably actual technical limits kick in at some point, but that's well past the point of "potential output". What we call potential output actually has a lot of very subjective notions of the good life and preferences already baked into it.

      It's just a thought I had about how we think about it conceptually. It's not a critique of the variable itself. And maybe people never shared my tendency to think of it as a very technical quantity, in which case its just a personal epiphany.

    5. Well, I think helps to bear in mind that we very rarely ever actually reach potential output (during WWII, for instance, we were well above it) when its measured empirically (in a sophisticated way, i.e. not LR average=potential). I, however, am not sure what meaningful relevance the idea that there are cultural determinants of output (i.e. a 40 hour work week) has to the discussion of potential output. Cultural norms will very unlikely change rapidly enough to push the PPF outward in a really meaningful way. Like, say, to mitigate inflation.

      And I do think you are talking about something more like a stochastic trend contra a deterministic trend assumption in which you are assuming shocks to "technology" very broadly defined drive production.


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