Look: I am eager to learn stuff I don't know--which requires actively courting and posting smart disagreement.

But as you will understand, I don't like to post things that mischaracterize and are aimed to mislead.

-- Brad Delong

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Thursday, November 17, 2011

That Aggregate Demand Thang

Karl has a thoughtful and insightful post, stating:

All that having been said the proximate cause of the slump is a sharp decline in consumer spending from which we have not recovered.

He has a couple of graphs to indicate the gap. Graph 1, Personal Consumption Expenditures, shows a recovery from the '09 low to a new recovery high, above the late '07 pre-recession peak.  (See it at the link.)  But this metric includes a few items that are either non-discretionary or totally outside of the consumer's control,   like bank profits (!?!)

Graph 2 is more relevant.  It indicates retail and food service spending.  Again not 100% discretionary, but a lot closer.  By thiis metric, we have not yet attained a new recovery high, and might actually be leveling again.

In conclusion, Karl asks:

We don’t think their desire for consumption has somehow become completely sated. This implies that there is some price at which they would want to buy more real goods and services. Yet, the market does not find that price.


My response:

 Excellent post, Karl. Thank you.
The market does not find that price because too many people can't afford to pay it. Real unemployment is still around 16%, and new job creation is at a far lower wage scale than that of the old jobs that were destroyed. I think this is fairly obvious.
Also, every penny generated by GDP improvements and productivity gains over the last 3+ decades has gone to the top two quintiles, and within them, disproprtionally to those at the top. The skew is greater the higher you go.
Today's generation of young adults makes less real income than their parents generation did 30 years ago. The American dream literally is dead.
Back to graph 1 - Even if the new trend line were more or less parallel to the old trend line (by my eye it has a lower slope), it is running about half a trillion dollars lower. At parallel trend, that gap will never be filled. At lesser slope, the gap widens every day.
This cries out for fiscal policy, which is not forthcoming.
We're screwed.


BadTux said...

The market doesn't find that price for a different reason, actually -- because of price stickiness, which I've covered on my own blog from time to time. That is, a business will not sell goods for less than it cost to produce them. A business which does such a thing is called a former business. Instead, a business will accept lower volume in order to remain profitable selling at a higher price than demand would otherwise justify, and because the whole point of a business is profit, will lay off all workers not needed to sell that reduced volume of product, which in turn will further reduce demand at the price point needed to remain profitable.

In addition, resource prices are dominated by capital equipment costs, not by manpower costs. That capital equipment must be amortized over the production lifespan of the capital equipment. If an aggregate crusher lasts ten years, its cost must be amortized over the entire lifespan of the copper mine. If the demand for copper and thus the amount of copper shipped plummets, this has the perverse effect of increasing the cost of copper, because that sunk cost must be paid for regardless of how much copper gets shipped. Assuming we already had a competitive free market and thus all copper producers were already running at the least amount of overhead needed to be profitable, what you'll have is that an *entire industry* can raise its prices due to reduced demand.

So add in price stickiness plus resource price increases, and there you go. This isn't rocket science. This is Business 101, and, specifically, rule #1 of business: "The purpose of a business is to make a profit." Duh!

- Badtux the Snarky Economics Penguin

nanute said...

Bad Tux,
Great point. I've noticed that the company that I work for just increased pricing to distributors without an expectation of increased demand. The question in my mind, is where is the break even point if sales decline as a result of increasing prices? I recently participated in a work related exercise where it was stated that a 10% increase in price can result in a 100% increase in profit. Is this possible? Does it depend on the product being inelastic, and does it assume that there will be no decline in sales?

Jazzbumpa said...

nanute -

It's hard to say what the exact assumptions are. Almost certainly, though, they are assuming a very low sensitivity to price.

The price/profit relationship relates to current margin. I just ran some made-up numbers and found this:

cost price profit Margin
15 16.67 1.67 11.13%
15 18.337 3.337 22.25%

Here, a 10% price increase doubles the unit margin. This assumes no cost increase associated with the price increase. For the total profit to double, there would have to be no loss in sales.

At lower margins, the 10% price hike more than doubles margin. At higher prices, the margin increase is less.


Jazzbumpa said...

Tux -

Yeah. Good points.