Apples, wheat, and haircuts: output and demand

What happens to output when the quantity of output demanded suddenly and unexpectedly falls below and stays below the existing level of output? (And prices either do not or cannot adjust to bring the two into balance).

I'm going to sketch three different economies, which give three different answers to that question. In an "apple economy" output stays the same. In a "wheat economy" output falls with a lag. In a "haircut economy" output falls immediately.

There is nothing fancy here. It's just a simple point, that seems worth making, even if many people already understand it. And I've got a question: is the economy moving towards a haircut economy or an apple economy?

I'm going to talk about economies that produce only one good, but are nevertheless monetary exchange economies. You can't consume the good you have produced yourself, but have to sell it for money, and use the money to buy what someone else has produced. You can't cut your own hair. There are different varieties of apples and wheat. Or there's a tabu on consuming your own production. It's just a metaphor.

1. The "Apple Economy".

The only good produced is apples, on trees that were planted long ago, and will keep on producing apples every year, regardless of the demand for apples. It takes forever for old apple trees to die, and for new apples trees to produce fruit. And these apples don't need picking; they just fall into your lap. The apple growers own the trees and sell the ripe apples.

By assumption, a fall in the demand for newly-produced goods and services will have zero effect on the output of newly-produced goods and services. If quantity demanded falls below production, it will cause an equivalent decline in the quantity of apples bought-and-sold. The unsold apples will either be added involuntarily to inventory, and will count as involuntary investment; or they will rot on the ground, and will reduce net output by increasing the depreciation of the stock of inventories.

2. The "Wheat Economy".

The only good produced is wheat. Wheat is planted in the Fall (it's winter wheat) in expectation of future demand. All the work goes into planting the wheat; it's a new self-harvesting variety that makes its own way to the grain-store. The farmers plant the wheat and sell it at harvest.

A sudden unexpected fall in quantity demanded will not affect the current year's output of wheat. The unsold wheat will be added to inventories, or will rot. But it will affect this year's planting, and next year's output of wheat, if it changes farmers' expectations of next year's demand.

3. The "Haircut Economy".

The only good produced is haircuts. You don't produce a haircut before you sell it. You produce it at the very same time. Haircuts are produced to order. You can't produce 100 haircuts if only 80 customers come in wanting a haircut. If the quantity of haircuts demanded falls, the output of haircuts falls too, and does so instantly.

Actual investment equals actual saving in all three economies all the time. As it must. But the three economies are different. The output of apples takes forever to adjust to bring desired investment equal to desired saving. The output of wheat adjusts in one year. The output of haircuts adjusts instantly.

All three economies are, of course, ideal types. The real world is a mixture of all three, and a lot more complex, with different firms operating in different stages of the production process, so that goods-in-process (intermediate goods) must also be bought and sold.

But, is the real world moving slowly towards a haircut economy? Or is it moving the other way, towards an apple economy?

Comments

[JL]

Which part of the world? The haircut economy seems relative to post-industrial service based economies, but if much of the world still opperates through the material production of goods (and is establishing lasting infrastructures simillar to apple trees)another way of phrasing the question would be, what parts of the world are moving in what directions and how will they intersect?

[JKH]

To the degree that the current US calamity originated with housing, and is taking a long time to resolve itself, this seems to have been a surprisingly apple oriented event in the midst of economic developments otherwise.

[Too Much Fed]

JKH said: "To the degree that the current US calamity originated with housing, ..."

I'm of the opinion that there was a consumer debt bubble that kept manifesting itself as various asset bubbles. The housing bubble was just a symptom.

[Too Much Fed]

"I'm going to talk about economies that produce only one good, but are nevertheless monetary exchange economies. You can't consume the good you have produced yourself, but have to sell it for money, and use the money to buy what someone else has produced."

So what happens if the amount of medium of exchange falls?

[jesse]

Thanks for the interesting question, and please remember I am not an economist by training. So my question, if this is a parable for the current economy, is why has the demand dropped?

If it is that everyone now consumes less, in the case of apples, the price drops to almost nothing until the trees go into decay: this sounds more like modern-day milk production actually. But what if people consume less because they have no capital to buy, or save (i.e. not buy) because they are unsure about whether they can buy tomorrow?

Let's take the parable a bit further -- what would you do, if anything, to bring demand back up in your 3 situations?

[Martin]

The Apple Economy is weird. Either Say's law is violated and the original cause is not supply, but demand, or the central bank is intentionally pursuing a deflationary policy. The Apple economy is Japan (the ideal type)?

The Haircut economy seems to me a situation where people have decided to consume more leisure. Why else would there be less demand for haircuts? I am assuming that the cause is not monetary, considering that with instantaneous adjustment, output would keep on falling if the problem was monetary (Tobin wrote a paper on this in 1967?).

The Wheat economy sounds like Lucas 1972 an unanticipated monetary shock. If there was a supply shock there would be inflation and no inventories.

[Determinant]

I feel we're moving toward an apple economy for two different reasons. First, people and firms, including banks, do not want to write off a loss on bad assets if they don't have to and will curtail their spending in order to pull themselves out instead, or beg somebody else to relieve them of their assets (at full price, no defaults). The dead hand of bad debt, if you will.

Second, Mike Mandel's website brought this to my attention:

http://innovationandgrowth.wordpress.com/2010/02/22/why-isnt-the-innovation-economy-creating-more-jobs-part-i/

The US and by extension Canada, particularly Canadian manufacturing, may be suffering an investment/innovation failure. We invested, but it just hasn't paid off like we thought it would. The Human Genome project was not the panacea some thought it would be.

So if we can't expand consumption through advanced technical research and innovation and expanding basic consumption through home construction failed and decimated the banking sector and money supply as a nasty side effect, I don't know where exactly we're going to go from here.

I don't think industry really knows either. That seems to be a recipe for stagnation, which is an apple economy.

[oblivious]

IIRC, someone on WCI previously wrote a post suggesting that the current economic situation was different than many past recessions in that we're coming off a debt bubble rather than an equities bubble. I'm not sure the same patterns will occur so straightforwardly in that case.

Western governments refuse to address the issues right in front of us (debt, financial transparency and regulation) but at the same time refuse to spur demand or increase investment in education, infrastructure, or research. In this case I can only see a way out when change is imposed on us by developing economies. I see this as an "apple" economy, especially for Canada which will have to switch from developing resource infrastructure to improving worker productivity in manufacturing as China becomes a consumer economy.

[Nick Rowe]

JL: Good point. I expect I had Canada in mind, and economies like Canada (whatever that means, in this context). But with different mixes of industries, countries could be moving in different directions.

JKH: Hmmm. Are houses apples or haircuts? The house itself is very long-lived, like an apple tree. And once it's built, it doesn't cost a lot to harvest its services. But if the house is empty, because nobody is willing to pay rent for its services, it is not producing any output. I think houses are closer to haircuts, in that regard. Hmmm.

TMF: "So what happens if the amount of medium of exchange falls?"

Falls where? What does that mean?

jesse: this post is really about the consequences of a fall in demand, not the reasons why it fell. Some would say that demand fell because people wanted to save more for the future, or invest less. Others would say it's because they want to hold more money, rather than spend it.

Martin: see my answer to jesse above. In all 3 economies it's a fall in demand, not supply (so it's not an increased demand for leisure). People aren't feeling hungry right now (or feel they don't need a haircut right now) and want to save for the future. Or maybe people want to hold more money, and they way to get it is to buy fewer apples, wheat, or haircuts.

Determinant: again, the difference between the 3 economies is in how they respond to a fall in demand, not in what causes that fall in demand.

oblivious: Why is switching from a resource-based economy to manufacturing like switching towards an apple economy?

[Too Much Fed]

"TMF: "So what happens if the amount of medium of exchange falls?"

Falls where? What does that mean?"

REALLY????

What happens if the amount of medium of exchange goes down? For example, start with $1 million of medium of exchange, and then suddenly the amount of medium of exchange goes down to $900,000.

[Determinant]

How about an apple economy because people want to ignore it as much as possible and wish it away? Or is that a wheat economy that thinks it's an apple?

[Too Much Fed]

If demand stays low in all 3 economies, will supply eventually decrease and/or will supply not increase?

[jesse]

The only things I can think of that are akin to an apple economy are
- A dairy farm where you have a fixed amount of cows that produce a fixed amount of milk, and it's difficult to convince farmers to cull perfectly good cows. Governments have sometimes taken to buying excess milk then dumping it down the drain.
- A nuclear power plant, where once it's fired up it goes for a long time at effectively a fixed rate. A fall in electricity demand leads to blowing off the energy partly due to the rate structure. Jurisdictions like France handle this by selling excess power on the cheap to Switzerland who pump water into mountaintop reservoirs.

I think the apple economy is more an ideal; most things have enough entropy that they decay.

So to follow this through, in the case of the interesting case of near-perfect apples (i.e. apples that have a tiny bit of wheat in them), if demand suddenly drops, the clearing price goes to almost zero but producers may withhold stock in anticipation demand will eventually return. They may even book the apples as having a higher price than the spot price. The reason "why" demand has fallen is important because it goes to how the excess inventory is dealt with. The question is whether there is a method of clearing apples off the market faster.

This analogy is the US housing market. There is no good way of clearing houses (apples) any faster because supply of houses exceeded the fundamental demand for houses. Worse many people cannot afford houses. Clearing debt off the books will not allow these people to afford houses. Those with debts who are cleared cannot afford to buy houses either until their credit ratings are reconstituted. From what I see the best way of facilitating quicker price discovery is with jobs.

If we were in a haircut economy, price discovery would be instantaneous, I think (?). In that sense I think the "oh I get it now" moment would arrive very quickly, and from what I see the developed world is miles away from that point. For that reason alone I would say that people are treating capital like apples when much of it may actually be haircuts.

[K]

Isn't "apple tree" just "capital asset"? Hunter-gatherer societies had relatively little capital assets, now we have lots. So I'd guess we are tending towards more apples less haircuts. And I don't think it's about service vs manufacturing: service companies have lots of capital in the form of human networks. These networks persist and consume resources whether demand is there or not, and it matters little to anyone whether they are actually doing nothing or delivering services to nobody. Just like it doesn't matter whether unwanted apples are grown and rotting on the ground or the excess apple trees are never fertilized. The problem is that the productive capital is there, must be maintained, and the marginal cost of service delivery may be quite low.

[rsj]

Hmm, I'm having difficulty posting to this thread.

I would say that we are becoming more and more of an apple tree economy, but simultaneously we are chopping the trees down and sending the wood overseas.

[Jon]

Nick, marins interesting point which you swept passed is that your haircut economy and your wheat economy are not single good economies. Leisure is a good.

No one does any work in your apple economy so no leisure at all there.

[himaginary]

In an apple economy, price must fall steeper than in a haircut economy, because adjustment by quantity is absent. Therefore, NGDP decrease relative to RGDP decrease in recession should be larger in an apple economy than in a haircut economy. But GDP(RGDP/NGDP) number is rather stable in an apple economy compared to that in a haircut economy, because it counts inventory and depreciation in.
In sum, a depressed apple economy would experience deflation, bad NGDP numbers compared to RGDP, but GDP itself (and perhaps unemployment) is not so bad as one might expect from the situation. Well, it does sound like Japanese economy.

As for depreciation-to-GDP ratio in Japan, I happened to comment about it in Cowen's post, and drew a graph here (discontinuity is due to revision in GDP statistics). Until the 80's it remained within 10-15% range, which is roughly similar to the US numbers in the fourth graph of rsj's post. But it took off in the 90's, and exceeded 20% around 2000.

[Greg]

Services are increasing as a proportion of product. Direction: haircut.

Transport, communication and computation costs and latencies are falling; these declines would tend to drive the non-service part of the economy towards make-to-order, in order to reduce working capital (inventory) costs. And that seems to be what's happening.

These cost and latency declines also allow service to order: two airlines can share one plane, if they each have half a plane's worth of customers, or run their own, if they both have full manifests. Two schools can share a Classics teacher. Etc.

We are mostly past the wheat stage of inventory-determined batch production, I think. Direction: haircut.

Obviously that is far too naive for you, Nick.

[Martin]

"Martin: see my answer to jesse above. In all 3 economies it's a fall in demand, not supply (so it's not an increased demand for leisure). People aren't feeling hungry right now (or feel they don't need a haircut right now) and want to save for the future. Or maybe people want to hold more money, and they way to get it is to buy fewer apples, wheat, or haircuts."

Okay fair enough, but then you're basically asking what do you think the stance of the monetary authority is combined with what kind of economy we live in.

The haircut economy is impossible, because if we'd be in a haircut economy and the problem would be demand, then that would be basically the end of story. The only question therefore that remains is, are we in a wheat economy moving to an apple economy or are we staying a wheat economy. In other words, is the world becoming Japan (the ideal type), or is the world not becoming Japan and is this a garden variety recession?

[Martin]

Either you have barter and Say's law of markets holds, or you have a monetary exchange economy and Say's law can be violated. And the specific violation of Say's law is then consistent with a specific stance of the monetary authority.

I think you could try for a cashless economy with the 'monetary authority' determining the nominal interest rate and some unobserved natural rate, but I am not too sure whether the composition of output is relevant then. Then again you'd be more talking about the stickiness of prices, instead of the composition of output.

[JL]

K : "And I don't think it's about service vs manufacturing: service companies have lots of capital in the form of human networks. These networks persist and consume resources whether demand is there or not, and it matters little to anyone whether they are actually doing nothing or delivering services to nobody."

But those networks have a cost no? What if the firm downsizes in response to the drop in demmand would we be talking wheat?

Also barber shops have capital assets, but in Nick's puzzle they only produce in ressponse to demmand. Some services like information recquire a product then they may behave like apples or wheat, but if production and consumption are immidiate like in many service industries then we are closer to haircuts.

What about the labor market? Is the potential work of the unenployed like apples on the ground or are they more like potential haircuts?

[Nick Rowe]

TMF: I totally misread you. Yes, if the supply of money falls, that might be one possible cause of a fall in output demanded.

Again though, different economists have different theories of what might cause a fall in aggregate output demanded, and this post is not about what causes that fall. It is about the consequences of that fall.

jesse: "I think the apple economy is more an ideal; most things have enough entropy that they decay."

Yep, it's an ideal.

Prices might be sticky, and that's what prevents a fall in prices from increasing output demanded. Or maybe the AD curve is vertical. Again, those are the standard sort of things macroeconomists argue about. I'm off on a different direction here.

K: "What about the labor market? Is the potential work of the unenployed like apples on the ground or are they more like potential haircuts?"

You were leading up to this point in both your comments. I think it's a very good one.

A house that is empty, a hairdresser waiting in the salon for a customer, a hairdresser waiting at home for a call from the salon when they have a customer, apples that never get eaten. what's the difference? If we produce it, but it never gets consumed, does it really count as production? (Why do I keep thinking of the tree falling in the forest?)

I expect there are two questions:

1. Given the way we (StatsCanada) collect statistics, will it be counted as output?
2. Ought we economists count it as output?

In the wheat economy, for example, if Qd drops by 10 tons, so there's 10 tons stored in inventory, farmers might plant 20 tons less for the next year. In what year should we count the wheat as having been produced. In the year it is harvested, or in the year it is eaten? What if, like the apples, it never gets eaten?

Ultimately, the problem here is the same as the problem with all investment. We produce an investment good. (An addition to inventories of apples and wheat is an example). But we would need to know the future to know if that investment good will create future consumption or not.

[Nick Rowe]

Jon: "Nick, marins interesting point which you swept passed is that your haircut economy and your wheat economy are not single good economies. Leisure is a good."

Yes, leisure is a good. But if an increased demand for leisure were behind the drop in demand for haircuts, there would also be an equivalent drop in the supply of haircuts. I expect I was imagining a case where there was no increased demand for leisure, but rather an increased demand for money, or saving for future consumption (take your pick, depending on your theory of AD), so the supply of haircuts stays the same when demand falls.

himaginary: why shouldn't the AS curve be vertical in all 3 economies? If apples/wheat/haircuts is the only good produced, why should a fall in the price of apples/wheat/haircuts in terms of money affect the quantity people would like to sell?

Greg: "Obviously that is far too naive for you, Nick."

Not at all. My question is equally naive.

Martin: "The haircut economy is impossible, because if we'd be in a haircut economy and the problem would be demand, then that would be basically the end of story."

You lost me there. Maybe the monetary and/or fiscal authorities could increase demand again. I want to stay silent on that question, in this post.

I think my question only makes sense in some sort of monetary exchange economy (otherwise Say's Law would hold). And I think it requires both sticky prices and a screw up of monetary policy. Others may disagree. But if AD does fall, for whatever reason, and P, or r, or whatever, does not adjust, what happens to Y? And does it depend on whether we produce apples, wheat, or haircuts?

[himaginary]

Nick:"If apples/wheat/haircuts is the only good produced, why should a fall in the price of apples/wheat/haircuts in terms of money affect the quantity people would like to sell?"

I wasn't thinking of price effect on quantity supplied. Rather, I was thinking of price effect on quantity demanded. There are two ways sellers can make supply equal demand: change price or change quantity. That is, when sellers face demand drop, they would either cut price or cut production (or mix of both). In an apple economy, they can't change production, so cutting price is the only way. In a haircut economy, they can always cut production in accordance to demand, so they won't need to cut price. It's something like Bertrand competition world versus Cournot competition world.

[Martin]

"I think my question only makes sense in some sort of monetary exchange economy (otherwise Say's Law would hold). And I think it requires both sticky prices and a screw up of monetary policy. Others may disagree. But if AD does fall, for whatever reason, and P, or r, or whatever, does not adjust, what happens to Y? And does it depend on whether we produce apples, wheat, or haircuts?"

Well the problem is that the answers depends crucially on the assumptions you make.

For example, the fall in AD, is that equal regardless the output, or is the fall in AD dependent on the composition of output and is it the 'shock' that is the same in all situations? If your model is that sticky prices icw a monetary shock cause recessions, then the fall in AD, depends on the shock icw the composition of output: different output, different stickiness.

[Too Much Fed]

Nick's post said: "Again though, different economists have different theories of what might cause a fall in aggregate output demanded, and this post is not about what causes that fall. It is about the consequences of that fall."

If demand stays low in all 3 economies, will supply eventually decrease and/or will supply not increase? That means real GDP stagnates or goes down.