A Notion of Demand-Led Growth

A key purpose of demand-led growth theory is to extend the ‘principle of effective demand’ to contexts in which productive capacity is best considered variable rather than fixed. The central idea is that, over any time frame, it is demand that determines output, and demand-led variations in income that adjust planned leakages to planned injections. Once it is acknowledged that capacity is variable, it becomes clear that the adjustment of output to demand, and planned leakages to planned injections, can be achieved not only by utilizing existing capacity more fully, but by expanding capacity through investment.

For the principle of effective demand to make sense, it is necessary: (i) that the economy is operating within the limits of its productive capacity (defined by the plant and equipment that can currently be brought into use); and (ii) that there is sufficient availability of labor-power and natural resources for production to be expanded in response to rising demand. If either of these conditions were violated, the economy would be supply (rather than demand) constrained. The Keynesian or Kaleckian view is that normally the economy is operating inside the ultimate supply limit to a degree that is determined by demand. The economy is therefore regarded as demand constrained under normal circumstances.

The demand-led growth process can be regarded as proceeding largely independently of the price level. In the context of a variable productive capacity, it is conceivable (though not inevitable) that output and capacity could respond to rising demand without creating excessive pressure on prices from the demand side. This would not mean a constant price level. It would simply mean that changes in the price level would mostly be the result of factors operating on the supply side, through changes in financing and production costs and the aggregate markup over money wages.

Such a scenario is at least plausible because of a characteristic feature of capitalist economies that is especially evident in the manufacturing and services sectors; namely, firms typically operate with planned margins of spare capacity. In the US, for instance, average rates of capacity utilization have varied from a low of 67 percent to a high of almost 90 percent since 1967, when measurements began. This behavior is not out of the ordinary. Across industrialized economies, average utilization rates of somewhere between 80 and 85 percent seem typical. A strategic factor driving this behavior would appear to be a competitive imperative to meet intermittent peaks in demand through an expansion of output. A firm’s failure to do so, due to insufficient capacity, could see it lose market share to competitors.

There also appear to be technical factors at work, basically of an engineering nature. Much plant is such that, inside physical capacity limits, average variable cost (relating to wages and materials) can remain approximately constant when output is varied. If anything. falling average variable costs seem more likely than rising average variable costs in many contexts, because of the common practice of “hoarding” workers in downturns and delaying the hiring of new workers in the early stages of recovery. This results in pro-cyclical variations in productivity. On the other hand, the prices of raw materials are more sensitive to demand than other prices, and could rise with output.

In general, nothing very precise can be said about the relationship between costs and output. Some demand-led growth theorists, rather than making a simplifying assumption about the behavior of costs, prefer instead to treat price determination as analytically separable from output determination and growth. Others suggest that the most appropriate simplifying assumption is a constancy in average variable costs over the relevant range of capacity utilization. This assumption implies that any firm with fixed costs will face falling unit costs (falling average costs) as output expands. Under either approach to pricing, normal pricing can be regarded as reflecting the cost associated with meeting the average level of expected demand. This average level of demand will correspond to an expected average rate of capacity utilization.

Within fairly wide limits, firms in the manufacturing and services sectors will adjust output to demand without necessarily altering cost-determined prices. Even where firms do alter prices as well as output in response to demand, these price effects are likely to be short-lived. Over a longer time frame, either the alteration in demand will prove to be a temporary fluctuation, in which case its effects will reverse, or the change in demand will turn out to be persistent. If the change in demand is persistent, it will call for an alteration in productive capacity and so have implications for the rate of investment. Once the additional capacity comes on line, the price pressures will dissipate.

In other words, a sustained growth in demand that pushes the economy toward full capacity is likely to induce capacity-enhancing investment. Increasingly, firms will find that they are mostly operating beyond their intended average or ‘normal’ rates of utilization. This is also likely to manifest as a higher realized rate of profit (because, for given distribution of income and capital-to-output ratio, the actual rate of profit and utilization rate move together). If the growth in total demand persists for some time, it becomes increasingly profitable for firms to install additional plant and equipment.

If it were not for the presence of spare capacity and the possibility of adding to capacity over time, the acceleration in investment would cause demand to outstrip supply limits. Whereas the impact of investment on demand is immediate, its capacity effects only register with a delay. It takes time to construct new plant and equipment. But because the economy normally operates with spare capacity, the demand effects of stronger investment can usually be accommodated through variations in output without an emergence of excessive demand-side inflationary pressures.

It should be kept in mind, though, that this argument relates to the average rate of utilization for the economy as a whole. There can be bottlenecks due to some sectors hitting full capacity before others. If so, in reality there are likely to be some price effects mixed with the output effects before capacity has had time to adjust.

The continual, gradual process in which firms attempt to adapt capacity to demand is carried out partly through the expansion or contraction of existing industries, including by entry or exit of firms, as well as through the emergence of new industries and the disappearance of declining ones. At a disaggregated level, there will be fledgling industries with capacity temporarily far below expected demand and declining industries with lots of unwanted capacity.

In this conception of growth, there needs to be a source of demand that is independent of endogenous, capacity-enhancing investment so as to induce that investment. In the approach considered here, the key role is played by components of autonomous demand that do not directly add to private-sector productive capacity. Government spending, autonomous private consumption expenditure and, for open economies, exports are the main examples of this kind of demand. The significance of this demand is that it promotes fuller capacity utilization. It calls for expansion of output without directly adding to private-sector capacity. Persistent growth of this demand tends to push the economy towards fuller rates of utilization and so encourages investment in additional capacity.

 
Related Posts

A comparison between the Keynesian or Kaleckian view that the economy is normally demand constrained with the opposing view is provided in:

Institutions, Monetary Operations and a Demand-Led Global Economy

Demand-led growth is considered in a bit more depth in:

The Role of Government Spending in Fostering Global Growth

Demand-Led Growth With Cycles – A Simple Model and Illustration

Demand-Led Growth – Government Spending and the Investment Share

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7 thoughts on “A Notion of Demand-Led Growth

  1. Nice piece

    “It would simply mean that changes in the price level would mostly be the result of factors operating on the supply side, through changes in financing and production costs ”

    I’ve been thinking about this quite a bit, and looking at the actual mechanism by which that comes about. As far as I can tell it can only come about if you accidentally end up with a monopoly. For prices to rise, somebody has to offer a price and somebody else has to decide to take it rather than going for the cheaper alternative. If prices rise then whoever is supplying that is suffering from a lack of competition. The problem is price setting power.

    The current economy tries to work by preventing a monopoly arising in the labour market. There must always be somebody else that can be hired, and those needing to be hired must be willing to sell at whatever price is on offer. So the labour market is co-erced into becoming entirely a demand led price taking structure by forced unemployment and threats of starvation.

    What we need is for that squeeze to move to the capitalist and interest earning layers. They should be the price takers – with a supplier of last resort in place if necessary. Only if they are forced to compete will we get the investment and innovation required to push productivity forward. Otherwise it is largely free money.

    And where capitalist structures cannot operate with those constraints, where capitalism is unable to use investment and innovation to push forward productivity, the service ought to be returned to worker or public control. There’s little point in profit if it cannot improve things.

  2. Yes, agreed, Neil. Well put. So long as goods are reproducible and there is competitive pressure, firms can be expected to adjust output to demand at more or less stable prices.

    In the case of bottlenecks appearing before full (average, economy-wide) capacity is reached, the “reproducible” aspect breaks down for some raw materials or kinds of labor, in which case there can be some temporary price effects even though competition may prevail.

    Even so, provided, over time, it is possible to open up the bottlenecks by expanding the supply of temporarily scarce inputs or kinds of labor (i.e. provided these are reproducible), the price pressures associated with bottlenecks can gradually be resolved.

    When it is a matter of dwindling non-replenishable natural resources, it becomes necessary to adapt production to the changing reality (which again can take time).

  3. The problem in the US is that finance capital has replaced industrial (productive) capital as the driver. Now large firms are driven by Wall Street “expectations” (demands) about stock price.

    The requisite profit rate is unreasonable for a competitive economy, so various forms of manipulation need to be applied, like “controlling costs,” industry consolidation (increase of monopoly power), stock buybacks, and so forth.

    The role of corporate profit has become distorted by Wall Street, at least in the US.

    The rationalization is that if all firms are maximizers of stock price, then the economy will maximize potential additively, which is a fallacy of composition. It’s also “short-termism,” which is not going to cut in competition with long-termers like China. The US has exported a lot of its industrial capacity, technology, and employment to China for short-term gain, which has been of enormous benefit to China over the past several decades.

    Now Trump is rumored to be preparing to charge China with conducting economic warfare against the US on Monday.

  4. Pete,

    Just a quick off-topic comment to wish you a Happy New Year and to recommend a terrific article I found these days.

    That article deals with Thomas Piketty’s work. I don’t know what’s your position viz a viz Piketty, but even if you don’t like his work or are particularly interested in it, the article is excellent because it deals with the subject of distribution and empirical research related to income distribution and inequality.

    Let me just say that as a Marxist I found it very intriguing and suggestive.

    It’s not an easy read and I’m sure it’s well above the pay grade of the average blogger, so it makes little sense asking them to read it. To make things worse, the author linked a whole lot of research papers.

    Without further ado:

    Marshall Steinbaum. May 12, 2017. Why Are Economists Giving Piketty the Cold Shoulder?
    http://bostonreview.net/class-inequality/marshall-steinbaum-why-are-economists-giving-piketty-cold-shoulder

    Enjoy!

  5. Thanks, Magpie. Appreciate it. I’ll check out the article.

    Happy New Year to you too, and to anyone else reading.

    Cheers.

  6. Best wishes for 2018 to you Peter!

    Prem decided to make the last 51 years available to anyone, beginning with a new app

    Without peace, no one would have had any time at all for economic activity. With peace came prosperity and dignity, and a chance to listen to the self.

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