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 normal output-to-capital 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.
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