Today I want to talk about Paul Krugman’s thought experiment of the hot-dog-and-bun economy in The Accidental Theorist (1998, p.18-23). When I first read his essay I didn’t realise how elaborated it actually is. That’s why I went back to it and plotted his example as today’s exercise.
Krugman’s hypothetical economy only produces hot dogs and buns with a labour force of 120 million workers. Each worker is able to either produce 0.5 buns or 0.5 hot dogs per day and he assumes that hot dogs and buns are consumed together. So it is desirable to have 60 million workers in the hot dog industry and 60 million workers in the bun industry. The diagram above depicts the economy’s initial Production Possibilities Frontier (PPF) and its current production levels which can easily be calculated:
60 million workers * 0.5 buns per worker per day = 30 million buns per day
60 million workers * 0.5 hot dogs per worker per day = 30 million hot dogs per day
Krugman then introduces a productivity increase only in the hot dog industry. Now each hot dog worker can produce exactly 1 hot dog per day. This pivots the PPF to PPF’. Recall that we still have the constraint to produce as many buns as hot dogs because we sell them together. So the new production level must be proportionally bigger to the initial level. (Imagine a line through the origin and your initial production level. Now continue on it until it crosses the new PPF’. You will end up at (40, 40) without any maths!) The main point here is that this new production level can only be reached through the reallocation of labour from the hot dog industry to the bun industry. In particular, we need the following distribution:
80 million workers * 0.5 buns per worker per day = 40 million buns per day
40 million workers * 1 hot dogs per worker per day = 40 million hot dogs per day
What happens to employment? Employment in the hot dog industry falls by one third whereas employment in the buns industry increases by one third. So the changes within each industry cancel out for the economy as a whole. Total employment remains at a constant level in the economy and there is only a reallocation of labour. In comparison, total output increases in both industries by exactly one third. As far as I understand, the output increase in the hot dogs industry is driven by the productivity increase. The output increase in the buns industry is driven by the labour influx.
To sum up, let’s look at the context of the example. Krugman published this thought experiment in reaction to William Greider’s book One World, Ready or Not: The Manic Logic of Global Capitalism in which Greider links productivity growth to job losses. However, he is misled by the fallacy of composition, because “the logic of the economy as a whole is not the same as the logic of a single market” (Krugman, 1998, p.22). Krugman nicely uncovers Greider’s faulty line of arguments in this thought experiment by showing that productivity growth in one industry (hot dogs) might well reduce employment in this one sector but total employment in the economy will not be reduced. Other sectors will soak up the freed-up labour. Think about this for a minute, what Krugman argues here is that one cannot make a conclusion about total employment in the economy by just looking at one industry.
In the second part of his essay, Krugman applies his hypothetical example to the manufacturing and services industry in the US from 1970 to 1997. He argues that – in a similar fashion – manufacturing output doubled driven by productivity growth while employment declined somewhat. Services output also doubled but driven by employment growth with stagnant productivity. Krugman shows that it would be plainly wrong to argue that productivity growth in manufacturing has caused job losses in the US economy as a whole. What is more, it actually created jobs in the services sector.
The final argument in the essay concerns the link between an increase in production and an increase in income and consumption. As an economy’s total production expands, total income will go up. In normal times people will then also consume more (the propensity to consume doesn’t change). However, Krugman admits that this natural relationship between income and consumption may break down during a recession. As far as I understand, this would be caused by cash hoarding in the Keynesian framework of money demand. Keynes argues that the demand for holding money comes from:
- The Transactions motive
- The Precautionary motive
- And the speculative motive.
The first and second motive (M1) depend on a person’s income Y, whereas the third (M2) depends on the interest rate:
Md = M1 + M2 = L1 (Y) + L2 (r) = L (Y,r)
In a recession people allocate their income somewhat differently. They want to hold more cash for precautionary motives but in order to hoard extra cash people cut down on consumption and investment. This will cause a shortfall in aggregate demand. As aggregate demand falls spare capacity may become an issue. Krugman’s main point is here that an increase in the money supply will be the cure without causing inflation. Inflation will not be triggered because – due to excess capacity – money supply will not be growing faster than real output (Pettinger, 2011). This can be summarised by the diagram below:
Printing money will ease the liquidity contraction caused by cash hoarding and will serve as a stimulus for consumption and investment. This will bring the economy back onto its PPF. Hence, recessions come from a shortfall in aggregate demand and not excess capacity caused by productivity growth. In short: Productivity growth is desirable and will not cause unemployment.
Thanks for reading!
Greider, W. (1998). One World Ready or Not: The Manic Logic of Global Capitalism. New York, N.Y.: Touchstone.
Krugman, P. (1998). The Accidential Theorist: And other Dispatches from the Dismal Science. New York, N.Y.: W.W. Norton & Company.
Pettinger, T. (2011). The link between Money Supply and Inflation. [online] Available at: http://www.economicshelp.org/blog/111/inflation/money-supply-inflation/ [Accessed 04/04/2016].