The capacity of an economy, Classical versus Keynesians

 One of the differences between the Classical and Keynesian models in economics is an assumption about how the economy operates.  Classical economists believe that the economy is operating at capacity, while Keynesian economists believe that the economy never reaches capacity in the short run (and we are always living in the short run). 

But what does "capacity" really mean, this post will briefly go over the economics of capacity by looking at this question:



Policy makers talk about the capacity of the economy to grow. What specifically is meant by the “capacity” of the economy? In what ways is capacity limited by labor constraints and by capital constraints? What are the consequences if demand in the economy exceeds capacity? What signs would you look for?

Because textbooks and teachers seem to approach this idea from several different points of view, I am going to give my opinion of one of many possible answers to this economic question.

First, what is the capacity of an economy?  Traditionally, this comes from the production function, and is made up of three terms: labor, capital, and technology.  The equation typically looks like this:

Y = A*K^a*L^b or something similar.

This production function assumes that we are producing at capacity because K (capital) assumes that all capital is being used.  In a Keynesian short run model, the term used in the production function could be some other value that is less than K, for example: J such that J<K.  This production function also assumes that everyone in the labor force is contributing to production, but if there is unemployment, than the true contribution to production would be some value less than the whole labor force.  For example: M such that M<L.  This would give us the following production function assuming that we producing at some level below capacity:

I = A*J^a*M^b where I is our actual production and I<Y

Second, capacity is limited by both labor and capital, because only so much of each input exists in the short run.  For example, people can only work 24 hours a day in the short run, but if we care about long term health and well being, this is significantly shorter.  Also, we only have so many machines and factories in the economy, and if they are being used 24 hours a day, they cannot be possibly used anymore intensively.

Third, what are the consequences of demand exceeding supply?  If our economy is at capacity, then prices must rise, this will cause consumers to be able to consume less goods and services until demand is equal to supply.  However, if capacity were to grow over time, supply could increase to accommodate this demand.

Finally, what indicators could you look for?  I would look for low unemployment rates, high intensity use of capital (ie. factories going 24 hours a day), and very old and young people joining the labor force.  These would all be indicators that the economy is operating at near capacity.