The New Paradigm - Federal Reserve Bank of Dallas

18
Exhibit 12
Mind Your Ps and Qs
The concepts of price level (P) and aggregate quantity (Q) are highly
dubious. Nonetheless, statisticians persist in creating these two
measures, which are scrutinized out to their third digit. Perhaps the
biggest loss of usefulness from aggregating output is caused by
combining industries whose returns to scale are increasing with
those whose returns are decreasing. The effect of an increase in
demand on prices depends on whether raising output drives average
costs up or down. Average costs usually rise in industries with
mostly variable production costs. The industries that dominated
P S
yesterday’s material world (such as agriculture, mining, construction
and heavy manufacturing) and much of the less-skilled services
economy (household, personal, repair and cleaning services, for
example) are in this category. But for many other, often newer, sectors
of the economy (such as computer hardware and software,
communications and pharmaceuticals), average costs often decline
as output expands because high fixed costs are spread over a large
number of buyers. To the extent that economic expansion comes in
industries of the latter type, GDP can grow without the inflationary
consequences often feared.
P S
D 1 D 2
D 1 D 2
P 2
P 1
Q 1 Q 2 Q
P 1
P 2
Q 1 Q 2 Q
up prices for scarce inputs. Production costs for additional
units rise, slowly at first but then more rapidly.
The bottom line: as Industrial Age companies expanded
operations, they had little choice but to raise prices to
cover higher costs. In an economy dominated by risingcost
industries, additional demand can ignite inflation. It’s
this view of basic costs, accurate for an industrial economy,
that led analysts to conclude that rapid growth can
threaten price stability.
The Information Age gave birth to companies and
industries with a decidedly different cost structure. Their
output exhibits increasing returns to scale over a wide
range of products. Instead of rising with additional output,
average costs continue to slope downward. (See Exhibit
12.) Goods and services become cheaper to produce as
the size of the market increases. This gives companies a
powerful incentive for aggressive pricing, including quantity
discounts.
Information Age enterprises need more customers to
recoup their investment in new-product development.
Today, bigger is often better, which helps explain the surge
in mergers and acquisitions in the 1990s. Companies combine
to capture the advantages that come from downward
sloping long-run average cost curves. (See Exhibit 13.)
What frees today’s technology from the old model of
increasing costs? It’s partly changes in the nature of what
we produce. Yesterday’s goods and services had a “rivalry”
in consumption, in which one person’s purchase barred
anyone else’s. In the New Economy, more companies
make products—such as information and entertainment—
that don’t disappear or even degrade with use. They can
satisfy many consumers at the same time, so additional
demand doesn’t lead to shortages.
Moreover, many New Economy businesses connect
people. It’s expensive to link one or two users in a network,
but it’s far less costly to add customers once the delivery
1999 ANNUAL REPORT Federal Reserve Bank of Dallas