Posted May 16, 2008on:
Dr Cullen has told businesses to increase productivity. Although this sounds utterly ridiculous, given that businesses will make all profitable investment they can in order to make their output at a lower cost (unless you believe there is a conspiracy to keep wages low 🙂 ) there could possibly be some method to his madness.
Treasury has been working hard on the productivity issue this year, but it is a difficult issue. If we could costlessly increase our productivity then we would have no trade-offs, as output could become un-limited. As a result, the trade-off they have been interested in is the trade-off between current investment in productivity and the future benefits. To make matters even more difficult, the factors lying behind productivity remain somewhat of a black box – a subject where an individuals industry expertise trumps the musings of a whole team of economists.
Given that information regarding productivity is implicitly tied up in businesses and given that the choice of investment in infrastructure and R&D are often subject to positive spillovers, Dr Cullen’s strategy of Jawboning may be ingenious.
Jawboning is a low cost way of trying to convince people to do what you want. In many ways its similar to guilt tripping – or possibly to giving warning about a credible threat. If the Finance Ministers skills are good enough this Jawboning may lead to a greater amount of “investment” now. However, for this to truly influence the future capital stock we need to know that investment won’t just fall back once Dr Cullen’s rant has finished. In other words there needs to be some factor that will hold up firm’s investment intentions.
One way to justify this is through “positive spillover effects”. When we have positive spillover effects, we know that the optimal choice of investment and the capital stock will depend on both the firms direct payoff from doing so and the level of investment by other firms. In a simple symmetric case we can look at the following diagram to get an idea of whats going on:
The red line is the firms “reaction function” – which determines what level of investment they will choose given industry investment. The blue line is a 45 degree line that represents the case when all the firms have settled down to the equilibrium level of investment. In this case we have a linear positive spillover effect, and there is no multiple equilibrium. Infact, the only equilibrium is where the “reaction function” crosses this 45 degree line.
As a result, Jawboning in this case is pointless (unless we believe there are true “social benefits” from this investment.
And so the point is?
However, say that the spillover was not linear:
Source: Resilience Science (link)
Taking the above graph on poverty traps (as I’m no good at drawing fancy graphs 🙂 )lets pretend that well-being at time t+1 is a firm choice of investment, and well-being at time t is the average industry choice. In this case there is positive spillovers all along the range of the choice variable – but the spillover is non-linear. In fact, there is a tipping point in the middle of the graph where the positive spillovers become so strong that a slight increase in the total level of investment will give an individual firm a large incentive to invest further.
In terms of capital investment we could think of this as a point where there is a discontinuous switch from labour intensive to capital intensive production methods.
Now in the above graph there are four equilibrium – each of these are points where the “reaction function” crosses the 45 degree line. The four eqm are : A death equilibrium where capital investment is zero (which is unstable 🙂 ), two stable equilibrium – a low investment and a high investment one, and an unstable equilibrium.
An unstable eqm is one where any little shock will make us fly away from it too one of the others. If Dr Cullen believed we were at this unstable eqm, then a little bit of a shock from his jawboning could have a big impact.
Furthermore, if Dr Cullen believes that he is especially persuasive, then if we are at the low equilibrium a shock from him talking may be sufficient to push us up to the high equilibrium.
Do you believe it?
Ultimately, I don’t believe that this is the reason for his jawboning. When we are told that the government has done everything it can for productivity we have to take their words with a significant grain of salt (although I do believe that apprenticeship schemes and the such are a great idea for improving productivity – really this deserves its own post). Blaming industry for low productivity seems like blaming a murder victim for the crime, just so you don’t have to figure it out!