Fall in Capacity Utilization reflects the Effective Demand Limit

The Effective Demand limit upon the economy is not a very visible concept in the econo-blogosphere. Yet, it represents a limit upon the utilization of labor and capital toward the end of a business cycle. When real GDP reaches its effective demand limit, normally we would see capacity utilization peak and start to fall.

Capacity utilization has now fallen for 5 months straight with the new data released today.

So does this continued fall in capacity utilization reflect the effective demand limit? From my own measure using profit-maximization estimations... yes.

Here is a graph which plots employment (1 - unemployment rate) with capacity utilization.

The graph shows the path to increasing profits in the economy. Profits increase as the data approach the effective demand limit and the profit max lines. Employing more capital and labor increases profits. When the limit lines are reached, then profits increase by rising up and to the left on the profit max line where capacity utilization falls while employment rises.

Profit potential is measured by this equation...

Profit potential = (U + C) - a*(U² * C²)

U = (1 - unemployment rate)
C = Capacity utilization
a = effective demand limit - 2.472 * effective demand limit + 2....... (I have been estimating the current effective demand limit around 75%.)

Back in December 2014 I wrote  (link) that the data in the plot above had reached the effective demand limit and that I would be watching to see if capacity utilization started to fall. Well, capacity utilization has fallen every month since. I explain the fall by the graph above.

The graph implies that the economy has reached my estimated effective demand limit and is now reducing capacity utilization to push profits higher. However, pushing profits up by reducing capacity utilization, as looks to be happening, is a delicate situation. The economy develops some instability and creative measures have to be taken to keep the economy out of a recession. It is also a time that bubbles can more easily form.

 

For more information...

Reaching the limits of the Profit Rate... The Nitty Gritty of Effective Demand, December 2014.

Comments

[Alan]

Hi Edward,

So does this development adjust your thinking on pending recession? Or do you still think more likely that effective demand will rise again before beginning to contract heading into 2016?

I keep in mind that equity market risk tends rise dramatically 4-6 months before a recession actually starts. That said, this one could be a bit different on that front. With rates so low, buybacks continuing, we may need to see the whites of the eyes before market acknowledges!

Thank you, Edward, getting caught up on last few posts now!

Best,

Alan

[Edward Lambert]

Hi Alan,
I still see the possibility of recession opening up more toward the end of 2015 going into 2016.
I do not think effective demand will rise again going forward into 2015. Headline inflation stopped its fall with oil prices rising.
The economic situation is developing some instability.