TCS Daily

The Elastic Economy

By Arnold Kling - April 16, 2003 12:00 AM

"For years I thought what was good for our country was good for General Motors and vice versa. The difference did not exist. Our company is too big. It goes with the welfare of the country."
- Charlie Wilson, 1953

In the fifty years since "Engine Charlie" made those remarks at a Senate hearing, The United States economy has become more diverse and more robust. We are better able to withstand shocks, minimize concentration of economic power, and sustain growth without being hampered by resource constraints. This can be summarized by saying that the economy has become more elastic.

In the ordinary use of the term, "elastic" means able to stretch. When we describe something as elastic, we mean that it can be bent, twisted, or expanded without breaking.

In economics, "elastic" has a technical meaning. It measures the power of substitution, as consumers and producers respond to changes in prices by changing the quantities demanded and supplied. The greater the response of quantity to a given price change, the greater the elasticity. If a small increase in the price of Coke causes a large shift by consumers toward other soft drinks, then that is high elasticity. If a small increase in the price of cigarettes causes only a small decline in smoking, then that is low elasticity.

Consumer choice is not the only source of elasticity in the economy. Producers provide elasticity by varying the methods and inputs used in production, as well as by introducing new products.

The ordinary definition of elasticity and the technical economic definition are closely related when we talk about an economy as a whole. For the economy as a whole, the more that quantities can adjust in response to prices, the more likely it is that the economy will "bend" rather than "break" when it is stressed. For example, a disruption in oil supplies will be handled more easily by an elastic economy than by an inelastic economy.

Causes of a More Elastic Economy

There are several factors that have caused the economy to become more elastic. They include product diversity, globalization, the Internet, and increased innovation.

Increased diversity of goods and services increases the elasticity of the economy by providing consumers with more ways to satisfy their wants. For example, fifty years ago telecommunications services consisted of telephones and telegrams. Today, those services include cellular phones, faxes, and emails. If the price of one service increases, people can shift to using other services.

Fifty years ago, people generally either prepared meals using time-consuming methods at home or dined at expensive restaurants. Those options are still available. In addition, today's substitutes include convenience foods, microwave cooking, and a variety of fast food and moderately priced restaurants.

Globalization has made the economy more elastic in a number of ways. It has contributed to the diversity of products and services available. It has provided opportunities for American firms to manufacture products abroad, substituting foreign labor for domestic labor. It has enabled the U.S. economy to rely on imports for some products, allowing resources to shift into other products and services.

The Internet has also made the economy more elastic in a number of ways. It has enabled consumers to be better informed of the characteristics and prices of products, so that they can substitute more intelligently. It facilitates international trade in services, so that U.S. companies may obtain computer programming services, clerical transcription, and other services in India or Eastern Europe.

Finally, the increased pace of innovation makes the economy more elastic. Inventory management, energy production and distribution, and other basic economic activities can now be addressed by methods that were not available twenty years ago.

One way to describe the elastic economy is that it has become more complex. Human wants continue to be relatively simple and basic. The fundamental resources, such as land and labor, are the same. However, there has been an explosion in the variety of ways of converting the fundamental resources into products and services that satisfy basic human wants. There are a large number of paths leading from resources to satisfaction, and just as with the Internet, a variety of paths diminishes the dependence on any one path, making the system as a whole more robust.

Consequences of a More Elastic Economy

With a more elastic economy, the markets for goods, labor, and resources look very different than they did fifty years ago. This has implications for the role of government policy and regulation.

With an elastic economy, the importance of any one product or any one company is reduced. No one product is as important to the economy as was the automobile fifty years ago. No single company today is as important to the economy as General Motors was in 1953. I would argue that even Microsoft's role in computing is less significant than was General Motors' role in transportation. Microsoft has an overwhelming share of computer software used for office work. However, they have never been the dominant company in other uses of computing, such as servers, games, communication switches, and - more recently - personal digital assistants and cell phones.

With an elastic economy, labor competition is worldwide. One of the most important phenomena of this decade is likely to be the movement of service industry jobs offshore. As Zimran Ahmed pointed out, "most people thought globalization had improved their lives but also thought it threatened their job security. This was held up as a contradiction, but in fact it's exactly right: free trade improves peoples lives by lowering the price of goods and services (making people richer) but also makes jobs less stable as domestic industries keep restructuring in line with technological change abroad."

Another irony is that although the overall economic outlook for the next two decades is exuberant, the outlook for most existing industries may be depressing! People can expect to have to adapt much more than in the past to new skills and new work environments. Twenty years go, could anyone have predicted employment in a call center, or as a web programmer, or for a company like Amazon or AOL? In a world of progress and displacement, in twenty years many people are going to be working for companies that as of now have not yet been started, doing jobs that as of today do not exist.

In an elastic economy, resource constraints are less binding. Environmentalists need to understand this, or they will fail to address Bjorn Lomborg's analysis, as I have written. The more elastic the economy, the more erroneous will be those environmentalists who ignore substitution.

Finally, in an elastic economy, as the market becomes more robust, government regulation becomes more clumsy. Price controls become more damaging, as the California energy crisis of two years ago illustrates. Regulatory mandates, such as CAFE fuel economy standards, deliver poor benefits relative to compliance costs. Labor market rigidities become even more dysfunctional, as is shown by the dismal performance of France and Germany.

Overall, the developments that lead to an elastic economy are extending the advantages that the U.S. has over more socialized countries. Centralized bureaucracies become less functional as the economy becomes more elastic. On the other hand, the private sector has become more chaotic but more robust.

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