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Relative Price Shifts and Creative Destruction

September 20, 2012

Relative prices, or the price of one good compared to the prices of all other goods, guide economic behavior by allowing individuals to compare their demand to the demand of the rest of society and the costs of producing the good. The price of a good not only lets consumers determine how much productive resources are required to produce it, but also signals to producers how much profit is to be earned by making various goods. A high price simultaneously discourages consumption of that good and rewards production of it, leading the market toward equilibrium. However, for many reasons, relative prices can change, and what was once a profitable good to produce can become unprofitable.

An Example
Suppose there’s an automobile making firm with workers, capital, and some productive technology. They buy inputs, such as natural resources, and make cars.

Input costs:
Workers: 200 workers making $60,000 per year = $12 million annual wages.
Raw materials: $3 million per year.
Capital: $5 million per year.

Output revenue:
Sell 1,000 cars for $20,000 each, for a total revenue of $20 million.

Let’s suppose a new technology comes along which allows cars to be made using only robots, but the price of cars and the price of inputs does not change. Could the car company remain in business? Yes – they’d just keep doing what they were doing before; no wage changes and no changes in profitability. As the price of cars, capital, and raw materials stays the same, the firm can go on paying the same wage forever. If trade with a poor country opened up and some other firms were outsourcing because of low wages, would that affect the profitability of the firm above, if the price of cars did not change? No. No economic change, whether it is technology or trade will change the profitability of our hypothetical firm in the absence of relative price shifts. The firm could perhaps increase their profitability by adopting techniques which increase efficiency, but they don’t have to.

Now, suppose the supply curve shifts out and the price of cars falls to $18,000. Revenue at the car firm drops to $18 million, and the firm can no longer afford to pay what they used to for inputs. Wages need to drop to $50,000 just for the firm to break even. You don’t need a story about an evil CEO or a hated outgroup, all you need is a relative price shift and the old production method will not work any more, at least, not without severe wage cuts.

The Creative Part of the Destruction
When the relative price of one thing falls, the relative price of another good must rise, as a tautology. In our example, if cars become cheaper, everything else becomes more expensive relative to cars. Everyone who buys a car now has $2,000 they can spend on other things. So long as total spending is stable, nominal income in other sectors will rise by the amount that it falls in the automobile sector. Because the supply curve shifted out, total economic production goes up, and the average person is richer than they were before. People cannot consume more than we produce on average, so increasing total production is the only way to increase total consumption. Sectors whose products increase in relative price can now compensate their workers more, perhaps leading to a shift in workers from one sector to another. Often there are costs to changing sectors, such as training and relocation.

Technology and Trade
Any supply shock will have an effect on employment and relative prices, whether it is technology or trade. Either scenario has the same economic effect: increased production coupled with a sectoral shift. Recently the prices of things that low skilled workers make have been dropping and the relative prices of things high skill people make have been increasing, leading to increased inequality. It is hard to see if this trend will be long lasting. As robots become more and more productive, relative prices may change in unexpected ways. I am not optimistic about the fate of low skilled workers in the next few decades.

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