Digging a Little Deeper:

Coordination Failure

So far in this chapter, we have thought of recessions as a result of a coordination failure between savers and investors, as groups. But coordination failure among suppliers of goods and services can also be a problem. Here is an example to show how a coordination failure could lead to recession through inadequate aggregate demand. We will use a simple economy in our example -- but not too simple, since it is the complexity of modern economic systems that makes coordination failure possible. For the example, we think of an economy that has five industries: shoes, shirts, coats, rugs, and beer, as shown in the schematic below.

Figure 3. The Shoe Factory Example.

(This is sometimes called "the shoe factory example," and I got it from the writings of Professor Paul Rosenstein-Rodin).

Now, here's the story: In each of the five factories in this tiny economy, the directors are making their plans for the year. Shall they expand production, hold steady, or cut back? Let's listen in and see how it goes:

Shoe factory:

"We sell most of our shoes to workers in the shirts, coats, rugs and beer industries. Those industries are cutting back production, laying workers off, so demand for shoes is dropping. So we'd best cut back. Of course, the workers we lay off will buy less shoes, but they don't buy much of our output anyway, since they spend most of their wages on shirts, coats, rugs and beer. So we'd better cut back."

Shirt factory:

"We sell most of our shoes to workers in the shoes, coats, rugs and beer industries. Those industries are cutting back production, laying workers off, so demand for shirts is dropping. So we'd best cut back. Of course, the workers we lay off will buy less shirts, but they don't buy much of our output anyway, since they spend most of their wages on shoes, coats, rugs and beer. So we'd better cut back."

...

And each of the other boards of directors reasons the same. Need we go through them all? Probably not: you can work it out. The result is that they all cut back production.

At the end of the year, the boards of directors meet to review their decisions. They say:

Shoe factory:

"We were right! Demand for shoes did drop! It's a good thing we cut back as we did!"

Shirt factory:

"We were right! Demand for shirts did drop! It's a good thing we cut back as we did!"

...

And so on, yet again. Everybody was right! But notice that it could have been different. If, somehow, they had coordinated their decisions, they could have maintained or even increased their production, and (within some limits!) been just as right. It would have been like this:

Shoe factory:

"Since we know that the shirts, coats, rugs and beer industries are going to keep up production and employment, there will be plenty of demand for shoes. So we'd best keep our folks at work to produce all those shoes."

Shirt factory:

"Since we know that the shirts, coats, rugs and beer industries are going to keep up production and employment, there will be plenty of demand for shoes. So we'd best keep our folks at work to produce all those shoes."

...

And, again, all the other industries reason similarly. So, at the end of the year, it is

Shoe factory:

"We were right! Demand for shoes held up! It's a good thing we didn't cut back!"

Shirt factory:

"We were right! Demand for shirts held up! It's a good thing we didn't cut back!"

...

If the five factories in this tiny economy coordinate their decisions and produce as much as they can with the labor that is supplied, then there is no recession. If they don't, as the first half of the example suggested, then there is a recession, and it is a result of the coordination failure.

More

Copyright