No Such Thing as a Free Lunch: Principles of Economics (Part 156)

Economics runs the world.

Machine Gun Kelly

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part F)

by

Charles Lamson

Excess Labor and Excess Capital Effects

We need to make one more point about firms' investment and employment decisions. Firms may sometimes choose to hold excess labor and/or excess capital. A firm holds excess labor (or capital) if it could reduce the amount of labor it employs (or capital it holds) and still produce the same amount of output.

Why would a firm want to employ more workers or have more capital on hand then it needs? Both labor and capital are costly---a firm has to pay wages to its workers, and it forgoes interest on funds tied up in machinery or buildings. Why would a firm want to incur costs that do not use revenue?

To see why, suppose our firm suffers a sudden and large decrease in sales, but it expects the lower sales level to last only a few months, after which it believes sales will pick up again. In this case, the firm is likely to lower production in response to the sales change to avoid too large an increase in its stock of inventories. This decrease in production means the firm could get rid of some workers and some machines, because it now needs less labor and less capital to produce the now lower level of output.

However, things are not this simple. Decreasing its workforce and capital stock quickly can be costly for a firm. Abrupt cuts in the workforce hurt worker morale and may increase personnel administration costs, and abrupt reductions in capital stock may be disadvantageous because of the difficulty of selling used machines. These types of costs are sometimes called adjustment costs because they are the costs of adjusting to the new level of output. There are also adjustment costs to increasing output. For example, it is usually costly to recruit and train new workers.

Adjustment costs may be large enough that our firm chooses not to decrease its workforce and capital stock when production falls. The firm may at times choose to have more labor and capital on hand than it needs to produce its current amount of output, simply because it would be more costly to get rid of them than to keep them. In practice, excess labor takes the form of workers not working at there normal level of activity (more coffee breaks and more idle time, for instance). Some of this excess labor may receive new training so that productivity will be higher when production picks up again.

The existence of excess labor and capital at any given moment is likely to affect future employment and investment decisions. Suppose a firm already has excess labor and capital due to a fall in its sales and production. When production picks up again, the firm will not need to hire as many new workers or acquire as much new capital as it otherwise would need to.

The more excess capital a firm already has, the less likely it is to invest in new capital in the future. The more excess labor it has, the less likely it is to hire new workers in the future. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., P. 620*

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