If prices in only a handful of markets fail to accurately reflect underlying economic realities (such as the intensity of consumer demand for oranges relative to the demand for grapefruit), the economy won’t suffer greatly. But when prices in general are out of whack—when prices in most markets send out mis information—widespread economic troubles arise. Entrepreneurs and investors throughout the economy will then act on false information about what consumers want and about what inputs make possible the lowest-cost ways to satisfy those wants.
With such widespread failure of prices to coordinate the plans of producers with the plans of consumers, economic activity stagnates. Some producers discover that they can’t sell all of the output that they have produced. Other producers find themselves unable to get all of the inputs necessary to carry through with their production plans. Yet other producers learn that, had they produced more output, they could have sold more output.
If prices are free to adjust in response to these discoveries of errors, they will eventually do so. The pattern of prices will then give entrepreneurs and investors more accurate direction about what to produce and how best to produce those goods and services. Such adjustments in production activities, however, are not instantaneous. They take time. Orchards planted with grapefruit trees cannot immediately be transformed into orchards planted with orange trees. Redesigning an automobile body or the casing of MP3 players to be made with more aluminum and less steel can’t be done with the snap of a plant-manager’s fingers.
Unemployment rises during the time it takes for these adjustments to be made. Workers in industries with unsold inventories are laid off, and time is required for them to find employment elsewhere. Even industries that expand in response to more accurate prices typically require some time to rearrange their production plans and facilities in order to make profitable the hiring of new workers.
The time it takes for the firms to adjust away from the production plans they made when prices were inaccurate is time during which unusually large numbers of workers are unemployed.
Such unemployment is not caused by too little aggregate demand.
Therefore, such unemployment cannot be cured by more government spending or other efforts to raise aggregate demand. Instead, such unemployment is caused by the widespread failure of individual prices to convey accurate information to entrepreneurs and investors about what specific products they should produce and about how best to produce these products. The only way to cure this malinvestment is to allow prices to adjust so that they better reflect consumer desires and the realities of resource availabilities. This cure, again, requires time—time for prices to adjust and for workers to find and move to jobs that are more economically sustainable.