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Market Failures And Business Cycles (Part 1)
The income that we earn is normally divided into two portions,
Consumption and Savings. We normally consume a large portion of
the income we earn for our day to day necessities as well as
irregular buys. Regular necessities include food, clothing,
toothpastes, soaps and other daily necessities. Irregular buys
include bikes, cars, books, movies, music and so on. After we
spend most of our incomes on Consumption, we save a small
portion of our income and invest it in shares, bonds, fixed
deposits and other long term investments.
In direct relation to our above mentioned activity, our economy
is divided into two sectors - Consumption sector and Investment
sector. If we exclude the government spending, Consumption
sector constitutes roughly around 80% of the size of economy. It
includes everything that we buy - food, clothing, cars, bikes,
TVs and other durable goods, books - every thing. And around 20
percent of the size our economy is constituted by the Investment
sector. Investment sector mainly includes activities such as
installing new plants and capacities, and housing. A three
sector model would also include government spending as well.
However free markets have more to do with these sectors and less
to do with Government Spending, so let us exclude governemnt
spending. The figures given above are only approximate and can
vary sizeably from economy to economy.
So how are profits made by the Consumption sector manufacturers?
In any economy, Consumption sector always produces in excess of
its requirements - it produces surplus. Consumption sector
capitalists as well as households also save a certain portion of
their income. Investors invest these Savings in the Investment
sector. So these Savings turn into the earnings of the
Investment sector capitalists and workers. The workers and
capitalists of the Investment sector then spend their earnings
on the consumption goods. So basically the surplus production of
the Consumption sector is consumed by the workers and
capitalists of the Investment sector. Therefore in a circular
flow monetary economy, the income of the Investment sector
becomes the profit or surplus of the Consumption sector firms.
There is a small assumption that is made here on which I shall
allude to at the end of the article.
So there are two things that we have to note here. First the
size of the investment sector decides on the size of the profits
of the Consumption sector. If there are huge Investments made,
the Consumption sector capitalists make huge surpluses or
profits and if the size of the Investment sector is on the lower
side, the Consumption sector capitalists would make lower
surpluses or profits. Also all of the Savings made should always
be invested. If Savings are made but are not invested, then it
would lead to a lower size of Investments and lower profits.
Insufficient profits would force the producers to cut down on
their production levels and this would directly lead to rising
unemployment and recession! It is a long recognized economic
thought that Savings made should be compulsorily invested fully
so that the economy can be in equilibrium. If the Savings made
are not invested fully, it can lead to disequilibrium between
Supply and Demand and can lead to piling up of unsold stocks of
inventories and a subsequent recession.
With the above short introduction to the structure of our
economy, we are ready for a small journey into the fascinating
world of Business Cycles.
Our economies are rarely ever static. They keep growing in size
every year. Now in a growing economy Consumption also grows.
Year on year more cars are purchased, more televisions are
bought, more computers are installed and so on. It is natural
that when Consumption grows by say 6%, the suppliers would
expect their surplus also to grow by 6% because surplus, which
is called profit in the business parlance, is obviously measured
in percentage terms. However the surplus production has to be
consumed by the workers of the Investment sector which obviously
means that even Investment would have to grow by 6%. However
this would mean that Savings, which is the fund for Investment,
would also have to grow by 6%. What would happen if Consumption
grows by 6% but Investment or Savings do not grow by an
equivalent percentage? To the extent of the inequality,
producers' surplus would remain unsold and the economy would be
in disequilibrium. So the equilibrium condition of the economy
would be -
Periodic Growth percentage of Consumption = Periodic growth
percentage of Investment = Periodic growth percentage of Savings.
Suppose during a particular period, there was a perfect
equilibrium in which Consumption was C, Investment was I and
Savings was S. Suppose during the next financial period C grows
by a certain X percentage points. Then S and I would also have
to grow by the same X percentage points. Suppose either I or S
does not grow by X percentage points, the economy would be in
disequilibrium even if Investment is equal to Savings!
Here in lies a blue print for different types of Business Cycles.
A normal characteristic of any recession is the presence of huge
un-invested Savings. Investors hoard money without investing it
because of lack of investor confidence. At the trough or the
lowest point in a business cycle, Consumption is relatively low
and Savings are relatively high, especially un-invested Savings.
Then as economic activity picks up, all of the Savings are
invested and the producers of the Consumption sector would be
able to realize their expected surpluses. The size of Investment
sector is equal to the surplus of the Consumption sector. Since
Savings are high and are fully invested, the producers of the
Consumption sector would be able to realize huge surpluses.
Economic activity picks up a roaring speed.
As economic activity picks up, there starts a battle amongst the
producers for market shares. For example, each car manufacturer
wants to sell as many cars as possible. He would not think - let
me produce less cars now, let me save and invest more for later.
So as the battle for market share picks up, Consumption
accelerates at the expense of Savings i.e. Consumption grows at
a faster rate than Savings. Our above mentioned condition tells
us that for equilibrium to exist, Consumption and Savings have
to grow at an equal pace. So if Consumption grows at a faster
pace than Savings, would this lead to disequilibrium
immediately? This may not immediately lead to disequilibrium
because producers would obviously not keep expecting to earn
abnormally high profits the way they earned in the initial
stages of the boom. Their expectations are also geared towards
comparatively lower profits or what is called as normal profits
as the boom progresses and therefore lower growth rate in
Savings vis--vis Consumption would not immediately damage their
expectations of surplus. This way the boom progresses from the
trough to the peak for a few years.
After a few years of growth of Consumption at a faster rate than
Savings, the percentage of Savings in the income would drop so
low that Savings are not sufficient to meet the expectations of
surplus of the producers of the Consumption sector. Even if
Savings are fully invested, this does not generate the surplus
as expected by the Consumption sector because of the lower size
of investment and would lead to disequilibrium. Producers see
their unsold inventory stock piles rise and their profits
dwindle. The situation needs correction. Consumption needs to be
cut and Savings need to be raised. As they are not able to sell
their goods, the producers of Consumption sector would be more
than willing to do so. They cut their production and increase
their Savings.
However the required correction might not materialize! The very
objective of capitalist economies is Consumption. If Consumption
is on the decline, we cannot expect Investment to increase. We
cannot have fewer bikes sold as compared to previous year and at
the same time have much higher Investment in the bike sector as
compared to the previous year. A cut in Consumption might
increase Savings but would not raise Investment. Investment
follows the path of Consumption and it itself starts in the
downward trend. As a result the increased Savings are not
invested and the disequilibrium takes on a relatively permanent
position and we have a recession! There are no automatic forces
to ensure immediate correction. What started with a cut in
Consumption to increase Savings leads to a fall in Investment.
This drop in Investment leads to a further depletion of
aggregate demand which then prompts the producers to cut their
production levels even further. Consumption declines even
further and the spiral continues until the economy settles at a
low output with a lot of unemployment. This sort of downward
spirals were recognized by the eminent British economist John
Maynard Keynes. Eventually, after a few years of low output,
some invention or some enthusiastic entrepreneurs who are
attracted by prevalent low interest rates might trigger
Investment to reverse its downward path and start the process of
expansion all over again. I believe that most recessions in US
and Europe after 1940s occurred in this way. I would call these
cycles - the Consumption led Business Cycles.
2005 Thotakura R,US registration:TXU 1-256-191
About the author:
Thotakura R is the originator a new revolutionary economic model
called "Threeway Economics" that demystifies the longstanding
mysteries of capitalism to a great level of detail including
Business Cycles,Inverted Yield Curves,Inflations,Price/Wage
rigidities. To learn more, Visit his site at:
http://www.threewayeconomics.com