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Market Failures And Business Cycles (Part 1)

The following is the most comprehensive ever explanation to the

most mysterious phenomenon of Capitalism - the Business Cycles.

In order to ensure that the article can be read by any well

educated reader, I have minimized the economics jargon and have

added a short and simple introduction to the structure of the

economy. Each and every one of us would be interested to know as

to why we cannot have a paradise on earth. Why is it that we are

often besieged by such painful downslides of economic activity

such as Great Depression or the nerve wracking periods such as

Stagflations? Why can't we all be always happy with hundred

percent employment all the time, with each and every one of us

employed? The following article provides simple and complete

Business Cycle explanations to Depressions before 1930s,

Recessions after 1940s, Stagflations of 70s and Continuous Booms

of 80s and 90s.

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

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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-à-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