Business Cycles and Market Failures (Part 1)
Business Cycles and Market Failures (Part 1)

Here we have the most thorough analysis of the most baffling aspect of capitalism—the business cycles—that has ever been presented. I have simplified the economic structure and reduced the amount of technical terms so that any informed reader should be able to understand the material. If we could all find out why Earth cannot be a paradise, we'd all be very interested. What gives rise to these terrifying economic downturns, like the Great Depression, and these equally terrifying stagflations? We should all be satisfied with full employment all the time. Why can't we have it both ways? This page explains the business cycle in a straightforward and comprehensive way, covering economic downturns beginning in the 1930s, recessions beginning in the 1940s, stagflation in the 1970s, and continuous booms in the 1980s and 1990s.
We typically split our salary in half and put half toward consumption and the other half toward savings. Everyday expenses and sporadic purchases typically eat up a sizable chunk of our money. Food, clothes, toothpaste, soap, and other personal care items are examples of regular requirements. Purchases of vehicles, books, movies, music, and bikes are examples of irregular purchases. We put aside a little amount of money each month after paying our bills and then put the rest into long-term investments like stocks, bonds, fixed deposits, and the like.
Our economy is split into two parts, the consumption part and the investment part, which are directly related to our aforementioned activities. About 80% of the total economy is devoted to consumption, if we don't include government expenditure. This encompasses all of our purchases, including groceries, apparel, transportation, electronics (TVs, motorcycles, vehicles, etc.), books, and anything else. Furthermore, the investment sector accounts for about 20% of the total size of our economy. Putting in new plants and facilities, as well as building homes, are the primary components of the investment sector. Government expenditure is also a part of a three sector model. Nevertheless, we will remove government spending as free markets are more relevant to these areas and less to overall spending. Note that these are simply ballpark figures, and actual values may differ significantly across economies.
So, how does the Consumption sector generate money for manufacturers? The consumption sector of any economy always generates surplus, or more output than is needed. Not only do people put money away, but capitalists in the consumption sector do the same. The investment sector is where these savings are put to work by investors. Capitalists and workers in the investment sector get their money from these savings. The investment sector's workers and capitalists subsequently purchase consumer products with their earnings. Workers and capitalists in the Investment sector essentially consume the surplus products of the Consumption sector. Thus, in a monetary economy with a circular flow, the firms in the consumption sector reap the benefits of the investment sector's income in the form of a surplus. At the conclusion of the piece, I will make a passing reference to a minor assumption.
Consequently, we must keep in mind two points. Profits in the consumption sector are first and foremost determined by the size of the investment sector. Capitalists in the consumption sector stand to gain more from large-scale investments, while those in the investment sector stand to lose less from smaller-scale investments. Plus, you should always put your savings into something. The magnitude of investments and profits are both affected by whether or not savings are invested. If manufacturers were to reduce output due to a lack of profitability, the result would be a spike in unemployment and a recession. For the sake of economic balance, it is a well-established economic principle that all savings must be invested in full. A recession may follow an imbalance in supply and demand, which in turn can cause unsold inventory to pile up if savings are not invested adequately.
Now that we have a brief overview of our economy's structure, we can embark on a mini-journey into the intriguing realm of business cycles.
The state of our economies is constantly shifting. They continue to enlarge each year. Consumption rises in tandem with an expanding economy. The annual sales of automobiles, televisions, computers, and other electronic devices continue to rise. Since surplus, sometimes known as profit in business jargon, is readily quantified in percentage terms, it stands to reason that suppliers would anticipate a corresponding 6% growth in consumption. Workers in the Investment sector must eat up the extra production, which implies that even Investment must expand by 6%. On the other hand, a 6% increase in Savings—the money set aside for investments—would be required. What would occur if there was a 6% increase in consumption but no corresponding increase in investment or savings? The economy would be out of whack if producers' surplus went unsold due to the degree of inequality. As a result, the state of economic equilibrium would be -
The percentage of investment growth that is proportional to consumption growth is equal to the percentage of savings growth that is proportional to investment growth.
For example, let's pretend that at any given time there was a perfect equilibrium with C representing consumption, I representing investment, and S representing savings. So, let's pretend that C increases by X percentage points in the next fiscal term. Our respective growth rates would therefore need to be X% as well. The economy would be out of whack even if savings and investment were to remain at par if neither of them grew by X percentage points.
This document serves as a blueprint for several business cycles.
Massive amounts of savings that have not been invested are a hallmark of every recession. Investors keep their money in the bank rather than putting it to work because they don't trust other investors. Consumption is low and savings, particularly uninvested savings, are large at the bottom of a business cycle. Once the economy starts to pick up speed, all of the savings would be invested, and the consumption sector's producers might finally reap the benefits of their anticipated surpluses. The investment sector's size is proportional to the consumption sector's surplus. Producers in the Consumption sector would have massive surpluses if savings were high and invested fully. The pace of economic activity accelerates dramatically.
A struggle for market share ensues as production speeds up in response to the reviving economy. For instance, maximization of sales is a goal for every automaker. He would never consider the idea of reducing production of automobiles in order to save money and invest more in the future. Accordingly, as competition for market share heats up, spending is increasing while saving is falling behind. According to our previously stated criterion, in order for there to be equilibrium, consumption and savings must increase at the same rate. Would disequilibrium ensue instantaneously if consumption were to outpace savings? Since producers would naturally not continue anticipating to earn abnormally high profits like they did in the early stages of the boom, this may not immediately generate disequilibrium. As the boom continues, they anticipate regular profits, which are relatively lower, and a slower growth rate in savings compared to Their surplus expectations would be unaffected by consumption right away. For a few years, the boom rises from its trough to its pinnacle in this manner.
After a few years of faster consumption growth than savings, the savings percentage in income will drop so low that it won't be enough to meet the surplus expectations of the consumption sector's producers. Because investments are smaller, even if savings are completely invested, the Consumption sector would not expect a surplus and the economy would be out of balance. Producers witness a decline in their profitability as their unsold inventory stockpiles increase. There has to be a change. We need to reduce spending and increase savings. Producers in the Consumption sector would gladly do it because they are unable to sell their goods. They reduced output while increasing savings.
Nevertheless, the necessary adjustment may never come to fruition! Consumption is the ultimate goal of capitalist economies. We should not expect investment to rise if consumption is falling. It is not possible to have a significant increase in investment in the cycling sector while also selling fewer bikes than last year. While reducing consumption could boost savings, it would have no effect on investment. Investment begins its own downward trend and follows the direction of consumption. Recession ensues because the extra savings aren't put to use, the imbalance becomes entrenched, and the economy continues to suffer. Immediate rectification cannot be guaranteed by any automatic forces. A decline in investment follows a reduction in consumption that aimed at increasing savings. As a result of falling investment, aggregate demand falls even further, which forces manufacturers to slash output even further. The downward circle of falling consumption keeps going until the economy hits rock bottom and high jobless rates are the norm. Famous British economist John Maynard Keynes saw this kind of downward cycle. Investment may be prompted to turn around and begin the expansion process anew after a few years of low output by an invention or by passionate entrepreneurs drawn by the prevalent low borrowing rates. In my opinion, this is how the majority of recessions in the United States and Europe since the 1940s happened. The Consumption-led Business Cycles are what I'd call them.
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