Overproduction, Underconsumption and the Business Cycle

Abstract

The mechanisms by which the national income is distributed between consumption and investment in the Free Enterprise system is competition. Taking for granted that the incentive to invest in the private sector is the expectation of profit, and that capitalists are rational people, it is clear that sustained investment requires that effective demand must eventually suffice to satisfy this expectation. This means that, allowing for some time-lags, full employment requires effective demand for consumption and investment to match or exceed the rate of accretion of the labour force and the rate at which technological innovation is increasing productivity. Under perfect competition an excess of labour would reduce wages and an excess of produce would reduce prices. Lower prices would increase real incomes and spending, and the ensuing greater velocity of money circulation would cause prices to rise again and revive investment and employment. This, in a nutshell, is the Real-Balance or Pigou effect. Without going into the question whether this would really be the sequence of events or if it would only happen when banks have reached the limit of their lending capacity, one thing is fairly certain, namely that it can only apply to an idealized and not to a actual Free Market system. In reality, when consumer demand continues for a lengthy period to fall below producers’ output, incentives to invest and to employ more labour will diminish; and if demand exceeds output, prices rise and inflation may be leading toward economic entropy. As profit expectations are prospective they may or may not be influenced by past and current experience, but usually an experienced rise in demand for goods and services tends to induce investment, and economic stagnation or falling demand to discourage it. Normally, if potential investors assume that the stagnation or diminution in demand is transient they may wish to take advantage of the lower interest rates and reduced cost of other resources to renew or supplement their stock. If they suspect that the recession will be lasting they will hold back, and the accent in technological improvements will shift from product innovation toward labour cost or other costs reducing process innovation. The only exception is the case when a potential investor has some completely new invention of a product in hand which is not merely replacing another but opens up a novel market.