RELEVANCE OF BUSINESS CYCLE

RELEVANCE OF BUSINESS CYCLES IN BUSINESS DECISION MAKING

• Business cycles auect all aspects of an economy. Understanding the business cycle is important for businesses of all types as they auect the demand for their products and in turn their profits which ultimately determines whether a business is successful or not.
•  Knowledge regarding business cycles and their inherent characteristics is important for a businessman to frame appropriate policies.
•  For example, the period of prosperity opens up new and superior opportunities for investment, employment and production and thereby promotes business. In contrast, a period of recession or depression reduces business opportunities and profits. A profit maximising firm has to consider the nature of the economic environment while making business decisions, especially those related to forward planning. 
• Business cycles have tremendous influence on business decisions. The stage of the business cycle is crucial while making managerial decisions regarding expansion or down-sizing. Businesses have to advantageously respond to the need to alter production levels relative to demand.
•  Different phases of the cycle require fluctuating levels of input use, especially labour input. Firms should exercise the capability to expand or rationalize production operations so as to suit the stage of the business cycle. Business managers need to work euectively to arrive at sound strategic decisions in complex times across the whole business cycle, managing through boom, downturn, recession and recovery. 
• Economy-wide trends can have significant impact on all types businesses. However, it should be kept in mind that business cycles do not auect all sectors uniformly. Some businesses are more vulnerable to changes in the business cycle than others.
•  Businesses whose fortunes are closely linked to the rate of economic growth are referred to as "cyclical" businesses. These include fashion retailers, electrical goods, house-builders, restaurants, advertising, overseas tour operators, construction and other infrastructure firms. 
• During a boom, such businesses see a strong demand for their products but during a slump, they usually suuer a sharp drop in demand. It may also happen that some businesses actually benefit from an economic down turn. 
• This happens when their products are perceived by customers as representing good value for money, or a cheaper alternative compared to more expensive products.
•  Overcoming the euects of economic downturns and recessions is one of the major challenges of sustaining a business in the long-term. 
• The phase of the business cycle is important for a new business to decide on entry into the market. The stage of business cycle is also an important determinant of the success of a new product launch. Surviving the sluggish business cycles require businesses to plan and set policies with respect to product, prices and promotion.
•  In general, economic forecasts are not perfectly reliable. Neither, of course, are the hunches and intuitions of entrepreneurs. Understanding what phase of the business cycle an economy is in and what implications the current economic conditions have for their current and future business activity, helps businesses to better anticipate the market and to respond with greater alertness.
•  However, taken together and applied carefully, economic forecasts can help business firms to prepare for changes in the direction of the economy either prior to or soon after these changes occur.

EXTERNAL CAUSES(POPULATION GROWTH)

Population growth:

•  If the growth rate of population is higher than the rate of economic growth, there will be lesser savings in the economy. Fewer saving will reduce investment and as a result, income and employment will also be less. 
• With lesser employment and income, the euective demand will be less, and overall, there will be slowdown in economic activities. 
• Economies of nearly all nations are interconnected through trade. Therefore, depending on the amount of bilateral trade, business fluctuations that occur in one part of the world get easily transmitted to other parts.
•  Changes in laws related to taxes, trade regulations, government expenditure, transfer of capital and production to other countries, shifts in tastes and preferences of consumers are also potential sources of disruption in the economy.

EXTERNAL CAUSES (NATURAL FACTORS)

Natural Factors:

•  Weather cycles cause fluctuations in agricultural output which in turn cause instability in the economies, especially those economies which are mainly agrarian. In the years when there are draughts or excessive floods, agricultural output is badly auected.
•  With reduced agricultural output, incomes of farmers fall and therefore they reduce their demand for industrial goods. 
• Reduced production of food products also pushes up their prices and thus reduces the income available for buying industrial goods. 
• Reduced demand for industrial products may cause industrial recession.

EXTERNAL CAUSES (TECHNOLOGY SHOCKS)

Technology shocks:

• Growing technology enables production of new and better products and services. These products generally require huge investments for new technology adoption.
• This leads to expansion of employment, income and profits etc. and give a boost to the economy. 
• For example, due to the advent of mobile phones, the telecom industry underwent a boom and there was expansion of production, employment, income and profits.

EXTERNAL CAUSES (POST WAR RECONSTRUCTION)

Post War Reconstruction:

 After war, the country begins to reconstruct itself. Houses, roads, bridges etc. are built and economic activity begins to pick up. All these activities push up euective demand due to which output, employment and income go up.

EXTERNAL CAUSES(WARS)

External Causes: 

The External causes or exogenous factors which may lead to boom or bust are:

Wars:

 During war times, production of war goods, like weapons and arms etc., increases and most of the resources of the country are diverted for their production. This auects the production of other goods - capital and consumer goods. Fall in production causes fall in income, profits and employment. This creates contraction in economic activity and may trigger downturn in business cycle.

INTERNAL CAUSES (PSYCHOLOGICAL FACTORS)

Psychological factors:

•  According to Pigou, modern business activities are based on the anticipations of business community and are auected by waves of optimism or pessimism. Business fluctuations are the outcome of these psychological states of mind of businessmen. 
• If entrepreneurs are optimistic about future market conditions, they make investments, and as a result, the expansionary phase may begin. The opposite happens when entrepreneurs are pessimistic about future market conditions. 
• Investors tend to restrict their investments. With reduced investments, employment, income and consumption also take a downturn and the economy faces contraction in economic activities.
•  According to Schumpeter’s innovation theory, trade cycles occur as a result of innovations which take place in the system from time to time. The cobweb theory propounded by Nicholas Kaldor holds that business cycles result from the fact that present prices substantially influence the production at some future date.
•  The present fluctuations in prices may become responsible for fluctuations in output and employment at some subsequent period.

INTERNAL CAUSES(MONEY SUPPLY)

Money Supply: 

• According to Hawtrey, trade cycle is a purely monetary phenomenon. Unplanned changes in supply of money may cause business fluctuation in an economy. 
• An increase in the supply of money causes expansion in aggregate demand and in economic activities. However, excessive increase of credit and money also set ou inflation in the economy. 
• Capital is easily available, and therefore consumers and businesses alike can borrow at low rates. This stimulates more demand, creating a virtuous circle of prosperity. 
• On the other hand, decrease in the supply of money may reverse the process and initiate recession in the economy.

INTERNAL CAUSES(MACROECONOMIC POLICIES)

Macroeconomic policies:

•  Macroeconomic policies (monetary and fiscal policies) also cause business cycles. Expansionary policies, such as increased government spending and/or tax cuts, are the most common method of boosting aggregate demand. 
• This results in booms. Similarly, softening of interest rates, often motivated by political motives, leads to inflationary euects and decline in unemployment rates.
•  Anti- inflationary measures, such as reduction in government spending, increase in taxes and interest rates cause a downward pressure on the aggregate demand and the economy slows down.
•  At times, such slowdowns may be drastic, showing negative growth rates and may ultimately end up in recession.

INTERNAL CAUSES (VARIATION IN GOVERNMENT SPENDING)

Variations in government spending:

 Fluctuations in government spending with its impact on aggregate economic activity result in business fluctuations. Government spending, especially during and after wars, has destabilizing euects on the economy.

INTERNAL CAUSES(FLUCTUATION IN INVESTMENT)

Fluctuations in Investment:

•  According to some economists, fluctuations in investments are the prime cause of business cycles. Investment spending is considered to be the most volatile component of the aggregate demand.
•  Investments fluctuate quite often because of changes in the profit expectations of entrepreneurs. New inventions may cause entrepreneurs to increase investments in projects which are cost-eflcient or more profit inducing. 
•  Or investment may rise when the rate of interest is low in the economy. Increases in investment shift the aggregate demand to the right, leading to an economic expansion. 
• Decreases in investment have the opposite euect.

CAUSES OF BUSINESS CYCLE

CAUSES OF BUSINESS CYCLES

Business Cycles may occur due to external causes or internal causes or a combination of both. The 2001 recession was preceded by an absolute mania in dot-com and technology stocks, while the 2007-09 recession followed a period of unprecedented speculation in the U.S. housing market.

Internal Causes: The Internal causes or endogenous factors which may lead to boom or bust are:

Fluctuations in Euective Demand: 

• According to Keynes, fluctuations in economic activities are due to fluctuations in aggregate euective demand (Euective demand refers to the willingness and ability of consumers to purchase goods at diuerent prices). In a free market economy, where maximization of profits is the aim of businesses, a higher level of aggregate demand will induce businessmen to produce more. As a result, there will be more output, income and employment. 
• However, if aggregate demand outstrips aggregate supply, it causes inflation. As against this, if the aggregate demand is low, there will be lesser output, income and employment. Investors sell stocks, and buy safe-haven investments that traditionally do not lose value, such as bonds, gold and the U.S. dollar. 
• As companies lay ou workers, consumers lose their jobs and stop buying anything but necessities. That causes a downward spiral. The bust cycle eventually stops on its own when prices are so low that those investors that still have cash start buying again. However, this can take a long time, and even lead to a depression. 
• The difference between exports and imports is the net foreign demand for goods and services. This is a component of the aggregate demand in the economy, and therefore variations in exports and imports can lead to business fluctuations as well. 
• Thus, increase in aggregate euective demand causes conditions of expansion or boom and decrease in aggregate euective demand causes conditions of recession or depression. (You will study about these concepts in detail at Intermediate level in Economics for Finance.

FEATURES OF BUSINESS CYCLE

FEATURES OF BUSINESS CYCLES

Diuerent business cycles diuer in duration and intensity. But there are certain features which they commonly exhibit:

(a) Business cycles occur periodically although they do not exhibit the same regularity. The duration of these cycles vary. The intensity of fluctuations also varies.

(b) Business cycles have distinct phases of expansion, peak, contraction and trough. These phases seldom display smoothness and regularity. The length of each phase is also not definite.

(c) Business cycles generally originate in free market economies. They are pervasive as well. Disturbances in one or more sectors get easily transmitted to all other sectors.

(d) Although all sectors are adversely auected by business cycles, some sectors such as capital goods industries, durable consumer goods industry etc, are disproportionately auected. Moreover, compared to agricultural sector, the industrials sector is more prone to the adverse euects of trade cycles.

(e) Business cycles are exceedingly complex phenomena; they do not have uniform characteristics and causes. They are caused by varying factors. Therefore, it is diflcult to make an accurate prediction of trade cycles before their occurrence.

(f) Repercussions of business cycles get simultaneously felt on nearly all economic variables viz. output, employment, investment, consumption, interest, trade and price levels.

(g) Business cycles are contagious and are international in character. They begin in one country and mostly spread to other countries through trade relations. For example, the great depression of 1930s in the USA and Great Britain auected almost all the countries, especially the capitalist countries of the world.

(h) Business cycles have serious consequences on the well being of the society.

TROUGH AND DEPRESSION

 Trough and Depression:

•  Depression is the severe form of recession and is characterized by extremely sluggish economic activities. During this phase of the business cycle, growth rate becomes negative and the level of national income and expenditure declines rapidly.
•  Demand for products and services decreases, prices are at their lowest and decline rapidly forcing firms to shutdown several production facilities. Since companies are unable to sustain their work force, there is mounting unemployment which leaves the consumers with very little disposable income.
•  A typical feature of depression is the fall in the interest rate. With lower rate of interest, people’s demand for holding liquid money (i.e. in cash) increases. Despite lower interest rates, the demand for credit declines because investors' confidence has fallen.
•  Often, it also happens that the availability of credit also falls due to possible banking or financial crisis. Industries, especially capital and consumer durable goods industry, suuer from excess capacity.
•  Large number of bankruptcies and liquidation significantly reduce the magnitude of trade and commerce. At the depth of depression, all economic activities touch the bottom and the phase of trough is reached.
•  It is a very agonizing period causing lots of distress for all. The great depression of 1929-33 is still cited for the enormous misery and human suuerings it caused.

CONTRACTION

 Contraction:

•  The economy cannot continue to grow endlessly. As mentioned above, once peak is reached, increase in demand is halted and starts decreasing in certain sectors. During contraction, there is fall in the levels of investment and employment.
•  Producers do not instantaneously recognise the pulse of the economy and continue anticipating higher levels of demand, and therefore, maintain their existing levels of investment and production.
•  The consequence is a discrepancy or mismatch between demand and supply. Supply far exceeds demand. Initially, this happens only in few sectors and at a slow pace, but rapidly spreads to all sectors.
•  Producers being aware of the fact that they have indulged in excessive investment and over production, respond by holding back future investment plans, cancellation and stoppage of orders for equipments and all types of inputs including labour.
•  This in turn generates a chain of reactions in the input markets and producers of capital goods and raw materials in turn respond by cancelling and curtailing their orders. 
• This is the turning point and the beginning of recession. 
• Decrease in input demand pulls input prices down; incomes of wage and interest earners gradually decline resulting in decreased demand for goods and services.
•  Producers lower their prices in order to dispose ou their inventories and for meeting their financial obligations. Consumers, in their turn, expect further decreases in prices and postpone their purchases.
•  With reduced consumer spending, aggregate demand falls, generally causing fall in prices. The discrepancy between demand and supply gets widened further. 
• This process gathers speed and recession becomes severe. Investments start declining; production and employment decline resulting in further decline in incomes, demand and consumption of both capital goods and consumer goods.
•  Business firms become pessimistic about the future state of the economy and there is a fall in profit expectations which induces them to reduce investments. 
• Bank credit shrinks as borrowings for investment declines, investor confidence is at its lowest, stock prices fall and unemployment increases despite fall in wage rates.
•  The process of recession is complete and the severe contraction in the economic activities pushes the economy into the phase of depression.

PEAK

 Peak:

•  The term peak refers to the top or the highest point of the business cycle. In the later stages of expansion, inputs are diflcult to find as they are short of their demand and therefore input prices increase.
•  Output prices also rise rapidly leading to increased cost of living and greater strain on fixed income earners.
•  Consumers begin to review their consumption expenditure on housing, durable goods etc. Actual demand stagnates. 
• This is the end of expansion and it occurs when economic growth has reached a point where it will stabilize for a short time and then move in the reverse direction.

EXPANSION

 Expansion:

•  The expansion phase is characterised by increase in national output, employment, aggregate demand, capital and consumer expenditure, sales, profits, rising stock prices and bank credit. 
• This state continues till there is full employment of resources and production is at its maximum possible level using the available productive resources. 
• Involuntary unemployment is almost zero and whatever unemployment is there is either frictional (i.e. due to change of jobs, or suspended work due to strikes or due to imperfect mobility of labour) or structural (i.e. unemployment caused due to structural changes in the economy). Prices and costs also tend to rise faster.
•  Good amounts of net investment occur, and demand for all types of goods and services rises. 
• There is altogether increasing prosperity and people enjoy high standard of living due to high levels of consumer spending, business confidence, production, factor incomes, profits and investment.
•  The growth rate eventually slows down and reaches its peak.

PHASES OF BUSINESS CYCLE

PHASES OF BUSINESS CYCLE

 Business cycles or the periodic booms and slumps in economic activities reflect the upward and downward movements in economic variables. A typical business cycle has four distinct phases. These are:

1. Expansion (also called Boom or Upswing)

2. Peak or boom or Prosperity

3. Contraction (also called Downswing or Recession)

4. Trough or Depression

BEHAVIOURAL PRINCIPLE(PRINCIPLE 2)

Principle 2 - The firm will be making maximum profits by expanding output to the level where marginal revenue is equal to marginal cost.

In other words, it will pay the firm to go on producing additional units of output so long as the marginal revenue exceeds marginal cost i.e., additional units add more to revenues than to cost. At the point of equality between marginal revenue and marginal cost, it will earn maximum profits.

BEHAVIOURAL PRINCIPLE(PRINCIPLE 1)

BEHAVIOURAL PRINCIPLES 

Principle 1- A firm should not produce at all if its total variable costs are not met.

• It is a matter of common sense that a firm should produce only if it will do better by producing than by not producing. The firm always has the option of not producing at all.
•  If a firm’s total revenues are not enough to make good even the total variable costs, it is better for the firm to shut down. In other words, a competitive firm should shut down if the price is below AVC. 
• In that case, it will minimise loss because then its total cost will be equal to its fixed costs and it will have an operating loss equal to its fixed cost.
•  The sunk fixed cost is irrelevant to the shutdown decision because fixed costs are already incurred. This means that the minimum average variable cost is equal to the shut-down price, the price at which the firm ceases production in the short run. Shutting down is temporary and does not necessarily mean going out of business.
• If price (AR) is greater than minimum AVC, but less than minimum ATC, the firm covers its variable cost and some but not all of fixed cost. 
• If price is equal to minimum ATC, the firm covers both fixed and variable costs and earns normal profit or zero economic profit. 
• If price is greater than minimum ATC, the firm not only covers its full cost, but also earns positive economic profit or super normal profit.