Business Cycles – Theory of Under Consumption

Theory of Under Consumption is also one of the oldest theory of business cycles, it was given in the 1930s.

Malthus and Sismodi criticized Say’s Law which states that ‘Supply creates its own demand’ and argued that consumption of goods and services could be too small to generate sufficient demand for goods and services produced. The over production of goods due to lack of consumption demand causes increases in inventories of goods which results in recession.

Under Consumption theory as propounded by Sismodi and Hobson was not a theory of recurring business cycles. They tried to explain How a free enterprise economy could enter a long run economic slowdown. A crucial aspect this theory is the distinction they made between the rich and poor. According to them – the rich sections in the society receive a large part of their income from returns on financial assets and real property owned by them. Further, they assume that the rich have a large propensity to save, as they consume relatively less portion of their income (because they earning much more income from different sources).

On the other hand, less well-off people in society obtain most of their income from work, that is wages from labour and have a lower propensity to save, due to low income.

They further assume that during the expansion process, incomes of the rich people increase relatively more than the wage income.

So, during the expansion phase, income distribution changes in favor of the rich, which causes the average propensity to save fall. In the expansion phase savings increases and therefore consumption demand declines.

According to Sismodi and Hobson, increase in savings during the expansion phase leads to more investment on capital goods and after some time production of goods and services increases.

But since society’s propensity to consume continues to fall, consumption demand is not good enough to absorb the increased production of consumer goods. This lack of demand for consumer goods or Under-Consumption emerges in the economy which halts the expansion of the economy. Since the supply increases relatively more than the demand for the consumption goods, the prices of consumer goods fall. Prices continue falling and go even below the average cost of production, which causes losses to the business firms. So when Under-Consumption appears, production of goods becomes unprofitable, firms cut down their production resulting in recession or contraction in the economic activities.

Karl Marx and Under-Consumption –

Karl Marx, the philosopher of scientific socialism had also predicted the collapse of the capitalist system due to the emergence of Under-Consumption. He predicted that capitalism would move periodically through expansion and contraction with each peak higher than its previous peak and each crash (depression) deeper than the last. Ultimately, according to Karl Marx, in a state of acute depression working class will overthrow the capitalist class which exploits them and in this way the new era of socialism or communism would come into existence.

Like other under-consumption theorists, Karl Marx argues that driving force behind business cycles is ever increasing income inequalities and concentration of wealth and economic power in the hands of the few capitalists who own the means of production. As a result, the poor workers lack income to purchase goods produced by the capitalist class resulting in under-consumption or over-production. With the capitalist producers lacking market for their goods, capitalist economy plunges into the depression. Then the search for ways of opening new markets started. Even wars between capitalist countries take place to capture other countries to find new markets for their products. With the discovery of new methods of production of finding new markets, the economy recovers from depression and the new upswing starts.

Critical Appraisal –

The view that income inequalities increases with growth or expansion of the economy and causes recession or stagnation is widely accepted. Therefore, even many modern economies suggest that if growth is to be sustained, then consumption demand must be increasing sufficiently to absorb the increasing production of goods. Further, Under-Consumption theory rightly states that income redistribution schemes will reduce the amplitude of business cycles.

The suggested behavior of the average propensity to save and consume of the property owners and wage earners in this theory have been found consistent with the observed phenomena. Even in the theory of economic development the difference in average propensity to save of the property owners and workers has been widely used.

Under-Consumption theory contains some important elements, the emergence of the lack of consumption demand as a cause of recession. There are many reasons other than growing income inequalities which are responsible for causing recession or trade cycles. Although this theory concentrate on a significant variable, it leaves too much unexplained.