Under-Consumption Theory of Business Cycle | Firm

In this article we will discuss about the under-consumption theory of business cycle.

On the basis of Marx’s ideas writers on socialism such as Major Douglas and A. Hobson developed the over-saving or under-consumption theory of business cycles. In the opinion of Hobson, “The right proportion of saving to spending at any given time depends upon the present condition of the art of production and consump­tion and the probabilities of such changes in models of work or living as shall provide social utility for new forms of capital within the near or calculable future”.

According to this theory, the root cause of depression is the prevalence of inequality of incomes in a capitalist economy. The capi­talists or owners of industry have too much of wealth. Since they cannot spend the whole amount they save the major portion of it.

The amount saved is invested in business for expansion and diversification. On the other hand, wages remain fixed at the subsistence level and do not rise even in a period of good business. Although workers have a strong propensity to consume they do not have adequate purchasing power to buy the goods produced by the expanding business firms.

So, businesspeople find it difficult to see their entire output at market prices to realise profits embodied in already produced stocks. So, they are faced with realisation crisis. The fall in prices and production initiates depression in the whole economy. Thus, according to this theory, the root cause of business cycles is too much saving, or what comes to the same thing — too little consumption.

In this context, we may note a related point. The followers of Karl Marx point out that the real cause of business cycle is something else. In a capitalist economy, wages are not permitted to rise as fast as prices of commodities even in a period of technological progress or economic expansion.

So, profits soar. Excess profits made by industrialists are largely, if not entirely, rein­vested. In other words, the major portion of profit is utilised for further expansion of business. This leads to an expansion of output. Since output increases much faster than the demand for consumer goods, there is over­production. This, in its turn, leads to a fall of prices and initiates business slump.

Criticisms:

The theory has been criticised on three main grounds:

First, it fails to offer a comprehensive explanation of business or trade cycles. The business cycle is, no doubt, a very complex phenomenon. Its causes are numerous. Therefore, it cannot just be explained in terms of a single cause, such as over-saving or under-consumption;

Secondly, the theory does not suggest an explanation of the occurrence of depression at fairly regular intervals;

Thirdly, the theory is based on the assumption that the savings of the rich automatically find their way into investment in industrial equip­ment.

This may not always be true. Saving will be utilised for investment in plant equipment and other durable assets if, and only if, there is a genuine prospect of making profit. In other words, it is the desire for profit and not the mere existence of saving which governs the rate of the volume of investment in capitalistic societies.