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Introductory Economics

dr. Richard F.J. Paping & drs. Geurt A. Collenteur

University of Groningen
Economic en Social History
Faculty of Arts

Groningen, January 2016

Content

1. Two fundamental theorems of welfare economics: Pareto and Pigou 2

2. Oligopolistic behaviour and game theory 4
3. Nominal and real data 6
4. Economic growth 7
5. Business cycles and economic swings 14

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1. Two fundamental theorems of welfare economics: Pareto
and Pigou

When it comes to (economic) theory concerning the question how to optimize or maximize
general or national welfare under existing circumstances, two opposing views stand out.
Some (the advocates of laissez-faire or free-market) hold the view that a free market will
eventually, when not hampered by government interference, create an efficient equilibrium.
This equilibrium, they argue, corresponds with an optimal national welfare. In essence, they
suggest that the ensuing income distribution maximises national welfare. They claim there is
no valid economic theoretical argument for redistributing income. Others (the
interventionists), however, claim there might be good reasons for a government to redistribute
income in order to improve total national welfare. The difference between both groups stems
from different fundamental assumptions and corresponds with two different approaches to the
economic concept of utility associated with the work of Vilfredo Pareto and Arthur Pigou,
respectively.
According to Pareto any equilibrium is efficient when and only when a shift in
resources implying an improvement for someone, results in deterioration for someone else. If,
on the other hand, someone can improve his or her economic position without someone else
losing any utility as a consequence, the initial situation was not Pareto-efficient. In a so-called
Pareto-efficient or a Pareto-optimum situation an improvement in utility for one person is
always at the expense of someone else. Fortunately, this Pareto-optimum is created by a free-
market economy with perfect competition in which all participants will try to optimize their
utility. The resulting income distribution is Pareto-efficient. Here the basic but implicit
assumption is that we cannot measure or compare individual utility and thus cannot assess the
national welfare effects of income redistribution. In a Pareto-optimum any change in income
distribution will increase someones welfare at the expense of someone elses. Given the
impossibility of comparing a gain in utility (welfare) with a loss in utility (welfare) of
someone else, Pareto does not offer an economic theoretical argument for changing the
existing income distribution when it comes to maximising national welfare.
When considering welfare effects of economic developments either through
government interference or through market forces economists usually also are interested in
the possibility of a so-called Potential Pareto Improvement. A potential Pareto
improvement could exist when changing economic conditions might result in a utility gain for

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A at the expense of a utility loss for B. If As gain in utility would be larger than Bs loss, that
is if As gain would be large enough to compensate Bs loss completely and A still has some
gain left, a potential Pareto improvement exists. Usually economists consider a Potential
Pareto Improvement to be an increase in total welfare. However, it has to be stressed that the
implied compensation might be feasible theoretically, but does not have to occur in reality.
That is why it is called a potential improvement.
Also, it must be pointed out that generally winners and losers are not individuals, but
groups of people or institutions, as for example consumers and producers or employers and
employees. If consumer surplus (Parkin, p. 107) rises more than producer surplus (Parkin, p.
109) decreases, total welfare will increase; this is clearly a potential Pareto improvement.
Whereas Paretos approach towards utility generally does not supply us with an
argument for welfare redistribution, the Pigouvian welfare theory provides us with an
instrument to assess changes in an existing welfare distribution. Using the well-known law of
diminishing marginal returns, Pigou argues that increasing additional money (earnings)
results in decreasing marginal utility (compare Parkin, p. 441, figure 19.1). Furthermore,
identical utility functions for all people are implied. Therefore, according to Pigou, it is
possible to compare changes in welfare distribution between people. Equating utility with
welfare, the Pigouvian welfare theory enables us to assess the effects of income redistribution:
a certain amount of money transferred from rich people results in a decrease in welfare
smaller than the increase in welfare experienced by poorer people receiving that amount of
money. This suggests that general welfare will increase by transferring income from richer to
poorer people because the latter have a higher marginal utility of money.
The Pigouvian welfare theory, also known as the subjective welfare theory, provides
us with a theoretically supported argument in favour of income redistribution policies as
practiced by many governments (see Parkin, p. 429). This is because the Pigouvian welfare
theory suggests that total national welfare is maximized when all incomes are equal.
The Pigouvian welfare theory has been heavily criticized, however, because it is
impossible to measure individual utility attributed to goods or money. Because individual
people attach different utility to goods and money it is impossible to assess changes in
individual welfare as measured through utility. This is why most economists usually use
Paretos welfare criterion. The downside is that any verdict on the consequences for welfare
of income (re)distribution is impossible.

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2. Oligopolistic behaviour and game theory
An oligopolistic company might face decision-making problems that do not fit into the normal
micro-economic free-market model. To assess the consequences of a decision regarding price
and quantity an oligopolistic firm needs to know the decision made by its competitor (Parkin,
p. 320-323). Game theory demonstrates how these competing firms, assuming they are not
informed in advance about the decision of their competitors, end up in the least profitable
position for both if they do not find ways to co-operate.
Let us assume just two companies operate on the market for Cola and let us call them
P.Cola and C.Cola. For each company, profits depend on the market operations (behaviour) of
the other company. Each company faces a choice between maintaining and lowering its price
(for the sake of clarity we ignore the possibility of a price increase).
For both companies lowering its price would be most profitable, provided however its
competitor does not lower prices. In that case the company would sell (much) more and hence
increase its profit to 5 in our example (see table 1). Of course, for the Cola market as a
whole it would be best if both companies would not lower their prices in our example both
would make a profit of +3 resulting in a total market profit of +6. But if P.Cola does not lower
its price, C.Cola could make a larger profit (+5 in our example) by lowering its price and vice
versa. Now take a moment to consider all possible options and their results as given in table 1.
It does not take long to realise both companies face a prisoners dilemma. The prisoners
dilemma is one of the most used and well-known examples of game theory.

Table 1. Prisoners dilemma in the Cola market

P.Cola company
10 % price no price
decrease change
10 % price P.Cola: 0 P.Cola: -2
decrease C.Cola: 0 C.Cola: +5
C.Cola company
no price P.Cola: +5 P.Cola: +3
change C.Cola: -2 C.Cola: +3

In facing this dilemma, both companies opting for an unchanged price level would be the best
rational outcome. Companies, however, do not know what their competitors decide; all they

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know is there is a reward for an individual company deciding to decrease its price and there is
a penalty for a company failing to decrease its price when its competitor does!
Despite this dilemma game theory suggests there is a possible equilibrium, the so-
called Nash equilibrium (Parkin, p. 323 - also known as the dominant strategy
equilibrium). This equilibrium is arrived at by considering the outcome of ones strategies
based on the possible strategies of a competitor. So, what would be best for C.Cola? To
answer this question we take a look at both possible strategies its competitor P. Cola has and
their consequences for C.Cola.

1. P.Cola decreases its price by 10 %. If C.Cola maintains its price level it will suffer a loss of
2 (see table 1), whereas decreasing its price will result in neither a profit nor a loss.
Conclusion: in this case the best strategy for C.Cola is to decrease its price level to avoid
losses.

2. P.Cola maintains its price level. If C.Cola decreases its price level it will generate a profit
of 5 (see table 1), whereas maintaining its price will result in an extra profit of 3. Conclusion:
in this case the best strategy for C.Cola is to decrease its price to acquire the highest profits.

So, whatever P.Cola does, it is always best for C.Cola to lower its prices. By symmetry, what
is true for C.Cola is also true for P.Cola. As a consequence both companies will decrease their
prices and do not have a reason to reconsider their strategy after learning their opponents
strategy! This is what is called the Nash equilibrium; it is an equilibrium precisely because
no company has a reason to reconsider its strategy.
The Nash equilibrium in our example results in no profits for either company, but for
both companies taken together this is not the best result. Had both companies decided not to
lower their prices they would have both made a profit of 3. Neither company, though, could
take the risk of not decreasing its prices because of the losses it would incur had its competitor
decided to lower its prices. Hence, it would be profitable for both companies to start co-
operating, for example by creating a price cartel. If both companies together decide to not
lower their prices, this will result in both earning a monopoly profit.
A cartel is a way to avoid a price war between oligopolistic competitors. Of course,
there is the danger of one of the participating companies lowering its prices unilaterally to
acquire a larger extra profit. However, as soon as the others lower their prices too, the whole
market will be worse off. As a consequence of a (usually secret) cartel, oligopolistic

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competitors do not compete with their prices but on other assets of their products, something
you can verify yourself by looking at their advertisements.
Cartels, as a general rule, are not easy to maintain, because:
- if attractive, other firms also seek admission to the market and are thus complicating
decision-making
- participating firms all have an incentive to cheat in order to produce more than their
allocated share (free-rider problem)
- high profits and prices will make it profitable for competitors to remain outside of the
cartel: in that way they can produce as much as they like and still profit from high
prices
- cartels and collusion to manipulate prices are strictly forbidden by several laws.

3. Nominal and real data

An increased value of total production (Gross Domestic Product (GDP)) between two periods
reflects the (combined) effect of two distinct developments over time:
1. a rise in the production of goods and services; and
2. a rise in the prices of those goods and services.
Both developments occur at the same time, but only an increase in the amount of goods and
services produced contributes to a higher standard of living. Higher prices only increase the
cost of living.
Usually, total production in a given period is measured in volume produced times
price paid per unit in that period. Economists call the resulting data nominal data or data in
current prices. A running series of nominal yearly data, however, is not a good starting point
for comparing the economic performance in those years. For such a comparison economists
need real data or deflated data, that is: data that reflect changes in output of goods and
services only.
There are several methods to construct such deflated data, which all boil down to one
essential mathematical correction: removing the impact of changes in prices from the data. To
do so, data on prices for goods and services is needed for both periods. By comparing the
price of a certain good in year T with the price of the same good in year T+1 the rise in price
can be calculated and then be used to correct the nominal data. Suppose GDP has increased by
5% over a certain period and prices have gone up with, say, 3% over the same period, the
question is how much of GDP growth must be attributed to price increase or inflation and

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how much to increased output? It will be easy to see the answer is not exactly 5% - 3% = 2%
because additional output is also sold at higher prices. We need a more sophisticated
approach. Assume GDP (Y) was 1400 in year T and grew to 1470 in year T+1 (which
constitutes a 5% increase) and prices were 50 in year T and 51.5 in year T+1. We then can
calculate what is known as a price index (PI) for year T+1:
51.5
Pt+1 = [ ------- x 100 ] = 103 (a 3% rise)
50
or as a general formula:
Pt+1
PIt+1 = ------ x 100
Pt

This is called a (price) index because in the base year t = 0, PI = 100.

To calculate the real growth (or fall) in total production we use the following formula:
(Nominal)GDPt+1 1470
(Real)GDPt+1 = ------------ x 100 = ----- * 100 = 1427
Price index t+1 103

So the (real) GDP in year T+1 = 1427 in prices of the base year T = 0. The real GDP growth
[1427 - 1400]
then is -------------------- * 100 % = 1.9%
1400

The way a price index was calculated here is just one (simple) way of doing it. There are
several more and more sophisticated possibilities, depending on the use they have to be put to.
Remember, however, that a Price Index (PI) is needed to calculate real growth from nominal
data.
PIs are useful to enable comparison and analysis over a period of years, but are also
applied for comparing countries as national price levels may vary.

4. Economic growth
Generally, an increase in total national production is what economists call economic growth.
A more refined concept focusing on standard of living increase of economic growth is
known as per capita growth of production. Once this growing output per capita turns into

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an almost completely self-sustained growth, economists use the phrase modern economic
growth. Modern economic growth refers to an economy with an increase in per capita
production on an (almost) yearly basis. To measure the size of total production on a yearly
basis economists use Real Domestic Product, Real National Income or comparable measuring
instruments. Real indicates that the original yearly figures have been deflated with an
appropriate price index (PI). A frequently used measure is Gross Domestic Product or GDP.
To express economic growth the percent change in comparison with the previous year
is calculated. Or in formula:
[(GDPt - GDPt-1) / GDPt-1 ] * 100%.
Here, when considering any kind of growth, the same principle will be used, i.e. investment
growth will be formalised as:
[(It - It-1) / It-1] * 100%.
Assuming 1980 (real) Investments amount to 418 and those for 1981 to 439, investment
growth between 1980 and 1981 is calculated as [(439 - 418) / 418] * 100%, which works out
as 21/418*100%, or 5.0%.
Total production in an economy is depending upon different factors of production and
their respective amounts used in the production process. Increased availability and use of a
factor of production will result in an increase in total production. Factors of production can be
differentiated as:
1) (untrained) labour
2) human capital
3) physical capital
4) natural resources, including land and mining
5) entrepreneurship.

It is easy to see that factors of production can increase in case of population growth (increase
in available labour), by extended education (increasing human capital),1 by investments
(increasing physical capital) and through land cultivation and new mining (increasing natural
resources).
For the sake of simplicity, these five factors of production usually are summed up in
two, compound, factors: labour (including human capital) and capital (including physical
capital and natural resources). If, for the moment, we ignore labour and investments in labour,

1
Sometimes Human Capital is also reckoned to be part of the Capital.

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Net Investments represent the increase in capital employed in the economy, known as capital
stock (Parkin, p. 534). Gross investments include both investments in the increase of capital
(net investment) and investments in replacing depreciated capital. The latter investments are
needed to maintain the existing level of output and do not result in economic growth (Parkin,
p. 462).
Net investments, investments that generate economic growth, can be either aimed at
increasing capital stock with the same type of capital employed already (extensive investment
or capital-widening-investment) or at replacing existing capital goods with more productive
capital stock (intensive or capital-deepening investment). In the latter case productivity
(production per capita / labourer) will increase, because this type of investment requires less
labour for the same amount of production. Eventually, because of technological innovation,
investments will result in replacing labour with capital stock.
The factors of production are crucial in the Neo-Classical growth accounting method
developed by Robert Solow. Neo-Classical here refers to the assumption that an economy is
always in equilibrium with no unemployment and a fully utilised capital stock. Market and
price mechanisms clear all markets, including those for labour and capital. In addition, the
Solow model does not require a fixed relation between the amount of capital and the amount
of labour employed in an economy.
The Solow model states that total production of a company or country depends on the
amount of factors of production utilised in the production process. This is exactly what is
included in a production function:

Yt = f (Kt, Lt)
where:
Yt = real total production in year t;
Kt = total capital stock in year t;
Lt = the amount and quality of labour utilised in year t; and

f indicates this is mathematical function.

N.B. Following Parkin et.al. we use K to indicate Capital and C to indicate Consumption.
Labour shows up as L and land as Gr.

The increase of real total production (economic growth) now depends on the increase in the
amount of labour and capital utilised.

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This production function is mathematically rather indistinct, also because the formula does
not specify the exact relation between the amount of labour on the one and the corresponding
amount of capital stock on the other hand. A mathematical function providing just that is the
much used Cobb-Douglas production function:
Yt = t * Kt * Lt1-
In the Cobb-Douglas production function t and both are technology coefficients, whose
levels are dictated by the existing technological plane. Generally speaking, can be seen as
technology embodied in the capital stock, although it also includes several other factors
influencing overall economic growth. Thus, if increases, total production will increase
without an increase in the factors of production. The symbol indicates the impact of capital
stock K on total production; 1 - represents the impact of labour on total production. The
symbols and 1- are known as the weights in the Cobb-Douglas production function.
A more complex Cobb-Douglas production function with three factors of production is
also possible. In developing countries in particular, the amount of available land still
constitutes an important factor in determining total production. Let Grt stands for the amount
of cultivated land (ground) in use in year t and for its associated weight:

yt = t * Kt * Lt1-- * Grt
Characteristic for a Cobb-Douglas production function is what economists describe as
constant returns to scale. Using the last production function and assuming a 10% increase in
K, L and Gr, this means total production (Y) will increase with 10% as well. This is because
+ (1--) + (the weights in the production function) sum up to 1.
Still assuming an increase in K, L en Gr of 10% each, economists use the expression
increasing returns to scale when total production increases with more than 10%. Increasing
returns to scale are considered to be the benefits of an increasing size of the production
process associated with increasing cost efficiency. Although increasing returns to scale are not
uncommon for companies, on a national level they are very unlikely to occur. Therefore,
increasing returns at the national level are considered to be highly improbable. In the same
way decreasing returns to scale at the national level are unlikely. If, in our example, total
production would increase with less than 10% this has to be attributed to a decreasing quality
of one or more factors of production. Again, this may occur within companies, but not at a
national level. Hence the idea that a Cobb-Douglas production function with constant returns
to scale is suitable for study of economic growth at the national level.

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 We saw that indicates the level of technological development to a large extent. The
symbols , (1--) and indicate the weight or contribution of the associated factors of
production. It can be proven that these weights by and large correspond with the
compensation for the use of their related factors of production and hence represent the income
distribution in an economy. Thus, indicates the share in the national income of interest and
profit, 1-- that for wages and the share of rent (or land lease). So, if = 0.2 the share of
rent in national income amounts to 20%.
Rewriting the production function in order to bring out the growth rates for labour,
capital, land and production results in the following formula:
yt-yt-1 t-t-1 Kt-Kt-1 Lt-Lt-1 Grt-Grt-1
= + . +(1--). + .
yt-1 t-1 Kt-1 Lt-1 Grt-1
This formula shows the growth rate of total production to be dependent on the growth rates of
technological development (), of capital stock (K), of labour (L) and the growth rate of land
(Gr). Using the symbol g to indicate the respective growth rates, the previous formula can be
rewritten as follows:
gy = g + * gK + (1--) * gL + * gGr
Now suppose the level of technological development increases by 2% yearly, capital stock
with 2.2%, labour with 1.4% and land with 0.1%. We also know the weights for capital stock
and land to be 0.3 and 0.2 respectively; by implication the weight for labour is 0.5 as the
summed weights have to amount to 1. We now can calculate the growth of national income as
follows:
gy = g + * gK + (1--) * gL + * gGr
= 2.0 + 0.3 * 2.2 + 0.5 * 1.4 + 0.2 * 0.1
= 2.0 + 0.66 + 0.7 + 0.02 = 3.38 (%)
Yearly national income growth thus amounts to 3.38%. Economic growth, however, will be
less if it is measured in income per capita. Assuming population growth to be roughly the
same as the increase in labour utilised in the production process (1.4%), yearly economic
growth per capita can be estimated at 1.98% (3.38% 1.4%), or about 2%.

The previous formula allows economists to use what is called growth accounting as a
method to study national economic growth. Where and are known, it is possible to
determine the respective contributions to economic growth of (increased amounts of) capital
and labour utilised in the production process. In the same way the contribution of an increase

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in technological development () can be measured. An increase in is also known to
economists as an increase in total factor productivity, as a growth in indicates the size of
increases in joint labour productivity and capital productivity.
In real life, actual yearly increases in real national product, the amount of labour and
capital employed or the amount of cultivated land are statistically known or quantifiable. The
unknown factor in real life, when it comes to assessing economic growth, is the contribution
of technological development (which is otherwise difficult to measure directly!). However,
also includes other factors such as climate effects, war etc. Using the Neo-Classical Solow
model and a Cobb-Douglas production function, however, the impact of technological
development can be estimated.
B. van Ark and H. de Jong in their article `Accounting for economic growth in the
Netherlands since 1913', Economic and Social History in the Netherlands 7 (1996) present
data for The Netherlands in the period 1913-1994. Yearly growth of Dutch GDP amounted to
2.99%, while labour employed in the production process increased with 0.44% per year and
the amount of capital (here including land) utilised with 3.48% per year. Furthermore, they
estimated at 0.32. The increase in total factor productivity can now be calculated as:

g = gY - .gK - (1-).gL = 2.99 - 0.32*3.48 - 0.68*0.43 = 1.58.

Total factor productivity represents technological progress as embodied in the production

process, which in The Netherlands grew with a yearly average of 1.58%. Consequently, Van
Ark and De Jong concluded that more than half (1.58% vs. 2.99%) of the Dutch economic
growth between 1913 and 1994 stemmed from technological improvement during that period.
However, it has to be remarked that the estimate of the contribution of total factor
productivity growth to economic growth drops to 1.21% yearly, if we would take into account
the contribution of the increase in human capital due to better education.
The Neo-Classical growth theory predicts a movement towards a process of steady (or
balanced) economic growth. That is, in the long run economic growth will equal the growth
in capital stock (but note the previous example for The Netherlands!). This is because the
increase in capital stock is depending on investments paid out of national savings. Now,
national savings constitute a more or less constant share in National Income or National
Product. Thus, growth of capital stock is directly depending upon total production, implying
in the long run an equal increase for both.

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 As noted earlier, the Neo-Classical model can not account for unemployment because
it presupposes full utilisation of all factors of production. Under-utilisation of labour
(unemployment) in this model results in lower wages as labour is relatively more abundant. In
turn, lower wages will tempt entrepreneurs to use more labour in their production process now
that the price of labour declines relative to that of capital. In this model, reducing wages will
automatically result in disappearing unemployment and the production process will become
more labour intensive and capital extensive.
A surplus of capital in any given economy will result in precisely the opposite
movement. The price of capital, that is the interest rate, will fall relative to the price of labour.
The lower costs of using more capital and less labour now entice entrepreneurs to substitute
labour for capital. This increased demand for capital will clear the market for capital.
The Neo-Classical model does not allow for plants to be under-utilised or for labour to
be laid off. In those circumstances the prices of factors of production will fall, inviting
entrepreneurs to increase their production by hiring more labour and ending under-utilisation
of plant. Free market and the price mechanism therefore ensure the economy will be in
equilibrium.
The Cobb-Douglas production function indicates that an increase in the amount of
labour employed will result in an increase in total production smaller than the initial increase
in labour. This is often seen as a consequence of the law of diminishing marginal returns
on labour, which holds when all other circumstances remain the same the famous ceteris
paribus condition. A simple example will clarify the reason. Assume two factors of
production, labour and capital (consisting mainly of land) with labour input growing with 2%
and capital input, being land mainly, does not change; assume also no technological
improvement. If weight is 0.4 and therefore 1 is 0.6, the Cobb-Douglas production
function approach works out as:

gy = g + .gK + (1-).gL = 0 + 0.4*0 + 0.6*2 = 1.2

This shows total production increases with less than the increase in labour input: 1.2% versus
2.0%. Consequently, production per labourer, and probably also production per capita, will
fall.
Here we have the reason why classical economist Malthus warned against excessive
population growth: the law of diminishing marginal returns on labour predicts a decline in
production per capita and hence a decline in living standards. Continued population growth

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would seem to result in food shortages and hunger crises. The Cobb-Douglas production
function, however, confirms that this relation between population growth and declining
productivity particularly holds for societies where land availability is the most important
factor of production that is: for agrarian societies. The function also suggests this so-called
Malthusian trap can be avoided through (rapid) technological development, or through a fast
increase in capital stock or human capital. In this way, economic growth (and the standard of
living!) can keep pace with or outperform population growth.

As an alternative to Solows Neo-Classical model of economic growth, economists point at

the Keynesian Harrod-Domar model. In essence this is a rather uncomplicated model,
differing from the Solow model in that the Harrod-Domar model assumes a fixed ratio
between capital stock and labour employed in the production process (but note technology
changes might change the ratio, thus enabling per capita economic growth). Ignoring
technological improvement, total production then depends solely on the amount of capital
stock utilised in the production process. The capital stock can increase through savings that
result in investments. Capital stock in the Harrod-Domar approach is seen as a proxy for a
certain number of jobs. Still ignoring technological development and assuming abundant
labour supply, a doubling of the capital stock will provide for twice as many jobs as before. If,
however, the number of jobs available in the economy falls short of the population growth
(the labour supply) unemployment will be the result. Whereas the Neo-Classical model does
not allow for unemployment, the Keynesian model implies (lasting) unemployment is
possible.
In the Neo-Classical model unemployment would disappear because of lower wages
stimulating entrepreneurs to hire more labour the market for labour would be cleared.
Keynesians, on the other hand, acknowledge the possibility for unemployment to develop a
more structural nature. They consider the mechanisms to re-establish an economic
equilibrium to be weak.

5. Business cycles and economic swings

In addition to the long term trend line growth, economic growth is also characterized by
fluctuations. These swings take more or less the graphical shape of a sinus pattern, with
alternating phases of higher and lower economic growth.

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 Reasons for cyclical developments in the economy are, despite the existence of a
number of theories on the subject, not very well understood by economists. For the economic
cycles recurring every about 8-12 year three possible explanations have been put forward:
1. a periodical shortfall in effective demand. This results from under-consumption,
which eventually will be followed by overconsumption;
2. alternating under- and overinvestment as a consequence of lagged decisions in
industry and other firms;
3. a monetary development causing investment swings.
These explanations point towards the demand side of the economy, where in most cases
cycles in investment are held responsible for swings in economic performance.
The Keynesian multiplier-accelerator-model contains a description of how economic
cycles might come about. The model assumes investment decisions to depend on the
economic growth rate in the previous year. Previous high economic growth invites
entrepreneurs to increase investment in the running year, because they expect a future
increase in their sales. Investment decisions therefore lag behind economic development. This
problem is aggravated by the delay in putting into operation the capital goods bought with the
investment. By the time production is actually expanding, economic growth might have
slowed down. In reaction companies will strongly reduce their investments and thus
contribute to the economic downturn.
The model points at lagged decision-making and overshooting by companies when it
comes to reacting to changes in consumer demand. Rising demand generates more
production, but by the time the necessary plant is ready to operate their total production
exceeds consumer demand. The resulting supply surplus forces down prices and creates
under-utilisation of production equipment. This mechanism is frequently cited as one of the
causes of the Great Depression in the 1930s, as well as a possible cause for the economic
crises in the 1970s and 1980s.
Pig cycles, also referred to as the cob-web model, offer a similar kind of explanation.
Here, producers base their future production on sales in the previous period, like in cattle
raising where the required number of cattle in year t requires breeding decisions in year t-1.
When the price of pork is high in year 1, farmers decide to increase their production of pigs
for year 2. This decision has to be made in year 1, because bringing up piglets takes at least 6
months. The result is predictable: in year 2 there will be an abundant supply of pigs and prices
will fall. Now bringing up pigs seems much less profitable and farmers will reduce their
production of pork for year 3. This necessarily lagged production decision by farmers and the

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long production period result in (strong) fluctuations in amount and hence price of pork
offered on the market.
All these explanations relate to the real economy, that is: to the economy of goods and
services. There is a monetarist view, however, which holds the government responsible for
the ups and downs in economic growth. Their arguments focuses on (irregular) swings in
money supply: because the money supply affects inflation, swings in money supply hinder
both companies and households in targeting inflation correctly, with economic instability as a
result.
Initially, surplus liquidity of the banks is responsible for a low interest rate. Surplus
liquidity is a term used to describe a situation in which banks hold cash they want to lend to
make a profit. A low interest rate entices companies and households alike to borrow money,
as a result of which investment boosts and consumer credit increases. Now the economy
moves towards a boom: unemployment falls and might turn into labour shortage with plants
being over utilised at the same time.
After a while the growing quantity of money in circulation outside the banking system
reduces the surplus liquidity of the banks, forcing them to reduce the creation of money
through lending. Rising interest rates slow down the increase in the quantity of money by
reducing investments and consumer expenditure. This, in turn, will restrain economic growth
and create a depression.
In times of depression the demand for money from companies and households will
fall, bringing down interest rates. Liquidity of the banks increases again because more money
will be kept in cash. Eventually, surplus liquidity of the banks will recur and the cycle starts
all over again.
Economic cycles in the monetarist view, therefore, are caused by fluctuations in the
quantity of money and the interest rate. They hold governments and Central Banks
responsible as it is their duty to minimise these fluctuations. Please note that here again cycles
are essentially due to shifts in effective demand and investments.

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