Economic Cycle

 

Alexander Liss

 

03/07/2009

 

 

     Just when the end of economic cycle was declared it had shown itself with the vengeance.

     There is something in capitalist economy that causes it cyclical development and it is very important to understand the roots of it.

     This is not an oscillation, which one could detect in any stable system; this is something more important, something essential to nature of the market.

 

Economy as Tool of Exploration

 

     Basic needs of people could be satisfied with very primitive economy, even when population grows.

     The market is based on ever growing desires, support for this growth is a major function of the market (usually it is done with sells and marketing).

     Even something that qualifies to be called a need as food, shelter, etc. is wrapped up into the mechanism of satisfaction of desires. This works – a market based society produces an excess of food, shelter, that only a small part of population feel shortage of it.

     Perpetual generation of desires and building systems to satisfy them leads to exploration, exploration in all possible direction – human psyche, places around the world, ways to construct buildings and connect banks of the river, etc. As long there are things to explore, there is the way to expand the market.

A new idea, which fits the market (new product or service, improvement of existing product or service, novel way to increase desires for products or services, etc.), could start a process of local expansion. Numerous local expansions interact with each other and serve as a basis of market expansion.

Finding an idea, which fits the market and getting funding for it always require exploration in various directions.

In addition, in the process of expansion, limits of environment, society and knowledge are tested and loosened. This is exploration.

 

Exponential Growth

 

     The idea, which got funding, continues to receive funding as long it could support sufficient market expansion. Support of market expansion is measured in generated profit and it is sufficient as long the level of profit is sufficient.

     Expansion is done with putting more efforts into the area of the market “surrounding” this idea, as product or service creation, marketing, etc. The quantity of these efforts is determined with funding. Hence more funding is put in the area.

     Often, the level of additional funding is defined as a share of additional profit generated because of this idea. In a simple case, the profit is proportional to level of funding and hence in any given moment, funding increment is proportional to funding. This is an equation, which defines exponential growth of funding and profit.

 

Hitting a Bound

 

     Experience shows that profit stays proportional to funding only for some time. Inevitably, the moment arrives, when the ratio of profit to funding starts to diminish. Often, this happens because some bound is encountered, which was not present at the beginning of the process of expansion. It could be that one reached limits in resources, or limits of ability to generate desires (for example, many people already have the product, or there is a limited speed of consumption of the product or service).

     When such bound is encountered, the expansion slows down; it is not exponential any more.

     This is a familiar pattern; one often observes it in the growth of company’s stock – a famous S-shaped curve. It starts with exponential growth, slows down to linear growth and eventually stagnates.

     Note that the “location” of this bound is not known upfront, had it been known, it would be avoided. Hence, the market “finds” this bound through its natural process of expansion. It is a tool of exploration.

 

Effects of Competition

 

     There is another reason why the ratio to funding start diminishing – competition.

     In the market practically always there are a few competing products and services, which correspond to competing ideas. Different competing products and services are not identical, they differ in what they offer and how much they cost; they form a set of partially exchangeable products and services.

     Often, not a separate product or service and corresponding idea should be analyzed, but a complete set of partially exchangeable products and services. In such set, there is an overall volume (quantity of units) and a distribution of volume among elements of the set.

     As in the case of a single product, initially the ratio of profit to funding is fixed for all elements of the set and there is exponential expansion for all of them, however at some point, the entire set hits the bound in its expansion. Some elements in the set are more affected by this bound then the other. Hence, two results could be observed, when the bound is hit. First, overall expansion slows down. Second, this slowdown is distributed unevenly between elements of the set – the distribution of volume changes.

     Eventually, some elements in the set meet their end, while others continue to exist. New elements are added at some point also, elements, which fit better in newly discovered situation with the bound present. Hence, the set of partially exchangeable products and services is changing.

 

Numerous and Unknown Bounds

 

     Had it been only a few such bounds, and had they been known, the society would learn well, where they are and found ways around them. Hence, it would be no issue with bounds.

However, there are many bounds and they are not known upfront. One has to expand the market just to find them and only then one could invent the ways to work around them.

     This pattern could be seen in all views on the market: local view, focused on one company or even on one product line, an aggregate industry-wide view or even nation-wide or global view of the market.

     This phenomenon injects genuine randomness in market operation. It is not known, when these bounds are to be hit, and it is not known how to work around them.

Some forecast and modeling could be done, and it is done. This reduces uncertainty, but does not eliminate it.  This modeling and forecast is an important part of the activity of market participants.

 

Contraction

 

     Expansion ensuing from the idea could be restricted by bounds to a different degree. In mild cases, expansion slows down, but still exponential. In more severe cases, expansion becomes linear or even could stop and become stagnation.

     In even more severe cases, expansion is impossible and the only way left to operate could be contraction.

     Operating during contraction is substantially different from operation during expansion. For example, covering warranty obligations during contraction is relatively more “costly” than during expansion. During contraction, fewer new units of the product are coming to the market, then during expansion, and correspondingly the cost of covering warranty is spread over smaller number of new units.

     Hitting contraction is natural market phenomenon; usually it precedes the end of useful life of the idea.

 

Uncertainty at the Bound

 

When the market in its expansion approaches the bound, it is felt. Business situation starts deviating more than usual from business forecasts – uncertainty increases. This leads to less successful business planning and increased volatility of markets. A formerly promising idea suddenly does not work as well as expected – it does not produce expected expansion or even related business could start contracting.

Sensitive market participants read the signs and bring in new ideas. However, often, people try to solve the problem by doing more of the same – cutting cost, increasing advertisement, etc. When there is a bound hit, doing more of the same does not help.

 

Life Cycle of the Idea

 

     First, from a large number of potentially useful ideas, only a few get funded. From those, which get funded, only a few fit the market and start the process of (incremental) expansion.

     Initially expansion is exponential, but eventually a boundary is hit and it slows down and even could be replaced with contraction.

     To analyze this slowdown, one needs to take in consideration a set of all other ideas ‘active” in the market, which brought to existence products and services partially exchangeable with a given one.

     The end of life for the idea could be discontinuation of the product or service, or introduction of new ideas, which supersede this one.

Many ideas go through all phases from expansion through stagnation and contraction. It is rare that ideas are cannibalized and new ideas are introduced before useful life of the original idea is exhausted.

Note that it is impossible to predict the duration of life cycle of each idea from introduction, through expansion, stagnation and contraction to the end. The duration shortens, when a new unknown bound is hit. Hence, one has to assume that the duration and the distribution of phases of the life cycle of an idea are random. One could try to predict it, but essentially cannot extend it.

Note also that when a severe bound is hit, many ideas quickly come into a contraction phase simultaneously.

 

Hierarchy of Ideas

 

There are “large” ideas and ideas “improvements”. For example introduction of a new product or service should be viewed as a “large” idea and incremental modifications of it should be viewed as “improvements” of this “large” idea. Another example would be setting up a business, which controls production of many different products and services should be viewed as a “large” idea in relation to ideas causing existence of these products or services.

Depending on point of view, one could focus on particular type of ideas and ignore related ideas “increments”.

Hence, this approach with ideas in the market allows generation of large variety of useful models.

 

Stream of Ideas

 

In the market, there is a perpetual stream of ideas driving its overall dynamic.

Ideas are introduced into the market randomly and they vary in speed of their initial expansion.

All ideas have similar shape of life cycle, but different durations and distributions of phases. These durations and distributions are essentially random.

Sometimes, lifecycles of many ideas are cut short virtually simultaneously, because the market as a whole hits a set of bounds, which affect many ideas. For example, harsh social situation, as a war, could reduce overall variety and extend of desires of the society and thus reduce durations of lifecycle of ideas caught in such period.

 

Funding

 

In developed markets, funding is done by specialists. Such division of duties leads to more efficient functioning of the market. This division could be done inside one company, where there is specialization in design, production, sales and financial decision-making. In many cases specialization goes even further with mechanisms of credit, borrowing, bonds, etc.

Such specialization is warranted, because funding decisions have to deal with long time horizon, take in consideration potential losses associated with risk taking and have to provide means to survive during downturns due to economic cycles.

Economic modeling and forecast are main tools used in funding decisions.

 

Skills

 

The mechanism of ideas and induced expansion of the market is based on specialization of market participants.

One type of specialists invents large number of new ideas.

Second type filters these ideas and provides funding for some of them.

Third type generates desires and support matching of desires with products and services associated with the idea (marketing, sales, and distribution).

Fourth type maintains stability of the process (introduces minor updates, maintains uniform production of units of product or service in spite of varying conditions).

Sometimes the same person acts in roles of different specialists, but more often different roles are played by different people.

Specialists are market participants in a more organized part of the market. They are compensated for their efforts according to rarity of their skills.

 

Satisfying Needs

 

At some point, it was discovered that it is possible to use the market to satisfy needs of the society as food, close, shelter, etc. This allowed much higher level of specialization and hence much higher level of overall efficiency of the society in this area.

From this point, a lower bound was imposed on speed of expansion of the market. The market should expand with at least the speed of the population growth.

Theoretically, such growth could be achieved through extensive expansion, where the majority of ideas provide linear expansion matching population growth and expansion is achieved simply by adding specialists with the speed of population growth.

However, this is highly unrealistic. There are disastrous events, and the society has to accumulate cushion to survive them. Society grows unevenly and the excess of growth is needed to compensate for that.  To avoid internal conflicts members of society have to see their well-being improving, hence excess of growth is needed.

Practically, the market has to grow with the speed higher than the growth of population. There is only a limited number of situations, when such growth could be achieved with linear growth – the society has to occupy highly advantageous position for that. The general way to archive it is with the stream if ideas, which provide some periods of exponential growth.

 

Observed Random Oscillations

 

When the market hits a set of severe bounds, many lifecycles of ideas are cut short virtually simultaneously. This leads to contraction of the market in many areas simultaneously.

Hitting such bounds is inevitable; however there is no way to predict when the next such event will happen.

To an observer, who ignores effects of hitting the bounds, this looks as random oscillation of the market, where period and magnitude of this oscillation is unpredictable.

This is exactly what astute observers say about the economic cycle. Each downturn has something new, which never happen before, however in hindsight one could find numerous similarities. The reason of it is unpredictability hitting the bounds.

 

Decreasing Magnitude of Oscillations

 

Market oscillations of high magnitude could bring periods, when society is uncomfortable; hence, decreasing the magnitude of oscillation is desirable.

This could be done with “cannibalization” – perpetual introduction of new ideas, while old ideas are not fully utilized yet. New ideas allow better adjustment to boundaries, which substantially slow down expansion brought by old ideas.

In addition, such regime of market functioning brings overall growth of the market closer to exponential growth and this even could masks oscillations.

Note though that generally the market does not support such behavior. Old ideas, which are close to the end of their life is usually sufficiently profitable and easy to maintain. It is difficult to get funding for new ideas to replace old ideas. Special socio-economic conditions need to be created to stimulate perpetual “cannibalization”.

Various limitations imposed on the market do not eliminate unpredictable nature of hitting the bounds and hence do not decrease the magnitude of oscillations.

Temporary increasing production of existing products and services or temporary increasing demand for existing products and services does not affect oscillations in a positive way.

New products and services, which fit new desires, products, which have a good chance to perpetuate for a long time, are needed to overcome effects of hitting the bounds causing market slump.

 

Mistakes of Marxism

 

Marxism attributed economic cycle to poor planning and consequent overproduction, which in turn shuts financing.

Curiously, too many still think that this is a cause of economic cycle and try to treat a market slump with increased demand to clear overproduction.

Description above shows that causes of the economic cycle are much deeper; they are at very roots of the market. Hence, the market slump cannot be treated through increase of demand for the existing types of products and services. It should be treated using different means, which stimulate introduction of new ideas.

Another mistake was caused by Marxists’ mechanical approach to analysis of the production. In Marxism, the emphasis was made on routine operations of production – churning large quantities of the product (what is called here maintaining stability of the process). The perpetual changing of products, the creation of new desires in the market participants was (deliberately?) left out.

This in turn was used for political means. Those, who churn large quantities of product, were declared a main element in production and political power was demanded on their behalf.

These mistaken views are shared by surprisingly large group of people engaged in study and management of economy. When they apply these views, results are disastrous. They waste resources trying to control the economic cycle through increase of demand in times of economic slump with consequent higher taxation in one form or the other. This leads only to deeper economic slump.

When they are in control of the economy, they orient it on satisfying needs of population and this immediately leads to destruction of market mechanisms and stagnation, because the natural market property of simultaneous expansion of desires, products and services is deliberately constrained in such case. Often, to stimulate economic expansion weapons race is introduced, which naturally leads to aggressive policies.