Production Cycle Theory of Vernon Production cycle theory developed by Vernon in 1966 was used to explain certain types of foreign direct investment made by U.S. companies in Western Europe after the Second World War in the manufacturing industry. In actuality, cyclical fluctuations are caused by expansion and contraction of bank credit which, in turn, lead to variations in the flow of monetary demand on the part of producers and traders. But it has failed to explain revival. The Product Life Cycle Theory is an economic theory that was developed by Raymond Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of international trade.The theory suggests that early in a product's life-cycle all the parts and labor associated with that product come from the area where it was invented. Hawtrey believes that trade cycle is nothing but small scale replica of inflation and deflation. According to this theory, the spot that appears on the sun influences the climatic conditions. Since income at this level is decreasing relative to the previous stage of the cycle, there is a decreased amount of investment. It is changes in the level of business activity which cause changes in the growth rate of the money stock. Thus optimism encourages borrowing borrowing increases sales, and sales raise optimism. Second, on the reaction mechanism of the economic system to the disturbances. As a result, investment in capital goods also increases and does not fall. Profits increase and old industries expand by borrowing from the banks. To explain the course of the Keynesian cycle, we start with the expansion phase. (4) Innovation financed through Voluntary Savings does not produce a Cycle: Critics point out that if an innovation is financed through voluntary savings or internal funds, there will not be an inflationary rise in prices. Therefore, it may be stated that banking system cannot originate a trade cycle. Prof. Hawtrey considers trade cycle to be a purely monetary phenomenon. The oldest of all international trade theories, Mercantilism, dates back to 1630. They adopt capital-intensive methods for producing more of capital goods. But empirical evidence shows that the response of investment to a change in output (v) is spread over many periods. (5) Investment does not fall with Increase in Consumer Goods: Hayek argues that with the production of consumer goods and the increase in profits from them, investment falls in capital goods. Hicks explains his theory of the trade cycle in terms of Fig. The theory exaggerates the importance of bank credit as a means of financing development. According to Hawtrey, the process of recovery is very slow and halting. This is shown as the “Secondary Wave” in Figure 2. Keynes’s theory of the trade cycle is superior to the earlier theories because “it is more than a theory of the business cycle in the sense that it offers a general explanation of the level of employment, quite independently of the cyclical nature of changes in employment.” However, critics are not lacking in pointing out its weakness. Full Employment level not Independent of Output Path: Another criticism levelled against Hicks’s model is that the full employment ceiling. But this concept of neutrality of money is based on old quantity theory of money which has lost its validity. Privacy Policy3. are falling. 5. A vicious circle is set up, a cumulative expansion of productive activity.”. This will lead to a fall in MEC. But the majority of economists have criticised him for overemphasising monetary factors to the neglect of non-monetary factors in explaining cyclical fluctuations. To conclude with Dernburg and McDougall, “The Hicks’s model serves as a useful framework of analysis which, with modification, yields a fairly good picture of cyclical fluctuation within a framework of growth. These, in turn, lead to reduction in the demand for factors of production. 1. Second, this is true both for long secular changes and also for changes over periods roughly the length of business cycles. This theory is realistic in the sense that it considers over investment as the cause of trade cycle. The first stage deals with the initial impact of innovation and the second stage follows through reactions to the original impact of innovation. These theories can be classified into non-monetary and monetary theories. (3) Hicks assumes constant values for the multiplier and the accelerator. A high rate of interest will not prevent the people to borrow. In a period of recession and depression, according to Keynes, rate of interest should be high due to strong liquidity preference. According to Hawtrey, prosperity cannot continue limitlessly. Thus “the full employment ceiling” acts as a direct restraint on the upward expansion of the economy. Hicks’s model also pinpoints the fact that in the absence of technical progress and other powerful growth factors, the economy will tend to languish in depression for long periods of time.” The model is at best suggestive. This theory has been formulated by Malthus, Marx and Hobson. Hence this distinction between autonomous and induced investment is of doubtful validity in practice. There will be competition for factors of production between capital goods and consumption good industries. According to this theory, prosperity begins when the market rate of interest is less than the natural rate of interest. But they do not react favourably during the depression phase because traders expect a further reduction every time the interest rate is reduced. MEC is rapidly increasing and rate of interest is sticky. All these will bid up the prices of assets and of both producer and consumer goods. Hicks assumes that autonomous investment continues throughout the different phases of the cycle at a steady pace. Report a Violation 11. Recovery: In the early period of recovery, entrepreneurs increase the level of investment which in … The product life cycle theory has been less able to explain current trade patterns where innovation and manufacturing occur around the world. Joseph A. Schumpeter has developed innovation theory of trade cycles. Looks at how this theory can be applied to international trade especially with regard to competition in the form of … At … This increases or decreases the flow of money in the economy and thus brings about prosperity or depression. The impulse for innovation is reduced and eventually comes to an end. Plagiarism Prevention 5. Further innovation is usually financed by the promoters and not by banks. (5) It ignores the effects of monetary changes upon business cycles. With low profits and reduction in loans, producers reduce the production of capital goods and adopt labour-intensive production processes. Hicks writes in this connection: “I shall follow Keynes in assuming that there is some point at which output becomes inelastic in response to an increase in effective demand.” Thus certain bottlenecks of supply emerge which prevent output from reaching the peak and instead encounter the ceiling at P1. This equilibrium is characterised by Schumpeter as the “circular flow” which continues to repeat itself in the same manner year after year, similar to the circulation of the blood in an animal organism. 7. In spite of its various merits, the Hicksian theory of trade cycle suffers from the following weaknesses its fundamental shortcoming is that Hicks assumes a fixed value of the multiplier during the fixed phases of the cycles. But critics point out that the direction of causation is just the opposite of it. Investment will fall; production declines leading to depression. These cycles are mostly monetary in origin. Before publishing your Articles on this site, please read the following pages: 1. First, as more capital goods are being produced steadily, the current yield on them declines. The product life-cycle theory was developed by Raymond Vernon in the mid-1960s. Critics have pointed out the weakness of Keynes’ theory. This will bid up prices of such assets. The consumption function takes the form Ct= aYt-1 . MEC depends on the expectations of the entrepreneur about future. According to Duesenberry, the ceiling fails to explain adequately the onset of depression. Thus Keynes’ theory is not much different from Pigou’s psychological theory of the trade cycle. The business cycle moves about the line. The induced investment, on the other hand, is dependent on changes in the level of output. Production process being small and labour-intensive, the demand for money is reduced, which increases the market interest rate which is more than the natural interest rate. For this, they pay higher remuneration to factors of production in comparison with the producers of capital goods. There is also much evidence that during business cycles the money stock plays largely an independent role. John Maynard Keynes, one of the most influential economists of the 20th century, never worked out a pure theory of trade cycles, though he made significant contributions to the trade cycle theory.Keynes states, “The trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.” Boom. There is unemployment. Thus in the Keynesian explanation of the trade cycle, “the cycle consists primarily of fluctuations in the rate of investment. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. This will lead to rise in market rate of interest above the equilibrium rate of interest. Hicks’ theory of trade cycle: Prof Hicks explains the phenomenon of trade cycles by combining the … 7. The product life cycle theory is used to comprehend and analyze various maturity stages of products and industries. A monetary change effects different economic magnitudes, some of which adjust faster than others which cause distortions in economic activity, thereby giving rise to the business cycles. Secondly, Keynes assumes that rate of interest is stable. The producers of capital goods invest less in the expectation of loss in the future. Pessimism gives way to optimism. Real income production, employment, prices, profit etc. He has ignored real factors. But it is not free from certain criticisms. There is increase in investment, bank loans and advances. It affects different industries in different ways. Schumpeter’s theory starts with the breaking up of the circular flow by an innovation in the form of a new product by an entrepreneur for earning profit. The economy does not turn upward immediately from Q2 but will move along the slump equilibrium line to Q3 because of the existence of excess capacity in the economy. With the increase in the purchasing power of consumers, the demand for the products of old industries increases in relation to supply. Friedman’s Theory 6. Induced by high profits, they try to produce more. There is a general uptrend in business community. Merchants place more orders which induce the entrepreneurs to increase production by employing more labourers. When the new product becomes successful, other entrepreneurs will also produce similar products. This is based on the Keynesian stable consumption function. These encourage borrowings on the part of merchants and producers. Expanding trade cycle theory beyond that purpose and function was, he believed, fallacious. 41 Downloads; Abstract. These innovations may reduce the cost of production and may shift the demand curve. Forced savings increase with the fall in consumption which are invested for the production of capital goods. Every increase in investment leads to a multiple increase in income via the multiplier effect. As the cumulative process of expansion continues, producers quote higher and higher prices. These effects will raise interest rates on the whole range of assets. (2) Monetary Changes not the Main Cause of Business Cycles: According to this theory, monetary changes are the main cause of business cycles. The Hicksian theory of trade cycle is based on the following assumptions: (1) Hicks assumes a progressive economy in which autonomous investment increases at a constant rate so that the system remains in a moving equilibrium. The latter curtail their productive activities due to fall in demand. In this sense, it is similar to that of Pigou’s psychological theory. International product cycle theory ignored FDI in Asian countries. According to Hawtrey, “Trade cycle is purely a monetary phenomenon” and he strongly advocated that changes in the flow of money are exclusively responsible for the ranges in economic activity which in turn create boom or depression. It does not say anything about recovery. 1. Another factor is the export of gold to other countries when imports exceed exports as a result of high prices of domestic goods. Howtrey’s Monetary Theory Of Trade Cycle: Prof. Hawtrey regards business cycle as purely a monetary phenomenon. TOS4. Thus, the variations in climate are so regular that depression is followed by prosperity. These factors force the banks to raise interest rates and refuse to lend. Meaning of Trade Cycle 2. Theories of Trade Cycle: Many theories have been put forward from time to time to explain the phenomenon of trade cycles. They place more orders with producers. Harrod doubts the contention that autonomous investment would be increasing at the bottom of the depression. Uploader Agreement. This leads to fall in the prices of factors and resources become unemployed. 8. It is in this way that the cyclical process will be repeated in the economy. (5) The carrying out of the new organisations of an industry. Innovations are not inventions. The warranted rate of growth is the rate which will sustain itself. This will increase the demand for consumption goods. Terms of Service Privacy Policy Contact Us, Business Cycles: Meaning, Characteristics and Control, Keynesianism versus Monetarism: How Changes in Money Supply Affect the Economic Activity, Keynesian Theory of Employment: Introduction, Features, Summary and Criticisms, Keynes Principle of Effective Demand: Meaning, Determinants, Importance and Criticisms, Classical Theory of Employment: Assumptions, Equation Model and Criticisms, Classical Theory of Employment (Say’s Law): Assumptions, Equation & Criticisms. If this theory is correct, then industrialised countries should be free from cyclical fluctuations. Hayek’s Monetary Over-Investment Theory 3. This leads to increase in their production. The expansion phase of the trade cycle starts when banks increase credit facilities. According to Hawtrey, “Increased activity means increased demand, and increased demand means increased activity. Hawtrey’s theory has been criticised on many grounds: 1. 4. On the other hand, an increase in the rate of interest will lead to reduction in borrowing, investment, prices and business activity and hence depression. Since consumption is stable during the short-run, revival is possible by increasing investment. As a result, the growth of output and income propelled by the combined operation of the multiplier and accelerator moves the economy on to the upward expansion path from Po to P1. Incomes fall. A boom occurs when real national output is rising at a rate faster than the trend rate of growth. In actuality, traders do not depend exclusively on bank credit but they finance business through their own accumulated funds and borrowing from private sources. Hence trade cycle is a wave like movement. They also cancel orders with producers. Trade Cycle Theory: Goodwin, Kalecki and Phillips. The reliance on the conventional hypothesis makes Keynes’ concept of expectations superfluous and unrealistic. This will create over production in other sectors. When the innovation is adopted by many, supernormal profits will be competed away. And investment decisions, depend upon the psychology of businessmen or producers. According to Hicks, it is the multiplier-accelerator interaction which weaves the path of economic fluctuations around the warranted growth rate. Since investment in an innovation is risky, he must pay interest on it with his newly acquired funds, the innovator starts bidding away resources from other industries. As pointed out by Lundberg, every investment is autonomous in the short run and a major amount of autonomous investment becomes induced in the long run. They further observe that a secular change in the growth rate of the money stock leading to longer period changes in money income are reflected mainly in different price behaviour rather than in different growth rates of output. In this phase, there is a slow rise in output, employment, income and price. Hence there is a smaller amplitude of resulting fluctuations. Consequently, output, employment and income increase. Factor prices go up. This will tend to raise service prices. Equilibrium rate of interest is one at which savings are equal to investment. Ultimately, expenditures rise on all directions without any change in interest rates at all. Secondly, innovation is not the only cause of business cycle. Thirdly, Keynes does not explain periodicity of trade cycle. Employment, output and income fall resulting in depression. 5.Distinction Between Autonomous and Induced Investment not Feasible: Critics like Duesenberry and Lundberg point out that Hicks’s distinction between autonomous and induced investment is not feasible in practice. Authors; Authors and affiliations; R. G. D. Allen; Chapter. If there is a lag in the adjustment of real money balances to the new price level, the initial portfolio adjustment will tend to overshoot. But the term marginal efficiency of capital is vague. Optimism takes the place of pessimism. Its first impact is on the financial markets where first bonds, then equities and only later on payments for real resources will be affected. And also, the more rapid the rate of growth, the shorter the depression.” Another factor which governs the duration of depression is the “carrying costs of surplus stocks.”. Low interest rate induces producers to get more loans from banks. It induces a secondary wave of credit inflation which is superimposed on the primary wave of innovation. Hicks begins from a cycle less situation PQ on the equilibrium path EE when an increase in the rate of autonomous investment leads to an upward movement in income. A business cycle is synchronic. Hayek has suggested that the volume of money supply should be kept neutral to solve the problem of cyclical fluctuations. (6) Inventory Investments do not Produce True Cycles: Hamberg further points out that in Hawtrey’s theory cumulative movements in economic activity are the result of changes in stocks of goods. Schumpeter assigns the role of an innovator not to the capitalist but to an entrepreneur. For this, business houses have to float fresh shares and debentures in the capital market. Thus the competitive impact of an innovation would not increase costs and prices. It is effective demand which determines the level of income and employment. They are business expectations, price changes, cost of storage, etc. The increased demand for assets will spread sooner or later affecting equities, houses, durable producer goods, durable consumer goods, etc. Once the original innovation becomes successful and profitable, other entrepreneurs follow it in “swarm-like clusters.” Innovation in one field induces innovations in related fields. It is associated with W.S.Jevons and later on developed by H.C.Moore. The initial rise in demand will thus be followed by a fall in demand. Further, Hicks’s contention that revival would start with the exhaustion of excess capacity has not been proved by empirical evidence. So for a few years, disinvestment in stocks will continue till the surplus stocks are exhausted. Through international trade, booms and depressions in one country are passed to other countries. This extension of cycle is followed by a period of revival which continues till the equilibrium level is reached. It results in depression. Thus Schumpeter’s theory is not a correct explanation of trade cycles. Further, as admitted by Hicks himself, depression may start even before reaching the full employment ceiling due to monetary factors. Keynes attributes the downturn to the sudden collapse in the MEC. Hence they save and invest which results in an increase in the volume of goods. 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