Let's learn about business cycles to enhance your theoretical knowledge of business economics

Business economics is an area of applied economics that examines business enterprises, the variables influencing the variety of organizational structures, and the interactions between businesses and the labor, capital, and product markets using economic theory and quantitative tools. Similar to how people go through different stages of life, practically every firm goes through several stages of the business cycle. One must first comprehend what business is in order to comprehend the business cycle. In business economics, profit maximization is the short-run or long-run process by which a firm may determine the price, input, and output levels that lead to the highest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.

We hope you have an understanding of the basics of business. If not, then you can go to our business ideas link to understand it in more detail. Now let’s continue with the business cycle further to understand it in detail.

What is the business cycle?

Economics is concerned with fluctuations in economic activity. The economic histories of almost all countries indicate that they have experienced fluctuations in economic activity, i.e., periods of prosperity alternated with periods of economic downturns. Business cycles or trade cycles are the rhythmic fluctuations in aggregate economic activity that an economy experiences over a period of time. A trade cycle is composed of periods of good trade, characterized by rising prices and a low unemployment percentage, alternated with periods of bad trade, characterized by falling prices and high unemployment percentages. In other words, the business cycle refers to the alternate expansion and contraction of overall business activity as manifested in fluctuations in measures of aggregate economic activity such as gross national product, employment, and income. The fact that these economic fluctuations are recurrent and occur periodically is a remarkable feature. In other words, they repeatedly happen but not always at regular intervals, nor are they of the same length at the same time. Some business cycles have been reported to be long, lasting a number of years, while others have been short, lasting only two to three years. Business cycles, or the periodic booms and slumps in economic activity, reflect the upward and downward movements in economic variables.

Having understood the meaning of the business cycle lets us understand the phases of the business cycle.

A typical business cycle has four distinct phases. These are:

Expansion is also known as a boom or upswing.
Peaks, booms, and prosperity
Contraction is also known as downsizing or recession.
Trough or depression

Each one of these is explained in detail as follows:

Expansion: Increased national output, employment, aggregate demand, capital and consumer expenditure , sales, profits, rising stock values, and increased bank credit are all characteristics of the expansion phase. This condition exists until all resources are fully utilized and production is at its maximum level using the productive resources available. Involuntary unemployment is virtually nil, and what little there is either frictional (induced by job changes, work suspensions due to strikes, or labor mobility issues) or structural (i.e., unemployment caused by structural changes in the economy). Costs and prices also tend to increase more quickly. There is significant net investment, which increases demand for all kinds of products and services. Due to high levels of consumer spending, business confidence, production, factor incomes, profits, and investment, overall expanding prosperity is indicated, and people enjoy high standards of living. In time, the growth rate eventually slows down and reaches a peak.
Peak The top, or highest point, of the business cycle is referred to as the peak. Input prices rise as a result of the difficulty in obtaining inputs in the later stages of expansion due to a shortage compared to demand. Rapid increases in output prices can raise the cost of living and put more pressure on people with fixed incomes. Consumers start to reevaluate their consumption expenditures on things like durables, houses, etc. The actual demand is stagnant. This marks the conclusion of the expansion and happens when economic growth reaches a position where it will stabilize for a short time and then move in the reverse direction.
Contraction: The economy can’t expand indefinitely. As we know, once a peak is reached, demand growth stops, and in some sectors, it actually begins to decline. The levels of investment and employment decline during a contraction. Producers retain their current levels of investment and production because they do not immediately sense the economy’s pulse and keep expecting higher levels of demand. A difference, or mismatch, between supply and demand emerges as a result. Supply far exceeds demand. This starts out slowly and only affects a few sectors, but it quickly spreads to all sectors. Producers respond by postponing future investment plans, canceling and stopping orders for equipment and other forms of inputs, including labor, after realizing that they have engaged in excessive investment and overproduction. The producers of capital goods and raw materials respond by canceling and reducing their orders as a result, which in turn generates a chain of reactions in the input markets. The producers of capital goods and raw materials respond by canceling and reducing their orders as a result, which in turn generates a chain of reactions in the input markets. A decrease in input demand pulls input prices down; the incomes of wage and interest earners gradually decline, resulting in a decreased demand for goods and services. Producers lower their prices in order to dispose of their inventories and to meet their financial obligations. The consumer, in turn, anticipates future price reductions and defers making purchases. Reduced consumer spending lowers aggregate demand, which generally results in a fall in prices. The gap between supply and demand continues to grow. The recession gets worse as this process picks up speed. Investments begin to decrease; production and employment decline; and earnings, demand, and consumption of both capital goods and consumer goods decline further. As profit expectations decline and business firms feel pessimistic about the status of the economy going forward, they are compelled to cut back on investments. Bank credit decreases as investment borrowing falls, investor confidence is at its lowest, stock prices drop, and unemployment rises despite wage rate falls. As a result of the severe contraction in economic activity, the recessionary process is now complete and pushing the economy into the phase of depression.
Trough and depression: The most severe form of recession, known as depression, is characterized by incredibly sluggish economic activity. The growth rate turned negative at this stage of the business cycle, and the amount of national income and expenditures rapidly declined. Prices are at their lowest point and are falling quickly, which forces firms to shut down multiple production sites as demand for goods and services decreases. Due to the rising unemployment caused by companies’ inability to maintain their workforce, consumers have very little disposable income. The decline in interest rates is a hallmark of depression. People demand more liquid assets, such as cash, when interest rates are lower. Because investors’ confidence has declined, credit demand has decreased despite decreasing interest rates. Credit availability frequently falls as a result of potential banking or financial crises. Industries suffer from excess capacity, particularly the capital and consumer durable goods industries. Significantly less trade and commerce is conducted as a result of several bankruptcies and liquidations. At the depth of depression, all economic activities touch the bottom, and the phase of trough is reached. Everyone is suffering greatly during this difficult time. The immense pain and agony brought on by the great depression of 1929–1933 is still remembered today. The phases of the diagram have been plotted on the below diagram:

Phases of the business cycle diagram

Graph Explanation: The broken line (marked “trend”) represents the steady growth line, or the growth of the economy when there are no business cycles. The figure starts with a ‘trough’ when the overall economic activities, i.e., production and employment, are at their lowest level. The economy revives and moves into an expansionary phase as production and employment increase. However, since expansion cannot go on indefinitely, after reaching the ‘peak’, the economy starts contracting. The contraction or downturn continues till it reaches the lowest turning point, i.e., the ‘trough’. However, after remaining at this point for some time, the economy revives again and a new cycle starts.

Examples of business cycles:

During the 1920s, the UK saw rapid growth in gross domestic product (GDP), production levels, and living standards. The growth was fueled by new technologies and production processes such as the assembly line. The economic growth also caused an unprecedented rise in stock market values. The UK economy was going through a boom during the 1920s.
China’s recent economic slowdown and financial mayhem are fostering a cycle of decline and panic across much of the world, as countries on nearly every continent see escalating risks of prolonged slumps, political disruption and financial losses. The recent slowdown in China indicates the beginning of a recessionary phase.
The Great Depression 1930: The world economy experienced the longest, deepest, and most widespread downturn of the twentieth century during the 1930s. It began in the US and has spread internationally. Between 1929 and 1932, the global GDP decreased by almost 15%. Income, employment, and production all declined. There are divergent views among economists regarding the causes of the Great Depression. While British economist John Maynard Keynes believed that the Great Depression was brought on by lower aggregate spending in the economy, monetarists believed that the banking crisis and a lack of money were to blame. Many other economists attributed the Great Depression’s primary causes to deflation, excessive debt, decreasing earnings, and pessimism. Whatever its causes, the global economy suffered widespread hardship as a result of the drop in output, employment, income, and spending. In 1933, the global economy started to revive. Some of the factors that assisted economies in gradually emerging from the recession and into the era of expansion and upturn were: increasing money supply; massive international inflows of gold; higher government spending as a result of World War II; etc.
The information technology bubble burst in 2000: The Dot.Com boom, or information technology (IT) bubble, generally spanned the years 1997 to 2000. Numerous new Internet-based businesses, also known as “dot-com companies,” were launched during this time. Starting internet businesses were encouraged to borrow money from the markets in 1998 and 1999 due to the cheap interest rates. Venture investors made significant investments in these businesses as a result of the internet’s quick development and the great potential it offers. Investors were less circumspect because of the overly optimistic market. It was discovered that corporations could raise their stock values by simply prefixing their names with “e-” or by adding “.com” at the end. As a result, their stock prices significantly increased. With the hope of eventually developing enough brand recognition to charge customers profitably for their services, these businesses provide their services or final products for free. These businesses experienced rapid expansion as a result, and a bubble of sorts emerged. Some businesses spend lavishly internally, such as on complex business facilities, due to the “expansion over profits” ethos. These businesses were not long-lasting. The bubble burst between 1999 and 2001. Many dot-com businesses ran out of money and had to be bought out or liquidated. Nearly half of the dot-com businesses were either liquidated or acquired by other businesses. Stock markets collapsed, and economies gradually started to experience a decline in economic activity.
Recent Example of Business Cycle: Global Economic Crisis (2008-09): US financial markets are to blame for the latest global economic catastrophe. The US economy entered a recession after the 2000 burst of the information technology bubble. The US Federal Reserve, the country’s central bank, lowered interest rates to help the economy recover. This led to the banks’ having large liquidity, or money supply. With lower interest rates, credit became cheaper and households, even with low creditworthiness, began to buy houses in increasing numbers. Increased demand for houses led to increased prices for them. Banks and households both assumed that housing prices would rise in the future as a result of rising prices. Due to an abundance of liquidity and the availability of new financial instruments, banks made loans without first determining the borrowers’ creditworthiness. Even sub-prime households and people with no assets or income are sometimes granted loans depending on their goodwill. During the boom, there was an overabundance of housing construction, and as a result, prices started to fall in 2006. In the second half of 2007, the housing bubble exploded. Sub-prime consumers began making significant installment payment defaults as a result of the decline in home prices for which mortgages were held. The banks suffered huge losses as a result. As a result of losses in banks and other financial institutions, the US economy as a whole and the global economy as a whole rapidly suffered the effects.

Impact after a firm reaches the 4th stage of recovery:

The economy cannot continue to contract endlessly. It reaches the lowest level of economic activity, called a trough, and then starts recovering. A trough generally lasts for some time and marks the end of pessimism and the beginning of optimism. This reverses the process. The labor market is where the process of reversal is initially felt. Workers are forced to accept wages that are lower than the going rates because of widespread unemployment. The producers expect lower costs and a better business environment. A period of time occurs when business confidence soars and improves, as a result of which they begin to invest again and build stocks; the banking system begins to expand credit; technological advancements necessitate new investments in new types of machines and capital goods; employment rises; aggregate demand picks up; and prices gradually increase. In a free enterprise system, the price mechanism also functions as a self-correcting process. The economy recovers as a result of increased investment. The transition from depression to expansion occurs at this stage. As investment increases, output rises, employment rises, income rises, and consumers start spending more money. Spending growth results in a rise in overall demand, which in turn drives up production of products and services. Labor force participation rises, the unemployment rate declines, and economic activity expands. It must be highlighted once more that no economy has a precisely scheduled cycle and that economic cycles are erratic. Their length and level of severity vary. They don’t follow any particular pattern. Some cycles may have longer boom times, while other cycles may have longer depression times.

Features of the business cycle:

Different business cycles differ in duration and intensity. But there are certain common features that they commonly exhibit:

Features of the business cycle:

Although they don’t show the same regularity, business cycles do happen occasionally. These cycles have varying lengths. Additionally, fluctuations vary in strength.
The expansion, peak, contraction, and trough phases of a business cycle are clearly defined. Smoothness and regularity are rare during these times. Additionally, the duration of each phase is uncertain.
Free market economies are typically where business cycles start. They are also everywhere. Disruptions in one or more sectors can easily spread to the rest of the sectors.
While business cycles have a negative impact on all sectors, some sectors—such as the capital goods and durable consumer goods industries—are disproportionately affected. Additionally,the industrial sector is more vulnerable to the negative effects of trade cycles than the agricultural sector is.
Business cycles are incredibly complicated phenomena with variable characteristics and underlying reasons. They result from a variety of causes. As a result, it is challenging to accurately predict trade cycles before they happen.
The effects of business cycles are felt concurrently by almost all indicators of the state of the economy, including output, employment, investment, consumption, interest rates, trade, and price levels.
Business cycles are infectious and have a global scope. They started in one nation and primarily spread to others through commercial ties. For instance, nearly every nation was impacted by the Great Depression of the 1930s in the USA and Great Britain, particularly the capitalist nations of the world.
The impact of business cycles on society’s well-being is significant.

Causes of the business cycle:

Business cycles may occur due to internal or external causes, or a combination of both.

Internal Causes: The internal reasons, or endogenous variables, that could trigger a boom or bust include:

Fluctuations in Effective Demand: According to Keynes, fluctuations in aggregate effective demand are what cause changes in economic activity (effective demand refers to the willingness and ability of consumers to purchase goods at different prices). A higher level of aggregate demand will encourage businessmen to produce more in a free market economy where profit maximization is the aim of business. As a result, there will be more output, income, and employment. However, if aggregate demand outstrips aggregate supply, it causes inflation. As against this, if aggregate demand is low, there will be less output, income, and employment. Investors sell stocks and buy safe-haven investments that traditionally do not lose value, such as bonds, gold, and the U.S. dollar. Consumers lose their jobs as a result of company layoffs and cease spending on anything but the necessities. A downward spiral results from that. When prices are so low and investors who still have cash start buying again, the bust cycle eventually comes to an end on its own. But it can take a long time, and it might even lead to depression. The difference between exports and imports is the net foreign demand for goods and services. Variations in exports and imports can also cause changes in business because this is a component of the economy’s aggregate demand. Thus, conditions of expansion or boom are caused by an increase in aggregate effective demand, while conditions of recession or depression are caused by a decrease in aggregate effective demand.
Fluctuations in investment: business cycles, in the opinion of some economists, are primarily caused by fluctuations in investment. The most volatile component of aggregate demand is considered to be investment spending. Due to changes in entrepreneurs’ profit expectations, investments fluctuate often. Entrepreneurs may increase investments in initiatives that are more profitable or cost-effective as a result of new inventions. Alternatively, investment may rise when the economy’s interest rate is low. Increases in investment shift aggregate demand to the right, leading to an economic expansion. Decreases in investment have the opposite effect.
Variations in government spending: Business fluctuations are the outcome of fluctuations in government spending and how such changes affect overall economic activity. The economy is unstable as a result of government spending, particularly during and after wars.
Macroeconomic policies: Business cycles are also a result of macroeconomic policies (monetary and fiscal). The most popular way to enhance aggregate demand is through expansionary policies like higher government spending and/or tax reductions. Booms follow from this. Similar to how interest rate easing, which is sometimes driven by political considerations, causes inflation and lowers unemployment rates, aggregate demand is pressed downward by anti-inflationary measures like reduced subsidies. Government expenditure, higher taxes, and interest rates, which slow the economy. Such slowdowns can occasionally be abrupt, exhibit negative growth rates, and lead to recessions.
Money Supply: Hawtrey claims that the trade cycle is solely a financial phenomenon. An economy may experience commercial fluctuations due to unanticipated changes in the money supply. Expanding aggregate demand and economic activity are results of rising money supply. However, an excessive expansion in credit and money also caused the economy to experience inflation. Consumers and businesses can both borrow money at low rates since capital is freely available. This stimulates demand, creating a virtuous circle of prosperity. On the other hand, a decrease in the money supply may reverse the process and trigger a recession in the economy.
Psychological factors : Pigou claims that current company operations are founded on the expectations of the business community and are influenced by waves of optimism or pessimism. These psychological states of mind of businessmen result in commercial swings. Entrepreneurs who are upbeat about the state of the market in the future may invest, which could signal the start of the expansionary phase. Entrepreneurs that are pessimistic about future market conditions experience the reverse. Investors frequently place limits on their investments. Reduced investments lead to a decline in employment, income, and consumption as well as a decrease in economic activity. Schumpeter’s innovation theory holds that trade cycles result from innovations that occasionally occur in the system from time to time. According to Nicholas Kaldor’s cobweb hypothesis, business cycles result from the fact that present prices have a significant impact on production at a later time. At some point in the future, the present price fluctuations may start to bear responsibility for fluctuations in output and employment in some subsequent period.

Eternal Causes: The external causes, or exogenous factors, which may lead to boom or bust are:

War Production: Production of war goods, such as guns and arms, surges during times of conflict, and the majority of the nation’s resources are devoted to their manufacture. This has an impact on the manufacturing of consumer and capital products. Income, profits, and employment all decrease when production declines. This results in a contraction in economic activity and could trigger a downturn in the business cycle.
Post-War Reconstruction: The nation starts to rebuild itself after a war. Construction of homes, roads, bridges, and other structures boosts economic activity. All of these actions increase effective demand, which increases output, employment, and income.
Technology shocks: Growing technology enables the production of new and better products and services. These products generally require huge investments for new technology adoption. This leads to the expansion of employment, income and profits, etc., and gives a boost to the economy. For example, due to the advent of mobile phones, the telecom industry has The economy underwent a boom, and there was an expansion of production, employment, income, and profits.
Natural Factors: Weather cycles cause fluctuations in agricultural output, which in turn cause instability in the economies, especially those economies which are mainly agrarian. Agricultural output is badly affected in the years when there are draughts or excessive floods. With reduced agricultural output, the incomes of farmers fall, and therefore they reduce their demand for industrial goods. Reduced production of food products also pushes up their prices and thus reduces the income available for buying industrial goods. Reduced demand for industrial products may cause an industrial recession.
Population growth: There will be fewer savings in the economy if the population growth rate exceeds the pace of economic growth. Less saving will lead to less investment, which will decrease employment and income. There will be a decrease in economic activity overall as a result of lower employment and income, which will result in lower effective demand. Trade connects the economies of almost all countries. As a result, depending on the volume of bilateral commerce, changes in the global economy might quickly spread to other regions. Changes in tax legislation, trade restrictions, government spending, the transfer of capital and manufacturing to other nations, and changes in consumer tastes and preferences are all potential sources of economic upheaval.

The importance of business cycles in the making of business decisions

All aspects of an economy are affected by business cycles. All types of businesses should be aware of the business cycle since it has an impact on the demand for their goods and, consequently, on their profits, which ultimately determine whether or not a business is successful. For a businessman to frame appropriate policies, knowledge regarding business cycles and their inherent characteristics is important. For instance, the prosperity period opens up new and better opportunities for investment, employment, and production, which in turn helps to promote business. On the other hand, chances for business opportunities and profits decrease during a period of recession or depression. A profit-maximizing firm has to consider the nature of the economic environment while making business decisions, especially those related to forward planning.
Business decisions are greatly influenced by business cycles. When making managerial decisions about expansion or downsizing, the business cycle stage is critical. Businesses have to advantageously respond to the need to alter production levels relative to demand. The cycle requires fluctuating levels of input use, particularly labor input at different phases. Companies should make use of their capabilities to expand or rationalize production operations in order to match the business cycle stage. Business managers need to work effectively to arrive at sound strategic decisions in complex times across the whole business cycle, including managing through boom, downturn, recession, and recovery.
Economy-wide trends can have a significant impact on all kinds of businesses. But it’s important to remember that not all sectors are uniformly impacted by business cycles. Some businesses are more vulnerable to changes in the business cycle than others. “Cyclical” businesses are those whose fortunes are closely linked to the rate of economic growth. These businesses include fashion retailers; electrical items; building homes; operating restaurants; and running construction and other infrastructure firms. During a boom, such businesses see a strong demand for their products, but during a slump, they usually suffer a sharp drop in demand. It may also happen that some businesses actually benefit from an economic downturn. This happens when their products are perceived by customers as representing good value for money or a cheaper alternative compared to more expensive products.
One of the main obstacles to long-term business sustainability is overcoming the effects of economic downturns and recessions. When deciding whether to enter a market, a new business must consider the phase of the business cycle. The success of a new product launch is significantly influenced by the stage of the business cycle. Businesses must plan and set policies with regard to products, prices, and promotions in order to survive the sluggish business cycles.
Economic forecasts are generally not perfectly reliable. Of course, entrepreneurial intuition and hunches aren’t either. Businesses are better able to anticipate the market and respond with greater attentiveness when they are aware of what stage of the business cycle an economy is in and the consequences the present economic conditions have for their current and future business activity. Economic forecasts, however, can help business firms prepare for changes in the economy’s direction either prior to or soon after they occur if they are taken together and applied carefully.