What Is the Acceleration Principle?
The acceleration principle is an economic concept that draws a connection between fluctuations in consumption and capital investment. It states that when demand for consumer goods increases, demand for equipment and other investments necessary to make these goods will grow even more. In other words, if a population's income increases and it, as a result, begins to consume more, there will be a corresponding but magnified change in investment.
Under the acceleration principle, the reverse is also true, meaning a decrease in consumption spending will tend to be matched by a larger relative decrease in investment spending as businesses freeze investment in the face of falling demand. The acceleration principle, also referred to as the accelerator principle or the accelerator effect, thus helps to explain how business cycles can propagate from the consumer sector into the business sector.
- The acceleration principle is the observation that investment spending tends to experience larger proportional swings in tandem with changes in consumer spending.
- The acceleration principle occurs because businesses must be cautious to avoid undertaking large, fixed-cost investments in response to short-term spikes in demand.
- The acceleration principle helps to explain how business cycles can propagate through the economy from the consumer sector to the business sector.
Understanding the Acceleration Principle
In the early 20th century, several economists noted that the rate of new investments moves in tandem with changes in consumer demand, but with an exaggerated movement relative to the change in demand. In his 1923 book Studies in the Economics of Overhead Costs, John Maurice Clark dubbed this the acceleration principle.
Companies frequently seek to gauge how much demand there is for their products or services. When the economy is growing, customers are buying, and low interest rates make it cheaper to borrow, management teams regularly seek to capitalize by ramping up production. This makes sense, as companies want to optimize their profits when they have a successful product
If they notice that economic conditions are improving and consumption is growing at a sustainable rate, they will likely invest to increase their output. This may require investing in new capital goods, particularly if they are already running close to full capacity, investing in more factories and capital investments to produce more. Failure to do so could see them miss out on a chunk of potential future revenues and lose ground to faster-responding competitors.
According to the acceleration principle, capital investment increases at a slower rate than demand for a product because businesses will not increase capital expenditures (CapEx) in the face of a short-term increase in demand. Instead, companies expand output using their existing or slack capacity first, and then add capacity only if they believe the increase in demand will be sustainable into the future.
How the Acceleration Principle Works
If an increase in consumer demand is rapid and sustained, then more businesses will undertake new capital investment. That is because investments to boost output often require significant fixed outlays and take time to build.
Economies of scale determine that investments are generally more efficient and come with greater cost advantages when they are significant. In other words, it is often technically or economically infeasible to expand capacity in small increments to meet short-term changes in consumer demand, and makes more sense financially to increase capacity substantially, rather than just by a little bit.
The acceleration principle does not compute the rate of capital investment as a product of the overall level of consumption, but as a product of the rate of change in the level of consumption.
Because of the often large fixed costs required to undertake new capital projects, once businesses begin to expand investment in the face of a sustained increase in demand, the size of the new investment spending may have to be significantly larger than the observed increase in demand. So an increase in consumer demand can lead to a proportionally larger increase in investment, once businesses decide to expand capacity.
Expanding fixed capital investment in the face of a temporary spike or falling demand could obviously be a costly mistake. As soon as demand slows, businesses will tend to reduce or eliminate costly new investments in expanded capacity—and usually freeze investment entirely if they expect demand will fall. This means that even a small reduction in consumer spending, or just a slow down in its growth rate, can induce a significant cut back in business investment spending.
A sustained acceleration of demand can ultimately induce a large increase in investment spending, triggering a period of rapid economic expansion. Likewise, less demand can result in a sharp cutback in investment and a decline in general business activity. Business expectations about the future path of consumer demand play a large role on both sides.
These observations form part of the foundation of Keynes's theory of how an economy can experience a sustained downturn. The acceleration effect can also interact with the investment multiplier effect to magnify both economic booms and recessions in this theory.