The acceleration principle is a theory of economics that links changes in consumption to changes in investment. It states that if there isn't already a surplus of manufacturing capacity in the economy, the need for machinery and other investments required to produce consumer products/goods will rise as demand for those things rises. To put it another way, if a population's earnings rise and they start to consume more, there will usually be comparable but exaggerated changes in investment.
According to the acceleration principle, the opposite is also true, which means that if businesses halt investment in the face of declining demand, a decline in consumer spending will typically be matched by a higher proportionate decline in investment spending. The "acceleration principle"-also known as the "accelerator effect" or the "accelerator principle"-aids in describing how business cycles can spread from the consumer to the business sectors.
Understanding the Acceleration Principle
Businesses typically try to determine the level of demand for their goods or services. Management teams typically look for opportunities to capitalize by increasing production/output while the economy is expanding, consumers are spending, and interest rates are low. This makes sense because businesses aim to maximize their earnings when they have a successful product.
They'll likely invest in boosting their output/production if they see that the economy is doing better and that consumption is increasing at a sustainable level. If they don't, they might lose out on possible future profits and fall behind quicker-reacting rivals. It may necessitate investment in new capital goods, especially if existing ones are already operating at near capacity in order to increase production.
The acceleration principle states that businesses won't raise capital expenditures (CapEx) in response to a temporary boost in demand; hence capital investment normally rises more slowly than product demand. Rather, businesses use their current or slack capacity to raise output before adding more, and the additional capacities are added if they think the demand rise will continue in the future.
How does the Acceleration Principle work?
More businesses will make new capital investments if consumer demand rises quickly and consistently. This is due to the fact that investments made to increase output frequently need high fixed costs and take time to develop.
Economies of scale indicate that when investments are substantial, they are typically more effective and have bigger cost advantages. To put it another way, raising capacity in small increments is usually technically or financially impractical to match transient changes in customer demand. It makes more financial sense to significantly raise capacity rather than just in smaller amounts.
Once businesses start increasing investment in response to a continuous rise in demand, the magnitude of the new investment spending is likely to be much greater than the observed rise in demand due to the usually high fixed expenses required to carry out new capital projects. Therefore, if enterprises choose to raise capacity, a rise in consumer demand may result in an investment increase that is proportionately higher.
Expansion of fixed capital investments in the face of a transitory increase or decrease in demand might be a pricey mistake. Businesses will typically limit or stop making expensive new investments in the increased capacity as soon as demand declines. If they anticipate a decline in demand, they would typically completely stop making investments. This implies that even a modest decrease in consumer spending or a mere slowing of its rate of increase might result in a large decrease in the company's investment spending.
Limitations of the Acceleration Principle
Below mentioned are some of the drawbacks/limitations of the Acceleration principle:
Fluctuations or Changes in the Capital-Output Ratio
A constant capital-output ratio is the basis of the acceleration principle. However, this ratio doesn't remain constant in today's dynamic world. Production methods are continually being developed and improved, resulting in higher output per capital unit. Alternatively, current capital equipment could be put to better use.
The capital-output ratio may also alter due to changes in business people's anticipations regarding pricing, salaries, and interest rates. As a result, the capital-output ratio fluctuates during the various stages of the business cycle rather than remaining constant.
The acceleration principle makes the assumption that resources must be elastic in order to be used in capital goods businesses and support their expansion; this is feasible when there is unemployment in the economy. The capital goods industry, however, is unable to grow once the economy achieves a state of full employment because there are not enough resources available. This restricts how the acceleration principle operates. Therefore, in a downturn where there is extra capacity, this theory will not hold.
Plants with Idle Capacity
The acceleration principle makes the assumption that no capacity in factories is unutilized or sitting idle. However, if some equipment is underutilized and idle, then a rise in the demand for consumer products/goods won't translate into an increase in the need for additional capital investments in the equipment. The acceleration principle won't operate in this case.
No Explanation of Investment Timing
According to the assumption that there is no capacity left over ("full capacity"), rising output/production demand will immediately induce investment. Thus, the acceleration concept falls short of explaining the timing of investment, where at most, it explains the investment volume. Actually, it's likely that it will take some time (time lag) before the new investment starts to flow. For example, if the time lag is four years, the result of additional investment won't be felt in one year but in four years.
Non-Importance of the Availability and Cost of Capital Goods
The timing of capital goods procurement is determined by their availability and cost, as well as the cost and availability of financing. These elements are not taken into account by the concept.
Not Effective for Temporary Demand
The idea of the acceleration principle also assumes that the rising demand would continue indefinitely. If producers anticipate that customer demand will only last a short while, they won't make any new capital investments. Instead, they might push the current capital equipment harder to keep up with the additional demand. Therefore, there won't be any acceleration.
No Acceleration Effect for Installed Equipment
It is considered that prior capital investments do not anticipate or account for a rise in consumer goods demand. If capital goods are already set up in anticipation of potential demand, it won't result in induced investment, and the acceleration effect will be nil.
Neglects the Role of Technological Factors
Because it ignores the part that technology considerations play a role in investments, the acceleration principle is inadequate. However, technological advancements may reduce labor costs or save on capital. As a result, they might alter the investment's volume.
Neglects the Role of Expectations
The expectations that businesspeople have when making decisions are neglected by the acceleration principle. Demand isn't the only factor that determines investment decisions. Future expectations, including those related to the stock market, politics, global events, the economy, etc., also have an impact on them.
Non-Elastic Supply of Credit
The acceleration principle makes the assumption that there is an elastic credit supply, allowing for easy access to cheap financing for investments in capital goods sectors when there is induced investment as a result of induced consumption. If there isn't enough access to reasonable financing, interest rates might be high, and capital goods investment will be very low. As a result, the acceleration won't function properly.
Neglects Profits as a Source of Internal Funds
This assumption also indicates that businesses use outside funding sources for capital expenditures. However, actual data indicates that enterprises prefer internal over external funding sources. Profits are overlooked as a source of internal financing, but actually, one of the main factors influencing investment is the level of profits.
Difference between Multiplier and Accelerator
People frequently mix up multiplier and accelerator even though they are two different economic concepts. While the accelerator shows how changes in production and consumption impact investments, multipliers show how changes in investment impact income and employment. Both economic ideas attempt to demonstrate how investments and production/consumption are related to or interact with one another. Consumption depends on investment for the multiplier, whereas investment depends on consumption for the accelerator.