Example of a Vicious Circle in a Two-Firm Economy

Virtuous Circle of Coordinated Investment and Demand

Figure 3.21: Vicious Circle from Low Expected Demand

Coordination Problem in Investment Decisions

Analyzing Economic Stagnation in a Manufacturing Town

An economy is experiencing a period of stagnation. Arrange the following events to correctly illustrate the self-perpetuating cycle that traps the economy in a low-activity state.

In a regional economy, most businesses are operating with significant unused production capacity. They are reluctant to invest in expansion or hire new employees because they do not expect sales to increase. Consequently, local household incomes remain low, and consumer spending is weak. Which statement best analyzes the underlying reason this situation is self-perpetuating?

In an economy where numerous firms are simultaneously operating with low capacity due to weak overall demand, a single, rational firm is likely to break this cycle by independently increasing its investment and production.

Explaining Economic Stagnation

The Self-Perpetuating Nature of Economic Stagnation

Match each economic condition or action with its most direct consequence in the context of a self-perpetuating economic cycle.

When many firms in an economy operate with significant unused production capacity, it leads to lower profits and incomes. This, in turn, suppresses overall ____, which reinforces the firms' initial decision not to expand, trapping the economy in a state of stagnation.

An economy is characterized by widespread low capacity utilization, where most firms could produce more but choose not to. This has led to stagnant incomes and persistently weak consumer spending. A government advisor argues that the most effective way to break this cycle is to provide a large investment subsidy to a single, major manufacturing firm, believing its expansion will 'kick-start' the rest of the economy. Evaluate the likely outcome of this specific policy.

Evaluating a Policy to Combat Economic Stagnation