Acceleration Principle

Key Takeaways

• The acceleration principle links investment changes to fluctuations in consumer demand.
• Increased consumer demand can lead to a larger proportional rise in investment spending.
• Businesses are cautious about new investments due to potential demand volatility.
• The accelerator effect explains how economic cycles extend from consumer to business sectors.
• Sustained demand growth prompts significant business investment, driving economic expansion.

What Is the Acceleration Principle?

The acceleration principle links changes in consumer demand to changes in capital investment. The principle states that increased consumer demand for consumer goods typically leads to greater investments in production capacity. A decrease in demand and spending results in a significant cutback in investment.

The acceleration principle helps to explain how business cycles can move from the consumer sector into the business sector, and how economic booms and recessions are influenced by investment cycles.

Exploring the Acceleration Principle in Depth

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.1

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, and 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 typically 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.23

Mechanisms Behind the Acceleration Principle

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 it makes more sense financially to increase capacity substantially, rather than just by a little bit.

Important

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 slowdown in its growth rate, can induce a significant cutback in business investment spending.

Key Factors and Implications of the Acceleration Principle

The acceleration principle may have the effect of propagating booms and recessions in the economy and is a core aspect of the Keynesian macroeconomic theory of recessions.

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.