While I was walking in Marseille today I was thinking about what exactly I should write the first of the three PhD essays I need to write for the thesis. The other two will be an extended version of my paper on a non-equilibrium version of ABCT and on the empirical illustration of ABCT on the example of the US economic boom and bust of 2002-09. I thought that the first essay should be on the crucial element of my version of ABCT, and today I finally managed to formulate it.
Let us start with what an entrepreneur must do when deciding about starting or continuing production of some good. She must decide on four things:
1) what good to produce;
2) in what amount to produce it;
3) what price to set for the output over time; and
4) what production process to use (i.e. which combination of intermediate goods and labor).
The process/pattern of such decisions in the real economy is mindblowingly complex. It is impossible to give even a general description of how the pattern plays out. The only thing an economist can do is try to figure out the necessary conditions for this process to occur, and what general problems will happen if those conditions are not fulfilled or are not fulfilled well enough. One of the most important conditions is the presence of relatively undistorted prices for consumer and intermediate goods. It is those prices that combined with knowledge allow entrepreneurs to overall relatively successfully navigate the enormous ocean of production alternatives.
But even this already mindblowingly complex picture is not yet complete. Production usually takes place over considerable swaths of time in uncertain conditions which implies that things might change in such a way before completion of a production project so as to make the entrepreneur modify or even completely abandon her project. And obviously, entrepreneurs are (however imperfectly) aware of the need for including contingencies into their plans. In other words, entrepreneurs must have certain idea of which changes will trigger at least serious deliberation on the future of the project.
One of the most important contingent factors are the dynamics of the demand for the output over time. Obviously, the entrepreneur does not want to end until the end of the project to see whether her original calculations have been appropriate. She wants to have certain red flags which would tell her that the demand for her output over the relevant period of time has either increased or decreased significantly compared to her calculations.
This is the crucial point in my version of ABCT. In my account the key mistakes are made not by entrepreneurs undertaking the unsustainably lengthy investment projects but by the suppliers of intermediate goods for which the undertakers of those projects compete over the boom period with the undertakers of shorter investment projects (the contested goods). The producers of the contested goods must fail to realize that the demand for them has increased compared to their expectations and sell it to the undertakers of the lengthier projects at the prices that do not reflect the long-term change in demand and fail to increase their production for the relevant period.
How does credit expansion create a high probability of such mistakes? The answer is that it tends to frustrate the contingency planning of the contested good producers. Their contingency planning must be based in some way on the demand pattern of certain past reference period or periods. For example, a producer of chocolate will probably know that there are spikes in demand over the year associated with the approaching of certain dates, especially the winter holidays. Thus, she will probably consider in her contingency planning that if a substantial increase in demand for chocolate happens in August this will be a signal for her that something substantial has changed. She will then probably raise the price and try to increase production.
However, the increase in demand faced by each particular producer may be insufficient for her to realize on time that the demand over the period will be higher. Contingency planning, in other words, may only envisage substantial red flags. Thus, in certain cases a sudden change in demand may be substantial enough to raise the price of a good by the end of a period but not substantial enough to be noticed when it presents itself.
Credit expansion that goes into lengthier investment projects will obviously tend to magnify this problem. It is very difficult for producers of contested goods to provide in their contingent plans for increases in demand from credit expansion even if they can predict that it will happen. They have no grounds on which to try to predict to which projects the newly created credit may go.
Realism Unleashed 