Why The Corporate Paradox Of Thrift Isn't Really A Problem

corporate thrift

According to some commentators, cost-cutting by companies in order to protect profits can in fact set in motion an economic slump. It is held that if everyone tries to cut costs and save more, demand for goods and services from retrenched workers weakens, and as a result, corporate revenues and profits come under pressure. This, in turn, sets in motion new layoffs, and this again eats into revenues and makes profits disappear. Economists call this the "corporate paradox of thrift."

By this logic, if everyone tries to cut costs and save more, no one ultimately saves more. Therefore, if every company decides to cut costs, this is going to hurt revenues and hence profits.

The conclusion, then, is that, collectively, it is impossible to lift profits through cost-cutting. On the contrary, it will lead to an economic slump. One solution advocated is for the central bank to counter the negative side effects of cost-cutting through easy monetary policy.

The corporate "paradox of thrift" follows the famous Keynesian "paradox of thrift," which asserts that if individuals in the economy as a whole try to increase aggregate savings, not only will it not succeed but in fact may also lower aggregate output, income, and employment. This is because increased savings at a given level of aggregate income mean decreased consumption. With a fall in aggregate income, people will find it much harder to save, and this thus implies that aggregate savings in the economy will decline because people have decided to save more. According to Keynes: "Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself."1

In this way of thinking, while saving may pave the road to riches for an individual, if the nation as a whole decides to save more, the result may be poverty for all.2

To Be Successful, Businesses Must Abide by Consumers' Demand

As a rule, a businessman who wants to be successful must stay on guard as far as consumers' demands are concerned. Therefore, whenever he observes a growing demand, he is likely to respond by lifting the production of goods. This means that in order to accommodate the rising demand and thereby secure higher profits, a businessman is likely to increase his demand for the various factors of production.

Conversely, when demand is slowing down, the businessman’s production of goods is likely to follow suit. Consequently, to protect his profits the businessman is likely to reduce his demand for the various factors of production in line with the decline in the production of goods.

Note that a major factor behind businesses embarking on cost-cutting is the emerging economic slowdown. This means that businesses are simply responding to the slowdown; they do not cause it. What is it, then, that sets in motion the economic slowdown that causes businesses to react in this way?

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