This theory is also known as the competition theory of business cycles. It has been put forward by socialistic-minded economists. According to this theory, the business cycle is due to overproduction which is inherent in a capitalist economy. In such an economy, there are several rival firms producing an identical commodity and selling it in the same market. As such, there is bound to be competition among these firms. Each firm will try to capture as large a portion of the market as possible, and in doing so, it will have produced more stocks than it could possibly sell in the market. This means there will be overproduction and the market will be flooded with large stocks of the commodity. The price of the commodity will inevitably fall in such a situation of overproduction. The same thing happens in the case of other commodities.
This same competition not only leads to overproduction and fall of prices; it also results in a rise in the cost of production of commodities. How? When each firm produces more to capture a larger portion of the market, it has to buy the services of the factors of production and raw materials at higher prices on account of their overall scarcity. Thus, two things happen simultaneously- the prices fall while the costs rise. Some of the marginal firms collapse, adversely affecting the fortunes of others. The rate of business failures is stepped up, and ultimately the entire economy finds itself in the grip of a depression.
The overproduction theory has been criticized on the ground that it does not furnish a comprehensive explanation of business fluctuations. It is true that overproduction induced by competition results in depression. But the theory does not tell why depression comes at fairly regular intervals. Further, the business cycle is a complex phenomenon. It cannot be explained in terms of competition alone.
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