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In essence, everything except their island defenses and units is just a front to interact with and make them more believable.
If you go into the red just by adding the first bread production chain, then chances are that your population is just far too small. Add more peasants and workers to compensate.
Also consider adding sizeable populations of peasants and workers to your other islands, as long as the islands can supply themselves (they only need to be happy, so you don't have to provide *everything* they ask for). Even though these people don't bring in the big money, it adds up, and wood is cheap and fast to produce in large quantities.
If you want to optimize your settlement strategy, try to stay just under 1000 people per population level per island (except your main island or when needed locally), since that's where you start paying royal tax, which reduces your income.
I was aware of rapid pop expansion to compensate for treasury losses but hesitant to do so because I was afraid production wouldn't be able to keep up. But after restarting, I managed to stabilize the situation by starting a second island early and aggressively pushing up pop and production at the same time. I still have my gripes about this because it's too scripted. It works easily on normal difficulty because you have a generous treasury and lots of resources. Once the difficulty is increased, I'd expect more micromanagement and rushed colonization of more islands.
Level 2 AI does expand, but they generally unlock areas when you unlock them.
Level 3 AI expands faster than level 2 AI, and moves into new areas independently of when you unlock them.
A higher AI level also translates into larger fleets, larger numbers of large ships, faster switch to steamships / airships, larger island defenses, and a more aggressive approach to warfare and share buying.
Kind of makes the game meaningless for me. I want a functional AI that has to abide by the same rules, resources, and limitations that I have. That rationally expands or diminishes. It's disappointing to know it's fiat.
So having them not play by the same rules as the player made them more of a challange at least.
And your actions against them do have effects on how well they'll do. Shooting their trade ships and blockading islands will hinder them, but you won't be able to completely shut them down.
It's not a nice or good way how they are implemented, I think, but neither were the pre-2070 style opponents (they were more believable, though, but that's all they had going for them).
Level 1 had limited numbers asked colony island, like you turn down like 6 time, they will stop asking and keep colony.
AI isn't code or design to follow rule like player do.
It's just do scripted to make world felt little alive, illusion if you will, dr hugo is little bit more useful than all other ai due trade right to get item specific.
Level 2 and 3 A.I usually expands on based of their time and building, not human player expect the arctic world map, they go on without player level/building.
Edit: Anno is the only game I concede that the AI is cheating because it completely ignores bonuses by outright playing by different rules from what I understand.