Prices, and Production: Lecture II, Part III

It is now time to add the flow of money into Hayek's theoretical apparatus. While the Hayekian triangle is used to illustrate the movement of goods through the economy's structure of production, it is just as legitimately utilized as a schematic to elucidate the flow of money. When the goods are moving from the bottom to the top of the triangle, money is moving in the opposing direction, being first paid for the consumers' goods, and moving downward until it is paid to the owners of the factors of production as income. In order to analyze the relationship between the proportional quantities of money used in each stage of production, and the opposing movement of goods, it is necessary that we take a definite assumption with respect to the division of the process among different firms for if more than one consecutive stage is owned by a single firm than there is no need for an exchange of goods against money in those stages. Here, we shall take the simplest assumption: that the previous division of the economy into stages of production with respect to the Hayekian triangles happens to coincide with the points at which goods change hands between separate companies.

The proportion of money spent for consumers' goods, and producers' goods is equal to the proportion between the aggregate demand for consumers' goos, and that of producers' goods (this is done with the assumption of a stationary state, which is the only one we are concerned with right now). In this case, there is a demand for 40 arbitrary units of consumers' goods, and 80 of producers' goods, ergo a proportion of 40:80, or 1:2, in the output between the two; this can also reflect the proportion between consumption, and investment during any period of time . Similarly, 1:2 is the proportion of money spent for consumers', and producers' goods . Once we have established this method, a couple fundamental facts become clear.

The first is that the quantity of money spent on producers' goods during any period of time may very well be far greater than the quantity spent on consumers' goods in that period of time. This fallacy originated with Adam Smith, who wrote: “The value of goods circulated between the different dealers can never exceed the value of those circulated between dealers and consumers; whatever is bought by the dealer being ultimately destined to be sold to the consumers.”¹ It is easy to see that this error results intuitively from the fact that the total expenditures made during production must be covered by the return from the sale of the eventual products. Nevertheless, it is also easily solved by the realization that most goods are exchanged several times against money before finally being sold to the consumer, a realization that can be visualized in a Hayekian triangle divided between different stages of production.

The second conclusion that follows is that the amount of capital invested in the structure of production, what Hayek referred to as the “capital equipment of society,” is not a magnitude that is brought into existence, and hence forth remains constant. To the contrary, whether the capital allocation there remains the same depends on whether entrepreneurs find it profitable to return the normal amount of their returns from selling the product of their respective stages in producing goods of the same sort a la J.S. Mill's “perpetual consumption and reproduction of capital.” It totally depends on the entrepreneur on whether he will continue to invest his net income in the same proportions as before, as Hayek wrote: “The continuance of the existing degree of capitalistic organization depends, accordingly, on the prices paid and obtained for the product of each stage of production; and these prices are, therefore, a very real and important factor in determining the direction of production” - hence the title Prices and Production.