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Shortening and Lengthening of the structure of production due to monetary manipulation - Real world examples

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praxe Posted: Sun, Feb 28 2010 12:16 PM

I just finished reading Prices and Production by F.A Hayek.  I am trying to come up with examples from economic history, or recent history, or even simple imaginary examples of the lengthening of the production process and the shortening of the production process that comes about due to the operation of monetary influences.

Here's my current understanding of the theory, please let me know if I got something wrong.

1. Lengthening of the production process:

1a. When backed by real savings, and not manipulated by monetary influences (constant money supply).

Real savings are invested, consumer prices fall, factors of production are freed up by later stages of production for investment in earlier stages.  Investments in earlier stages create new stages which lower the price of the intermediate factors of production, increasing margin in the lower stages, increasing sales at the new lower price point.

My Somewhat Contrived Imaginary Example for 1a:

Two towns people invest with farmer to build a chicken coop.  They invest $2 a day.  They temporarily have less money to spend in town at the restaurant eating chicken.  They eat two meals a day for $2 instead of three meals a day for $3.  The reduced demand at the later stages of production (restaurant) cause the restaurant to lay off a waiter who goes to work building the farmer's chicken coop for $2/day plus supplies that he gets by chopping down trees in the forest.  The restaurant has less business during the day so it doesn't need the trees in the forest for the fuel so it cuts down fewer of them.  Chicken coop is eventually completed, the farmer gets more eggs, and loses less to foxes thanks to the new chicken coop.  The cost of operating the restaurant falls as there is more production.  Towns people go back to consuming three meals a day, but the price is still $2 thanks to the increase in chicken coop production.  The waiter is employed from time to time working at the restaurant and maintaining the chicken coop.   The farmer is able to lay off a farm hand who formerly guarded the chickens at night and ran around the field looking for eggs the chickens would lay is now working at the restaurant.

So we have real savings (town people reduced consumption) reducing demand on the factors of production( waiter,lumber ) in later stages of production (restaurant) freeing that up for investment in earlier stages of production (chicken coop building) which frees up factors of production (hen watcher) for use in other stages of production (restaurant) thus providing factors of production for maintenance of the capital structure (chicken coop builder/maintainer) all resulting in increased output (more chickens).

If I added all the money payments to the above it would get really complicated.  Perhaps an excel sheet or something like that would be in order.

 

 

2. Shortening of the production process

1a. When consumer credit is used to stimulate an economy, the factors of production become concentrated in the later stages of production, causing a shortening in the production structure as earlier stages of production are abandoned half way or become unprofitable.

So assuming the elongated production structure from part 1.

The restaurant raises its prices.  The chicken coop builder goes back to work at the restaurant because it pays better than maintaining the chicken coop. The chicken coop falls apart from lack of maintenance but now that the prices are higher, the farmer can afford to pay the hen minder to find chicken eggs and chase off foxes, even at a lower level of production.  We are back to the shortened production structure.

Can any of you trade cycle experts critique my analogies?   Does anyone have any economic news articles that show lengthening and shortening production cycles due to fluctuations in consumer and producer credit?

Thanks,

-praxe

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chloe732 replied on Sun, Feb 28 2010 2:04 PM

praxe:
Two towns people invest with farmer to build a chicken coop. 

There seems to be an important aspect that is missing in your example. Think in terms of human action. Why do the townspeople feel a dissatisfaction with the current state of affairs? Why would they invest in chicken coop construction? They don't seem to benefit at all from their $2 per day investment, so why would they invest? How will chicken coop construction relieve that felt unease that started the process in the first place? Why did the townspeople suddenly experience a decrease in time preference?

In the Crusoe analogy (Man, Economy & State), it's clear that Crusoe wants to increase his productivity (a felt unease), so he defers current consumption (saves) in order to build sticks and nets (factors of production) to then consume more in the future. This lengthens his production process. The calculated risk of exchanging some current consumption for increased future consumption allowed his time preference to decrease; he then took action. I don't see these aspects of human action in your example, and I think it's important to consider before getting into the other mechanical details.  

"The market is a process." - Ludwig von Mises, as related by Israel Kirzner.   "Capital formation is a beautiful thing" - Chloe732.

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praxe replied on Sun, Feb 28 2010 4:21 PM

I did leave out the saver's motivation, mainly because Hayek leaves out interest out of his examples as they are already pretty complicated.  The savers would receive return of principal and interest out of the chicken farmer's margin after the completion of production of the chicken coop.

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Esuric replied on Sun, Feb 28 2010 4:31 PM

praxe:
1a. When consumer credit is used to stimulate an economy, the factors of production become concentrated in the later stages of production, causing a shortening in the production structure as earlier stages of production are abandoned half way or become unprofitable.

Hayek doesn't really talk about consumer credit too much. But yes, consumer credit would increase the demand for lower order goods, causing a contraction in the structure of production. Producer credits, conversely, will expand and lengthen the structure of production.

Lengthening the structure of production can be thought of as one firm becoming two. For example, a car company produces its own leather seats. When time preferences fall, which is the same as saying that savings has increased, then firms at the lower stages of production will have to cut costs (more than other, higher stages of production). This means that they will release X amount of labor into the market, and cut some of the intermediary capital goods they produce, like leather seats (they may in fact eliminate producing some intermediary products all together). A lower rate of interest will reduce costs, and the relative increase in the prices of intermediary goods (leather seats) will redirect production towards higher phases of production. An entrepreneur will start a company that produces leather seats for other car companies, and it will absorb the labor initially released. This expands the structure of production, makes it more capitalistic, which increases the total level of output. It's important to note that the redirection of production towards higher phases will also lower the prices of intermediary goods (an increase in supply), which lowers costs, for each successive stage (when you lower the price of iron, you lower the costs of steel, the costs of cars, ect, ect).

More direct methods will reverse this process. An increase in demand for current goods raises the rate of interest, and the price of lower order goods relatively increases. Lower order firms see higher profits, and they begin to absorb the higher stages of production (vertical consolidation). They will start producing the leather seats themselves.

"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."

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praxe replied on Sun, Feb 28 2010 4:53 PM

Esuric:

A lower rate of interest will reduce costs, and the relative increase in the prices of intermediary goods (leather seats) will redirect production towards higher phases of production. An entrepreneur will start a company that produces leather seats for other car companies, and it will absorb the labor initially released. This expands the structure of production, makes it more capitalistic, which increases the total level of output. It's important to note that the redirection of production towards higher phases will also lower the prices of intermediary goods (an increase in supply), which lowers costs, for each successive stage (when you lower the price of iron, you lower the costs of steel, the costs of cars, ect, ect).

More direct methods will reverse this process. An increase in demand for current goods raises the rate of interest, and the price of lower order goods relatively increases. Lower order firms see higher profits, and they begin to absorb the higher stages of production (vertical consolidation). They will start producing the leather seats themselves.

When prices are lowered at the lower order stages, won't the margin compression in the lower orders work its way back through to the higher orders of production?  Resources will be freed from the lower orders, but must they not be put to use in more efficient means of production in the higher orders of production to avoid generating a loss with the new smaller margins? 

I can't see how one firm splitting into two really improves matters here.  I would think that the new leather seat firm must have to employ new machinery or further specialization of production techniques in order to increase its output and thus its efficiency in its use of the origional means of production to justify a new business unit.

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Esuric replied on Sun, Feb 28 2010 5:50 PM

praxe:
When prices are lowered at the lower order stages, won't the margin compression in the lower orders work its way back through to the higher orders of production?  Resources will be freed from the lower orders, but must they not be put to use in more efficient means of production in the higher orders of production to avoid generating a loss with the new smaller margins? 

I don't know if I'm following you, but marginal costs don't fall immediately, and prices are merely one variable, along with costs. The economic system adjusts itself to changes in subjective preferences (horizontal changes reflect intra-temporal changes, and vertical changes reflect inter-temporal changes). Marginal costs fall because production is redirected towards the higher phases of production, which is the result of a lower rate of interest and higher relative prices for future goods (in relative terms--prices may fall for all stages in absolute terms, but it's about the relation between prices and costs). [The second part of my response may answer this question].

praxe:
I can't see how one firm splitting into two really improves matters here.  I would think that the new leather seat firm must have to employ new machinery or further specialization of production techniques in order to increase its output and thus its efficiency in its use of the origional means of production to justify a new business unit.

Leather seats are an example of intermediary producer (capital) goods. The higher phases of production (after a fall in consumer demand for final goods) will, at first, have higher profit margins (higher relative prices for their goods), which, along with the lower rate of interest, will allow them to bid away fixed and durable capital goods from the lower phases of production. They absorb the labor supply, and after the initial transitional process, there will be a greater degree of firms producing intermediary capital goods (the structure of production has lengthened). This increases the technical efficiency of capital and production. You can increase the efficiency of capital in more than one way: (1) technological innovation and discovery and (2) rearranging your production methods, and altering capital combination's. A given amount of capital does not yield constant output, it can be rearranged in different orders reflecting different degrees of roundaboutness, which will yield different input-output results. It is important to remember that capital is heterogeneous and complementary.

Another way to think about it is that the division of labor and capital, that is, specialization, has progressed. The totality of all stages has become more efficient; they require less resources (individually) for production, which is represented by lower marginal costs, and higher aggregate output.

"If we wish to preserve a free society, it is essential that we recognize that the desirability of a particular object is not sufficient justification for the use of coercion."

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