I'm having trouble with the notion of the higher order capital goods being more interest rate sensitive. For instance, it makes sense that a segment of production which is capital intensive is sensitive to interest rates. If the rate of interest is too high in the perspective of an entrepeneur he will not invest in the needed capital. And it seems intuitive that higher order processes are more capital intensive just from observation of an economy. Burger flippers basically just need a grill and a restaurant, more of the costs are in labor, whereas griddle/frier producers require a complex array of machinery and tools for the fixing thereof. But what is the reason that the segment of production furthest from the final good is necessarily the most interest rate sensitive?
For example, if we're producing HomeDepot miniShacks, the entire process might go like this: logging->cutting->treating->assembling->transporting->selling. How is it necessarily the case that logging is more capital intensive and thus interest rate sensitive than treating wood with chemicals?
The standard explanation is that higher order goods are furthest from the final good and so there is a longer period between the initial investment and the "payoff" - that period in which revenue starts coming in and interest can start to be paid off. But the producer of higher order goods does not have to wait for the demand from the final good producer; due to the forward-looking nature of entrepeneurship, a producer of a good "one level" beneath him will buy that highest order good to satisfy his own business plan. This is ultimately dependent on how much of the final good is bought from what is produced, but the point is that the producer of the highest order good is not deprived of revenue for a greater period of time (or at least not the period of time it takes for one "round" of production to occur). He can sell his good to the next producer down the line. So what in Bohm-Bawerk's laws makes it completely implausible/impossible that the segment of production "beneath" him is less capital intensive? Or am I not conceiving of this issue correctly?
It occurred to me that producers in those segments furthest from the final good will be more subject to both time lag and more layers of entrepeneurial failure/success. Mises might call this the higgling of the market. But it doesn't seem a compelling reason that, granting abstention from consumption and reallocation of said absentions into the loan market, process N's frontier of production will necessarily expand greater than N-1's (N here being a 'stage' of production).
The Anarch is to the Anarchist what the Monarch is to the Monarchist. -Ernst Jünger
"Well, yeah. But I find this to be kind of a non-answer. Of course an increase in the supply of loanable funds will lower the costs for producers, but I can't help but feel like your answer skirts the issue, which is, why the person who buys from the logger should have express stronger demand than the person who buys from the plank-curer, by nature of his being an 'earlier' stage capitalist."
Imma give this one more go.
One of the issues that I have been leaving out here is that consumption spending decreases, either in real or nominal value, and that this is required in order to actually decrease the interest rate in the first place. With that said, forget what I just said because it makes the next example impossible XD
Here we will assume that magically the interest rate falls and that this causes no decrease in consumer spending real or otherwise. This just makes the example work more.
Now what I outlined above is that what happens is that both MC for each stage, and demand within each stage (besides the final) rises. So let's take a bunch of arbitrary numbers and set this baby to work.
5th stage: Fall in MC by 10%
Therefore:
4th stage: Fall in MC by 10%. Increase in demand by 10%
3rd stage: Fall in MC by 10%. Increase in demand by 20%
2nd stage: Fall in MC by 10%. Increase in demand by 30%
1st stage: Fall in MC by 10 percent. Increase in demand by 40%
Therefore the first stage of production will produce a whopping 50% more in our example (assuming arbitrary and convenient numbers concerning both prices and production)
Now in the real world consumption decreases in the first stage, but MC shifts too. Now at some the decrease in demand at the earlier stages is "offset" by the gains made up in other stages, so for instance the final three stages of production might have decreased production, but since this is slowly offset by the decrease in costs along the stages, then perhaps finally the 4th stage ends up producing more. So for instance we might have:
5th Stage: Fall in MC by 5% decrease in demand by 15% (result: 10% decrease in production)
4th Stage: Fall in MC by 7% decrease in demand by 10% (result: 3% decrease in production)
3rd Stage: Fall in MC by 4% decrease in demand by 3% (result: 1% increase in production)
2nd Stage: Fall in MC by 8% increase in demand by 1% (result: 9% increase in production)
1st stage: Fall in MC by 5% increase in demand by 9% (result: 14% increase in production)
Far enough down the productive stages the initial decrease in consumer demand is replaced by decreasing costs that leads to increased production.
If you consider this a "non-answer", when taken into conjunction with my earlier remarks on capital, then I don't know what a real answer is
Edit
Actually, I think that this is such a good answer that I'm going to pat myself on the back and toot my own horn and do something I usually consider a real narcissistic/dick move... But it's different for me because this is a good answer and I'm a special snowflake.
Ah ok that looks good. I was reading your earlier responses as simply that an increase in the supply of loanable funds will make producers demand more, and was not taking into account the cumulative effect. Thus only understanding you to be saying "The cost of business decreases by X owing to Y reduction in interest payments. Thus early stages will benefit most." Thanks for the model.
There are two things I find problematic about the thesis that higher order goods are more sensitive to interest rates:
1) It doesn't seem like the production process is as linear as supposed. True, the appropriation of natural resources from the Earth is a sort of starting point. However, even this uses capital. Which is the highest order, the miner of iron ore or the manufacturer who shapes the iron into tools that are used for mining iron ore? In the example Smiling Dave gave, the production process was lengthened by adding a step in the middle, not by changing anything at the beginning. Natural resources like logs and ore can be used in a wide variety of production processes. It doesn't seem like a lengthened production process would necessarily entail an increased demand for them.
What I thought roundaboutness referred to was not the length of the production process in regards to the transformation of a natural resource into a consumer good, but to the turnover of an individual business--the length of time that it takes to transform the products they buy into the products they sell. It makes sense that businesses with longer turnovers would be more sensitive to the interest rate because it takes longer to pay off the loans. Such businesses might include those that rely heavily on labor-intensive work, like research and development. Often new industries start off by producing everything from scratch in one long turnover, but later these processes are broken down into smaller turnovers that are performed by separate businesses. This may be partly due to the fact that longer turnovers are more sensitive to the interest rate.
2) Debt isn't the only way to finance a business. Businesses also sell equity. You can only say that different stages of the production process are disproportionately affected by changes in the interest rate if you assume that all businesses have the same debt to equity ratios. But this is far from the case. Businesses that are more sensitive to fluctuations in the interest rate rely more heavily on equity to reduce this risk. Technology companies like Apple tend to have low debt to equity ratios.
FOTH,
"It doesn't seem like the production process is as linear as supposed. True, the appropriation of natural resources from the Earth is a sort of starting point. However, even this uses capital. Which is the highest order, the miner of iron ore or the manufacturer who shapes the iron into tools that are used for mining iron ore?"
This is a good point, and I think that it might actually lead to a much more interesting view of the production structure, yet in this example that you give I should think that it's obvious where the product as a whole goes. For instance, iron which is then made into a tool to produce more iron is at the "top" of the production structure. If more iron is made into capital that then goes into the production of other first order goods then it is a good of a higher order than iron that is destined for use in a consumers good. Remember that when were talking about the use of a specific production structure we are usually talking about the linear production of a singular good: logs to planks to treated planks to chairs. This is a snapshot of how the original means of production is refined to an increasing level of specificity and then made into a consumers good. No one is saying that wood only goes to the production of chairs.
"You can only say that different stages of the production process are disproportionately affected by changes in the interest rate if you assume that all businesses have the same debt to equity ratios."
... Why? The interest rate is the time preference of money. If an industry can't give a normal return then it ultimately makes sense for share holders just to sell off the company itself and invest their money elsewhere, and the interest rate is the lower bound for what a normal return is. You could "be your own bank" and have more than enough money to fund your own industry at a loss for decades, but if you're making a profit of 10% and the interest rate is 15% (both high intentionally) then you're running at an economic loss, and regardless of your psychic profit and preferences you would be better off financially by selling the company and investing your money.
Yes, I agree in that the iron ore is "higher" in the sense that it is closer to nature, but I don't see how that plays into the lengthening of the production process. Maybe a different example would be of more help. Let's return to Crusoe who has just made a fishing pole so that he can catch more fish. At first, he eats the fish raw but then decides that it might be worthwhile to spend some extra time cooking them--increasing the length of the production process. In what way does this decrease in time preference affect the higher order (fishing pole construction) more than the lower order (cooking) and the middle order (fishing)? Does Crusoe need to build more fishing poles because he has decided to cook his fish?
OK, let me summarize what I take to be the Austrian view. To oversimplify, producers are divided into two categories: "higher order" and "lower order" (which I contend should actually be longer and shorter turnover, but that's beside the point here). If the interest rate goes up, the profitability of the higher order producers goes down--drawing investment away from the higher order. Thus, we could say:
If the interest rate increases by Y percent, then X dollars of investment will move from businesses of the higher order to those of the lower order.
Now to move on to equity/debt ratios. Suppose there are two companies (again, oversimplifying with an extreme scenario). Company A is 100% financed by equity and company B is 100% financed by debt. The costs of production for each company is $100. The rate of interest is 1%. Suppose company A sells its product for $110, and company B sells its product for $111.1. Thus, the rate of profit is 10% for both companies. Now suppose the interest rate rises to 5% while the prices remain the same. Now company A is still making a profit of 10% but company B is only making a profit of 5.8%. Forgive me if I made any math errors, but I think you should see the point. If the interest rate rises, then investment is going to shift from businesses financed by debt to those financed by equity. Thus, we could say:
If the interest rate increases by Y percent, then Z dollars of investment will move from businesses of the high debt ratio to those of the low debt ratio.
Now if all businesses with a high debt ratio also happen to be businesses of a lower order and all businesses with a low debt ratio happen to be of a higher order, and if X equals Z, then an increase in the interest rate by Y percent would not cause a shift in investment at all. The structure of production would remain the same.
Does that make sense? I've been playing around with another example in my head which may explain things more clearly--and address the relationship between the interest rate and time preference. I don't have time to write it now, but maybe in the next few days.
EDIT: I realized after posting that the rate of profit should perhaps be calculated based on the equity invested rather than the total capital outlay. In this case, we should make company B financed by 10% equity and 90% debt. Thus, at an interest of 1%, the product would have to sell for roughly $102 to realize a 10% rate of profit for the equity invested. But a rise in the interest rate to 5% would turn that profit into a loss, while still leaving company A unaffected. So my point remains valid just the same.
Question: Is the Robinson Crusoe example supposed to communicate anything about the interest rate or is it simply supposed to illustrate that more roundabout production processes tend to be more productive? What exactly can be said about the interest rate (or even proto-interest rate) in the Crusoe scenario?
Sorry I haven't responded to your earlier post. It's on my to do list (I've been vaguely AWOL on these forums lately) and I only just realized that it's been a week since your post. So I'll answer your second question here.
In the Crusoe example the net is supposed to show the importance of taking time for production instead of consumption. The Interest rate is likened to his time preference, since this is the Austrian view of what interest signals within society. The question I've always had is what the saved fish are supposed to signify.
2400th post
No problem. Take your time. I took nearly a week to respond to your post.
I can see how time preference, rate of savings, and production vs. consumption come into play in this example, but I do not think it communicates anything about the interest rate, or I should say, the real interest rate. I agree that more savings are necessary to undertake more roundabout processes of production. I think I even agree that time preference correlates to the rate of saving. But I do not think that the average rate of savings in a society necessarily correlates to the rate of interest, nor do I even suppose that there is a tendency for it to. We might introduce into the Crusoe scenario a second person who offers to lend Crusoe fish during the time he builds the net/pole. If the rate of interest is low, Crusoe might accept the loan, and we might then say that this loan funds the enterprise. But if the rate of interest is high, it doesn't mean that Crusoe will no longer engage in the production process. After all, we already concluded that he would if he were by himself. Why would the presence of a lender now stop him from saving his own fish to fund the project as before? (BTW, I think the saved fish are supposed to signify capital funds, or production funds.)
This is just meant to clarify my previous post for when you have time to respond.