Economics Questions

Re: Higher Order Goods and Interest Rate Sensitivity

Fool on the Hill — Sat, 04 May 2013 01:47:12 GMT

No problem. Take your time. I took nearly a week to respond to your post.

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.

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.

Re: Higher Order Goods and Interest Rate Sensitivity

Neodoxy — Fri, 03 May 2013 06:36:36 GMT

FOTH,

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.

Edit

2400th post

Re: Higher Order Goods and Interest Rate Sensitivity

Fool on the Hill — Fri, 03 May 2013 02:42:03 GMT

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?

Re: Higher Order Goods and Interest Rate Sensitivity

Fool on the Hill — Fri, 26 Apr 2013 02:26:24 GMT

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.

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?

... 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.

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.

Re: Higher Order Goods and Interest Rate Sensitivity

Neodoxy — Sat, 20 Apr 2013 17:29:18 GMT

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.

Re: Higher Order Goods and Interest Rate Sensitivity

Fool on the Hill — Sat, 20 Apr 2013 05:07:48 GMT

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.

Re: Higher Order Goods and Interest Rate Sensitivity

Jargon — Thu, 18 Apr 2013 22:00:37 GMT

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.

Re: Higher Order Goods and Interest Rate Sensitivity

Neodoxy — Thu, 18 Apr 2013 21:46:58 GMT

"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%

Therefore:

3rd stage: Fall in MC by 10%. Increase in demand by 20%

Therefore:

2nd stage: Fall in MC by 10%. Increase in demand by 30%

Therefore:

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.

Re: Higher Order Goods and Interest Rate Sensitivity

Jargon — Thu, 18 Apr 2013 15:40:35 GMT

Neodoxy:

"To whom does it matter? The capitalist of the earliest stage? And if it is only the next capitalist, not the seller of the final good, in the Str.-of-Prod. who buys his good, why does it matter how long the whole Str.of.Prod takes to complete?"

I explained this earlier:

"For this reason the logger need not say "hmm... The production structure appears to be lengthening today. I'm gonna go log me some logs cuz I'm a logger who logs", rather the logger might just see the demand for his logs increases because now the plank curer's costs have gone down, while at the same time the logger's supply curve shifts to the right precisely because his prices have gone down."

The fact is that if you agree with me on the point above then this MUST be the case. It ultimately doesn't matter who finally figures it out, but someone has to or else the productive structure will run at a loss. Because costs, including interest, are ultimately passed on to the next stages of production (in equilibrium) it must matter because that is simply how much cost accumulates.

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.

Anyways I think that I've come up with an explanation which is satisfying enough, that early stage capitalists will not have to suffer a cut-back that late stage capitalists must suffer in the face of reduced consumer demand. So according to this idea, it will tend to be the earliest stage capitalist who is most encouraged by lowering of societal time preference, but there may easily and often be other factors which guide the SoP to thicken at the top rather than lengthen (for instance if the cost of new expensive durable producers goods was much higher in a stage of production 'one level' beneath the earliest stage of production than in that earliest stage, then a thickening would occur).

Re: Higher Order Goods and Interest Rate Sensitivity

Neodoxy — Wed, 17 Apr 2013 23:43:33 GMT

"To whom does it matter? The capitalist of the earliest stage? And if it is only the next capitalist, not the seller of the final good, in the Str.-of-Prod. who buys his good, why does it matter how long the whole Str.of.Prod takes to complete?"

I explained this earlier:

"For this reason the logger need not say "hmm... The production structure appears to be lengthening today. I'm gonna go log me some logs cuz I'm a logger who logs", rather the logger might just see the demand for his logs increases because now the plank curer's costs have gone down, while at the same time the logger's supply curve shifts to the right precisely because his prices have gone down."

The fact is that if you agree with me on the point above then this MUST be the case. It ultimately doesn't matter who finally figures it out, but someone has to or else the productive structure will run at a loss. Because costs, including interest, are ultimately passed on to the next stages of production (in equilibrium) it must matter because that is simply how much cost accumulates.

However, upon further reflection I believe that it is most likely to begin with the original stages of production. If we think of a single producer whose costs fall as a result of the decrease in the interest rate, then he will almost certainly be able to maximize profits by increasing output (MC falls at every quantity and therefore hit MR at a greater quantity). Then the second order capitalist will be able to do the same because his costs are lower, and so on down the line.

Edit

Further on this last point, not only does the MC of the first stage of production decrease, therefore increasing profit-maximizing output, but the same happens for the next stage of production. Because his costs have decreased his demand for inputs increases. Therefore not only does the supply of first order capital goods shift rightward, but the demand does as well, dramatically increasing the quantity of first order goods produced.

If the we take a disequilibrium condition where length of production is "too long" and interest ultimately pushes the costs of production as a whole over consumer expenditures on the total product. If this occurs then the final stage of production will run a loss. In light of this they realize that the costs of inputs exceed output and will therefore they will decrease their demand and refuse to buy the entirety of the second to last stage's capital. This moves down the line until the original stage of production must cut the amount it's supplying as demand has shifted to the left.

Remember that this is the "final" possible way that this could occur. This is the fail-safe in the capitalist system if the entrepreneurs in the final stage don't realize that this will be the case and cut their demand, and the producers before that realize that the final stage producers will do this, and therefore cut their demand, on and on to the original stage of production.

Re: Higher Order Goods and Interest Rate Sensitivity

Jargon — Wed, 17 Apr 2013 22:40:53 GMT

Neodoxy:

Because otherwise losses would result to the producers in the first stage of production and this production structure does not last. If there's just you, me, and bob each of whom are capitalists producing in one year over the course of 3 years, you produce the first capital good and I pay you for that. Then using your capital good I produce the second capital good and Bob pays for that, then Bob produces the consumers good and the consumers pay for it. The consumer spending must be enough to pay off all of our combined costs or else the production structure was unsustainable. I have to pay for your costs or else you would not produce your good, but because my payoff comes from Bob he has to pay for the cost, not only of my product but also of your product. If the costs didn't "stick", then I might (ignoring interest payments for now) pay you 5$ for your capital good, spend $5 producing my capital good on top of that, and then Bob would only pay back for MY capital good with $5 and I would be 10 dollars net in the hole.

Thusly interest payments drastically increase the amount needed all down the line because you take out a loan to cover your costs, then I take out a loan to cover your costs, my costs, and your interest costs. Then Bob has to take out a loan to pay off my costs, your costs, his costs, my interest payment, and your second round of interest payments.

Ok I see that the the consumer demand for the capital structure of a given consumer good must be equal or greater than the production costs for the capital goods within that structure.

Therefore the period of time between when the consumers good hits the market and when the production which ultimately leads to that good first begins matters since the longer any good takes to produce the greater the opportunity cost will be.

To whom does it matter? The capitalist of the earliest stage? And if it is only the next capitalist, not the seller of the final good, in the Str.-of-Prod. who buys his good, why does it matter how long the whole Str.of.Prod takes to complete?

Re: Higher Order Goods and Interest Rate Sensitivity

Neodoxy — Wed, 17 Apr 2013 20:55:10 GMT

"How/Why?"

Because otherwise losses would result to the producers in the first stage of production and this production structure does not last. If there's just you, me, and bob each of whom are capitalists producing in one year over the course of 3 years, you produce the first capital good and I pay you for that. Then using your capital good I produce the second capital good and Bob pays for that, then Bob produces the consumers good and the consumers pay for it. The consumer spending must be enough to pay off all of our combined costs or else the production structure was unsustainable. I have to pay for your costs or else you would not produce your good, but because my payoff comes from Bob he has to pay for the cost, not only of my product but also of your product. If the costs didn't "stick", then I might (ignoring interest payments for now) pay you 5$ for your capital good, spend $5 producing my capital good on top of that, and then Bob would only pay back for MY capital good with $5 and I would be 10 dollars net in the hole.

Thusly interest payments drastically increase the amount needed all down the line because you take out a loan to cover your costs, then I take out a loan to cover your costs, my costs, and your interest costs. Then Bob has to take out a loan to pay off my costs, your costs, his costs, my interest payment, and your second round of interest payments.

"Ok, but we didn't anyways. We assumed 3 stages with the costs 500, 350, and 275"

That was my fault. I sometimes fumble over myself when making examples. I thought I erased that bit.

"Maybe it's the way you set this up, but it makes no sense to me. Exactly who is paying the cost 'S1'? If the manufacturers in S2 have to pay costs which have 'stuck' to the product from the first stage then why are their operating costs not higher than the manufacturers in S1?"

All of the "SX's" was supposed to signal the number of the stage of production. Thusly whatever capitalist is forwarding the funds in stage 1 is paying for stage 1. The "operating costs" are higher in stage 2 than stage 1 if you include the price of capital. If you're talking about variable costs at any particular point in time they are wholly unaffected by this. That is the whole problem, all costs of production ultimately come from the consumer, and all investment opportunities have to at very least match the interest rate. Therefore the period of time between when the consumers good hits the market and when the production which ultimately leads to that good first begins matters since the longer any good takes to produce the greater the opportunity cost will be. I don't understand where, in your current conception of the production structure, the money to pay off the original stages comes from.

Remember, in the market economy the interest rate is the opportunity cost of time. The longer the production period, the higher the opportunity cost in the form of interest, whether this be implicit or explicit through preexisting funds invested into the company or loans taken out from banks.

Are we getting any deeper now?

Re: Higher Order Goods and Interest Rate Sensitivity

Jargon — Wed, 17 Apr 2013 20:05:29 GMT

Neodoxy:

The reason why what matters is how far away the logger is from consumption is because his costs "stick" to the product throughout the productive structure.

Now if the logger's total costs are (without interest) $500, then this has to be paid for all down the line, and due to interest it magnifies not only in that stage but throughout each stage.

How/Why?

If we assume (for the sake of brevity) three stages of production with equal costs.

Ok, but we didn't anyways. We assumed 3 stages with the costs 500, 350, and 275

Thusly for the three stages we have:

Let I=1+i

500I=S1

S1I+350I=S2

S2I+275I)=S3

Or, if we were to expand out this problem we would get

500I^3+350I^2+275I^1=Total amount paid by consumers

Maybe it's the way you set this up, but it makes no sense to me. Exactly who is paying the cost 'S1'? If the manufacturers in S2 have to pay costs which have 'stuck' to the product from the first stage then why are their operating costs not higher than the manufacturers in S1?

The cost from the first stage is passed down to each stage and must be paid for at interest until the consumers pay off the total costs.

How?

The plank-curer pays 500 dollars for the logs and then he must pay for that at interest. So to must the chair maker who must pay for the costs of the logger and the plank-curer at interest. Thusly, decreasing I decreases costs dramatically all down the line.

For this reason the logger need not say "hmm... The production structure appears to be lengthening today. I'm gonna go log me some logs cuz I'm a logger who logs", rather the logger might just see the demand for his logs increases because now the plank curer's costs have gone down, while at the same time the logger's supply curve shifts to the right precisely because his prices have gone down.

Do YOU Dig?

Sad to say that I do not dig. And if all this were true (not saying that it isn't) wouldn't it necessitate that any societal lowering of time preference would induce a thickening of the production structure most prominently in the bottom/later stages? As, apparently, they pay for the interest payments of all those producers above them? Which would then be proving the exact opposite of Bohm Bawerk's structure of capital...

Re: Higher Order Goods and Interest Rate Sensitivity

Neodoxy — Tue, 16 Apr 2013 20:05:27 GMT

Also,

I do agree that a change in the interest rate is just as likely to cause, as you say, a "thickening" in the production structure as it is to lengthen it, although this does in truth count as a "lengthening" of the structure of production since more total time is spent in production than was previously the case.

I've been saying it a lot lately, but seriously guys; Man, Economy, and State.

Re: Higher Order Goods and Interest Rate Sensitivity

Neodoxy — Tue, 16 Apr 2013 00:11:26 GMT

Tisk tisk Jargon, I think you're forgetting a very simple detail about how the structure of production and costs work.

"What you are saying above, I believe, is that, because the logger is the furthest from the point of consumption (in a temporal sense) he is most vulnerable to the price of loanable funds, because the amount of time his endeavor will take is of the utmost importance. I am responding that it matters not how far he is from consumption. What matters is how far, temporally, he is from the person who will purchase his product, no matter where he might be situated in the capital structure."

I think that you are right about our differences, but I think that you are wrong on causality. The reason why what matters is how far away the logger is from consumption is because his costs "stick" to the product throughout the productive structure. Let's assume that after an increase in investment resulting from a decrease in consumption we have finally reached the new equilibrium position, thusly bypassing all problems of entrepreneurial error in the short run. Now if the logger's total costs are (without interest) $500, then this has to be paid for all down the line, and due to interest it magnifies not only in that stage but throughout each stage. If we assume (for the sake of brevity) three stages of production with equal costs. Thusly for the three stages we have:

Let I=1+i

500I=S1

S1I+350I=S2

S2I+275I)=S3

Or, if we were to expand out this problem we would get

500I^3+350I^2+275I^1=Total amount paid by consumers

The cost from the first stage is passed down to each stage and must be paid for at interest until the consumers pay off the total costs. The plank-curer pays 500 dollars for the logs and then he must pay for that at interest. So to must the chair maker who must pay for the costs of the logger and the plank-curer at interest. Thusly, decreasing I decreases costs dramatically all down the line.

For this reason the logger need not say "hmm... The production structure appears to be lengthening today. I'm gonna go log me some logs cuz I'm a logger who logs", rather the logger might just see the demand for his logs increases because now the plank curer's costs have gone down, while at the same time the logger's supply curve shifts to the right precisely because his prices have gone down.

Do YOU Dig?