Production & the Market Process

Robert P. MurphyMises Academy

July 27, 2011

Lecture 2: 1st Half of Chapter 6 of Man, Economy, and State

1st Half ofChapter 6 of MES

I. Assumptions

II. Stationary Economy

II. Interest Theory in the Austrian Tradition

A. Bohm-Bawerk

B. Fetter

C. Mises

I. Assumptions

Chapter 6 deals with the “pure” rate of interest (due to time preference). Later chapters will handle the components of the market rate of return due to a purchasing-power-premium and risk.

However, we relax some of the unrealistic assumptions from Chapter 5. We allow for factors to be used in various goods (i.e. less specific), and we have capitalists paying factor owners after each each stage (i.e. not joint ownership).

II. Stationary Economy

A. Facts About Economy of Fig. 41

Interest rate observable from price spreads; about 5.2% (with rounding) at each stage.

Sum of capitalist and factor owners’ income equals total consumer spending.

Total gross investment = 318 oz. (95+76+57…)

Gross investment x interest rate = total income of capitalists (with rounding)

Net investment = 0 oz.

B. Capital Goods in the ERE

Capital goods earn no “independent” income in ERE; only land and labor do.

Income accruing to capitalists is due purely to the time element; they advance present goods to workers in exchange for future goods.

III. Interest Theory in Austrian Tradition

A. Eugen von Bohm-Bawerk

Interest problem: Why is it that capitalists earn an income, without seeming to contribute anything productive (like labor or natural resources)?

1. Naïve Productivity Theory

Bohm-Bawerk said the answer not that “capital goods are productive.”

Yes, we can produce more with capital goods than without them. But that explains why businessowners pay prices for capital goods. It doesn’t explain why investors pay lower prices for capital goods than they will eventually yield them (when the higher output is sold).

1. Naïve Productivity Theory (cont’d)

$100,000

$110,000

2. Bohm-Bawerk’s Agio Theory

Present goods are preferred to a like kind and quantity of future goods.

Now, one of the reasons Bohm-Bawerk thought present goods subjectively preferred to future goods, was the higher (technical) productivity of “roundabout processes.”

B. Frank Fetter

Thought Bohm-Bawerk had ironically slipped back into the same error he had exploded. Fetter argued that interest had nothing to do with productivity of capital at all; it was due entirely to subjective time preference.

C. Ludwig von Mises

Agreed with Fetter, but thought time preference was a necessary implication of action. (Fetter had just thought it was an empirical fact about human valuation.)