WEBVTT NOTE 6.01. Many Stages: The Pure Rate of Interest 1 00:00:00.000 --> 00:00:06.000 Chapter 6. Production. The Rate of Interest and its Determination. 2 00:00:06.000 --> 00:00:12.000 1. Many Stages. The Pure Rate of Interest. 3 00:00:12.000 --> 00:00:19.000 The discussion in this chapter deals with the pure rate of interest, as determined by time preference. 4 00:00:19.000 --> 00:00:27.000 On the role of the purchasing power component in the market rate of interest, see Chapter 11 on money. 5 00:00:27.000 --> 00:00:34.000 Up to this point we have been treating the structure of production as amalgamated into one stage. 6 00:00:34.000 --> 00:00:47.000 One or several firms have all been vertically integrating all the stages of production of a product with all factors specific until finally the product is sold to the consumer. 7 00:00:47.000 --> 00:00:50.000 This is certainly an unrealistic assumption. 8 00:00:50.000 --> 00:01:12.000 We shall now consider the production situation in the real world, where A, factors are non-specific as well as specific, and B, production is divided into numerous stages, as the factors continue to work and advance from the higher to the lower stages of the production process. 9 00:01:12.000 --> 00:01:13.000 Capitalists 10 00:01:13.000 --> 00:01:19.760 Instead of assuming that one firm, one set of capitalists, purchases factors and retains 11 00:01:19.760 --> 00:01:25.440 ownership of the product up through the sale to consumers, let us suppose that there are 12 00:01:25.440 --> 00:01:32.040 different firms and different sets of capitalists at definite intervals, and at each interval 13 00:01:32.040 --> 00:01:38.100 the product, in the stage it has reached up to that point, is sold for money to another 14 00:01:38.100 --> 00:01:41.300 capitalist or group of capitalists. 15 00:01:41.300 --> 00:01:46.740 It is not necessary to make any restrictive assumptions about how many separate stages 16 00:01:46.740 --> 00:01:52.660 occur or what the time intervals between individual stages might be. 17 00:01:52.660 --> 00:01:58.900 For purposes of convenience, we shall assume that each stage takes the same length of time. 18 00:01:58.900 --> 00:02:05.420 Now, instead of collecting interest income for services in one lump sum at the final 19 00:02:05.420 --> 00:02:19.420 The Capitalist or Capitalists acquire interest income at each stage. If each stage takes one year, then the entire production process for the good takes six years. 20 00:02:19.420 --> 00:02:37.420 When the stages are all lumped together or vertically integrated, then one capitalist or set of capitalists advances the owners of original factors their money six years ahead of time, and then waits for this period to acquire his revenue. 21 00:02:37.420 --> 00:02:54.420 Strictly, since the work and pay of labor and land would be continual as the product advanced to its final form, the earliest hired labor and land would be paid, say, in year one, and the latest toward the end of year six. 22 00:02:54.420 --> 00:03:01.420 With separate stages, however, each capitalist advances the money for only one year. 23 00:03:01.420 --> 00:03:17.420 Suppose consumers spend 100 ounces on a particular good. Of the 100 ounces, 5 ounces go as interest income to the sellers of the consumer's good, and 95 are paid out to the owners of factors. 24 00:03:17.420 --> 00:03:29.420 15 ounces go for the use of land and labor, original factors, and 80 go into the purchase of factor services of capital goods of a higher order. 25 00:03:29.420 --> 00:03:36.420 At the second stage, capitalists receive 80 ounces in revenue from the sale of their product. 26 00:03:36.420 --> 00:03:48.420 Of the 80 ounces, 16 go into the purchase of land and labor factors, and 4 accrue as interest income to the second-level capitalists. 27 00:03:48.420 --> 00:03:54.420 The remaining 60 are used for the purchase of higher-order capital goods. 28 00:03:54.420 --> 00:04:00.940 The same process is repeated until, on the highest stage, the highest order capitalists 29 00:04:00.940 --> 00:04:09.320 receive 20 ounces of revenue, retain one for themselves, and pay out 19 to land and labor 30 00:04:09.320 --> 00:04:10.660 factors. 31 00:04:10.660 --> 00:04:16.660 The sum total of income to land and labor factors is 83 ounces. 32 00:04:16.660 --> 00:04:21.280 Total interest income is 17 ounces. 33 00:04:21.280 --> 00:04:27.760 In the foregoing section on interest, we showed that money is always non-specific. 34 00:04:27.760 --> 00:04:34.960 And the result is that in the ERE, the interest return on monetary investment, the pure rate 35 00:04:34.960 --> 00:04:41.280 of interest, is the same everywhere in the economy, regardless of the type of product 36 00:04:41.280 --> 00:04:45.000 or the specific conditions of its production. 37 00:04:45.000 --> 00:04:48.420 Here we see an amplification of this principle. 38 00:04:48.420 --> 00:04:54.980 Not only must the interest rate be uniform for each good, it must be uniform for every 39 00:04:54.980 --> 00:04:57.700 stage of every good. 40 00:04:57.700 --> 00:05:04.380 The interest rate return received by product owners, that is, by capitalists, is equal 41 00:05:04.380 --> 00:05:06.060 at each stage. 42 00:05:06.060 --> 00:05:13.100 At the lowest stage, producers have invested 95 ounces in factors, both capital goods and 43 00:05:13.100 --> 00:05:20.980 and Original Factors, and receive 100 ounces from consumers, a net income of 5 ounces. 44 00:05:20.980 --> 00:05:26.860 This represents a return on the investment of approximately 5.2%. 45 00:05:26.860 --> 00:05:33.980 In the ERE, which we are considering, there are no profits or losses due to uncertainty, 46 00:05:33.980 --> 00:05:38.620 so that this return represents the rate of pure interest. 47 00:05:38.620 --> 00:05:45.980 In the ERE of our example, the pure rate of interest is THE rate of interest, since, as 48 00:05:45.980 --> 00:05:52.560 we shall see, deviations from the pure rate are due solely to uncertainty. 49 00:05:52.560 --> 00:06:02.060 The capitalist at the next higher stage invests 60 plus 16, or 76 ounces in factors, and receives 50 00:06:02.060 --> 00:06:10.220 receives a net return of 4 ounces, again, approximately 5.2%, and so on for each stage 51 00:06:10.220 --> 00:06:16.300 of investment, where, except for the vagaries of the arithmetic in our example, the interest 52 00:06:16.300 --> 00:06:19.380 rate is uniform for each stage. 53 00:06:19.380 --> 00:06:26.300 At the highest stage, the capitalist has invested 19 ounces in land and labor and receives a 54 00:06:26.300 --> 00:06:37.700 The Interest Rate must be equal for each stage of the production process. 55 00:06:37.700 --> 00:06:43.700 For suppose that the interest rate were higher in the higher stages than in the lower stages. 56 00:06:43.700 --> 00:06:50.060 Then capitalists would abandon producing in the lower stage and shift to the higher stage, 57 00:06:50.060 --> 00:06:52.820 where the interest return is greater. 58 00:06:52.820 --> 00:06:55.100 What is the effect of such a shift? 59 00:06:55.100 --> 00:07:00.640 We can answer by stressing the implications of differences in the interest rate. 60 00:07:00.640 --> 00:07:07.540 A higher interest rate in stage A than in stage B means that the price spread between 61 00:07:07.540 --> 00:07:14.840 the sum of factors entering into stage A and the selling price of its product is greater 62 00:07:14.840 --> 00:07:19.840 in percentage terms than the price spread in stage B. 63 00:07:19.840 --> 00:07:38.840 Thus, if we compare Stage 4 and Stage 1 in our example, we find a price spread of 43 to 45 in the former case, and 95 to 100 in the latter, for a net interest return of approximately 5.2% in each. 64 00:07:38.840 --> 00:07:51.840 Let us suppose, however, that the sum of the factor prices for Stage 4 is 35 instead of 43, while the sum of factor prices in Stage 1 is 98. 65 00:07:51.840 --> 00:07:57.840 The sum of factor prices here excludes interest income, of course. 66 00:07:57.840 --> 00:08:05.940 Capitalists investing in Stage 4 would earn a net return of 8, or 23%, while investors 67 00:08:05.940 --> 00:08:09.900 in Stage 1 earned about 2%. 68 00:08:09.900 --> 00:08:15.680 Capitalists would begin to stop investing in Stage 1 and shift to Stage 4. 69 00:08:15.680 --> 00:08:22.760 As a consequence of this shifting, the aggregate demand in Stage 1 for its factors diminishes, 70 00:08:22.760 --> 00:08:27.920 and the prices of the factors used in Stage 1 therefore decline. 71 00:08:27.920 --> 00:08:34.340 In the meanwhile, greater investment in Stage 4 raises factor prices there, so that the 72 00:08:34.340 --> 00:08:38.560 cumulative price rises from 35. 73 00:08:38.560 --> 00:08:45.140 Products of Stage 4 increase, and the increased supply lowers the selling price, which falls 74 00:08:45.140 --> 00:08:47.240 from 43. 75 00:08:47.240 --> 00:08:53.560 These arbitrage actions continue until the percentage spread in each of the two stages 76 00:08:53.560 --> 00:08:55.800 is equal. 77 00:08:55.800 --> 00:09:01.680 It is important to realize that the interest rate is equal to the rate of price spread 78 00:09:01.680 --> 00:09:04.080 in the various stages. 79 00:09:04.080 --> 00:09:10.800 Too many writers consider the rate of interest as only the price of loans on the loan market. 80 00:09:10.800 --> 00:09:17.480 In reality, as we shall see, the rate of interest pervades all time markets, and the productive 81 00:09:17.480 --> 00:09:24.200 loan market is a strictly subsidiary time market of only derivative importance. 82 00:09:24.200 --> 00:09:30.200 In the reams of commentary on J. M. Keynes' general theory, no one has noticed the very 83 00:09:30.200 --> 00:09:36.360 revealing passage in which Keynes criticizes Mises' discussion of this point. 84 00:09:36.360 --> 00:09:42.740 Mises asserted that Mises' peculiar new theory of interest confused the marginal efficiency 85 00:09:42.740 --> 00:09:48.940 of capital, the net rate of return on an investment, with the rate of interest. 86 00:09:48.940 --> 00:09:55.580 The point is that the marginal efficiency of capital is indeed the rate of interest. 87 00:09:55.580 --> 00:09:58.680 It is a price on the time market. 88 00:09:58.680 --> 00:10:04.960 It was precisely this natural rate, rather than the loan rate, that had been a central 89 00:10:04.960 --> 00:10:10.000 Capital Problem of Interest Theory for many years. The essentials of this doctrine were 90 00:10:10.000 --> 00:10:15.800 set forth by Boehm-Bawerk in Capital and Interest and should therefore not have been surprising 91 00:10:15.800 --> 00:10:22.560 to Keynes. It is precisely this preoccupation with the relatively unimportant problems of 92 00:10:22.560 --> 00:10:27.880 the loan market that constitutes one of the greatest defects of the Keynesian Theory of 93 00:10:27.880 --> 00:10:30.000 Interest. 94 00:10:30.000 --> 00:10:36.080 Not only will the rate of interest be equal in each stage of any given product, but the 95 00:10:36.080 --> 00:10:44.400 same rate of interest will prevail in all stages of all products in the ERE. 96 00:10:44.400 --> 00:10:50.700 In the real world of uncertainty, the tendency of entrepreneurial actions is always in the 97 00:10:50.700 --> 00:10:56.880 direction of establishing a uniform rate of interest throughout all time markets in the 98 00:10:56.880 --> 00:10:58.320 economy. 99 00:10:58.320 --> 00:11:06.280 The reason for the uniformity is clear. If stage 3 of good X earns 8% and stage 1 of 100 00:11:06.280 --> 00:11:13.360 good Y earns 2%, capitalists will tend to cease investing in the latter and shift to 101 00:11:13.360 --> 00:11:19.620 greater investments in the former. The price spreads change accordingly in response to 102 00:11:19.620 --> 00:11:26.040 the changing demands and supplies, and the interest rates become uniform. 103 00:11:26.040 --> 00:11:33.040 We may now remove our restrictive assumption about the equality of duration of the various stages. 104 00:11:33.040 --> 00:11:44.040 Any stage of any product may be as long or as short as the techniques of production and the organizational structure of industry require. 105 00:11:44.040 --> 00:11:50.040 Thus, a technique of production might require a year's harvest for any particular stage. 106 00:11:50.040 --> 00:12:03.040 On the other hand, a firm might vertically integrate two stages and advance the money to owners of factors for the period covering both stages before selling the product for money. 107 00:12:03.040 --> 00:12:11.040 The net return on the investment in any stage will adjust itself in accordance with the length of the stage. 108 00:12:11.040 --> 00:12:17.040 Thus, suppose that the uniform interest rate in the economy is 5%. 109 00:12:17.040 --> 00:12:23.040 This is 5% for a certain unit period of time, say a year. 110 00:12:23.040 --> 00:12:35.040 A production process or investment covering a period of two years will, in equilibrium, then earn 10%, the equivalent of 5% per year. 111 00:12:35.040 --> 00:12:40.040 The same will obtain for a stage of production of any length of time. 112 00:12:40.040 --> 00:12:46.480 Thus, irregularity or integration of stages does not hamper the equilibrating process 113 00:12:46.480 --> 00:12:48.920 in the slightest. 114 00:12:48.920 --> 00:12:55.480 It is already clear that the old classical trinity of land, labor and capital, earning 115 00:12:55.480 --> 00:13:01.060 wages, rents and interest, must be drastically modified. 116 00:13:01.060 --> 00:13:07.780 It is not true that capital is an independent productive factor, or that it earns interest 117 00:13:07.780 --> 00:13:14.220 for its owner in the same way that land and labour earn income for their owners. 118 00:13:14.220 --> 00:13:20.660 As we have seen and will discuss further, capital is not an independently productive 119 00:13:20.660 --> 00:13:21.660 factor. 120 00:13:21.660 --> 00:13:27.820 Capital goods are vital and of crucial importance in production, but their production is in the 121 00:13:27.820 --> 00:13:33.300 long run imputable to land, labour and time factors. 122 00:13:33.300 --> 00:13:40.300 Furthermore, land and labor are not homogeneous factors within themselves, but simply categories 123 00:13:40.300 --> 00:13:44.100 of types of uniquely varying factors. 124 00:13:44.100 --> 00:13:50.500 Each land and each labor factor, then, has its own physical features, its own power to 125 00:13:50.500 --> 00:13:52.460 serve in production. 126 00:13:52.460 --> 00:13:58.780 Each therefore receives its own income from production, as will be detailed. 127 00:13:58.780 --> 00:14:01.860 Capital goods, too, have infinite variety. 128 00:14:01.860 --> 00:14:05.580 But in the ERE, they earn no incomes. 129 00:14:05.580 --> 00:14:12.060 What does earn an income is the conversion of future goods into present goods. 130 00:14:12.060 --> 00:14:18.940 Because of the universal fact of time preference, future satisfactions are always at a discount 131 00:14:18.940 --> 00:14:22.020 compared to present satisfactions. 132 00:14:22.020 --> 00:14:28.580 The owning and holding of capital goods from date one, when factor services are purchased, 133 00:14:28.580 --> 00:14:35.380 Until the product is sold at date two is what capitalist investors accomplish. 134 00:14:35.380 --> 00:14:41.260 This is equivalent to the purchase of future goods, the factor services producing capital 135 00:14:41.260 --> 00:14:48.720 goods with money, followed by the sale at a later date of the present goods for money. 136 00:14:48.720 --> 00:14:55.320 The latter occurs when consumers' goods are being sold for consumers' goods are present 137 00:14:55.320 --> 00:14:56.500 goods. 138 00:14:56.500 --> 00:15:02.500 When intermediate lower order capital goods are sold for money, then it is not present 139 00:15:02.500 --> 00:15:07.780 goods but less distantly future goods that are sold. 140 00:15:07.780 --> 00:15:14.500 In other words, capital goods have been advanced from an earlier more distantly future stage 141 00:15:14.500 --> 00:15:21.260 toward the consumption stage to a later or less distantly future stage. 142 00:15:21.260 --> 00:15:26.340 The time for this transformation will be covered by a rate of time preference. 143 00:15:26.340 --> 00:15:34.620 Thus, if the market time preference rate, that is, interest rate, is 5% per year, then 144 00:15:34.620 --> 00:15:42.220 a present good worth 100 ounces on the market will be worth about 95 ounces for a claim 145 00:15:42.220 --> 00:15:45.140 on it one year from now. 146 00:15:45.140 --> 00:15:53.160 The present value for a claim on 100 ounces one year from now will be 95 ounces. 147 00:15:53.160 --> 00:15:58.520 On this basis, the estimated worth of the good could be worked out for various points 148 00:15:58.520 --> 00:15:59.520 in time. 149 00:15:59.520 --> 00:16:06.960 Thus, the claim for one-half year in the future will be worth roughly 97.5 ounces. 150 00:16:06.960 --> 00:16:12.960 The result will be a uniformity of rates over a period of time. 151 00:16:12.960 --> 00:16:19.920 Less capitalists advance present goods to owners of factors in return for future goods. 152 00:16:19.920 --> 00:16:26.480 Then, later, they sell the goods which have matured to become present, or less distantly 153 00:16:26.480 --> 00:16:31.560 future goods, in exchange for present goods, money. 154 00:16:31.560 --> 00:16:37.680 They have advanced present goods to owners of factors, and in return, wait while these 155 00:16:37.680 --> 00:16:43.440 These factors, which are future goods, are transformed into goods that are more nearly 156 00:16:43.440 --> 00:16:45.920 present than before. 157 00:16:45.920 --> 00:16:52.520 The capitalist's function is thus a time function, and their income is precisely an 158 00:16:52.520 --> 00:16:59.240 income representing the agio of present as compared to future goods. 159 00:16:59.240 --> 00:17:06.800 This interest income, then, is not derived from the concrete heterogeneous capital goods, 160 00:17:06.800 --> 00:17:11.000 but from the generalized investment of time. 161 00:17:11.000 --> 00:17:17.240 As Boehm-Bawerk declared, interest may be obtained from any capital, no matter what 162 00:17:17.240 --> 00:17:23.360 be the kind of goods of which the capital consists, from goods that are barren as well 163 00:17:23.360 --> 00:17:29.460 as from those that are naturally fruitful, from perishable as well as from durable goods, 164 00:17:29.460 --> 00:17:35.400 from goods that can be replaced and from goods that cannot be replaced, from money as well 165 00:17:35.400 --> 00:17:45.400 It comes from a willingness to sacrifice present goods for the purchase of future goods, the factor services. 166 00:17:45.400 --> 00:17:55.400 As a result of the purchases, the owners of factors obtain their money in the present for a product that matures only in the future. 167 00:17:55.400 --> 00:18:09.400 Thus capitalists restrict their present consumption and use these savings of money to supply money, present goods, to factor owners who are producing only future goods. 168 00:18:09.400 --> 00:18:23.400 This is the service, an advance of time, that the capitalists supply to the owners of factors, and for which the latter voluntarily pay in the form of the interest rate.