2. The Effect of Net Investment
Having considered the ERE and its relation to specific entrepreneurial profit and loss,
let us now turn to the problem, when will there be aggregate profits or losses in the economy?
This is connected with the question, what is the effect of a change in the level of aggregate
Saving or Investment in the Economy Let us begin with an economy in the equilibrium
depicted in chapters 5 and 6. Production 6 years in total length. Total gross income
is 418 gold ounces. Gross savings investment is 318 ounces. Total consumption 100 ounces.
The net savings investment is zero.
Of the 100 ounces of income, 83 ounces of net income are earned by land and labor owners,
17 ounces by capital owners.
The production structure remains constant because the natural rates of interest coincide
and the resulting price spreads conform to the aggregate of individual time preference
Schedules in the Economy.
As Hayek states, whether the structure of production remains the same depends entirely
upon whether entrepreneurs find it profitable to reinvest the usual proportion of the return
from the sale of the product in turning out intermediate goods of the same sort.
Whether this is profitable, again, depends upon the prices obtained for the product of
of this particular stage of production on the one hand and on the prices paid for the original means of production and for the intermediate products taken from the preceding stage of production on the other.
The continuance of the existing degree of capitalistic organization depends accordingly on the prices paid and obtained for the product of each stage of production,
and these prices are, therefore, a very real and important factor in determining the direction of production.
What happens if in a certain period there are now net savings as a result of a lowering of time preference schedules?
Suppose, for example, that consumption decreases from 100 to 80 and that the saved 20 ounces enter the time market.
Market.
Gross savings have increased by 20 ounces.
During the transition period, net savings has changed from 0 to 20.
After the new level of savings has been reached, however, there will be a new equilibrium with
gross savings equaling 338 and net savings equaling 0.
To the superficial, it might seem that all is lost.
Is Not Consumption Decreased from 100 to 80 oz? What then will happen to the whole complex
of productive activities that rest on final consumption sales? Will this not lead to a
disastrous depression for all firms? And how can a reduced consumption profitably support
an increased volume of expenditures on producers' goods? The latter has aptly been termed by
by Hayek, The Paradox of Saving, that is, that saving is the necessary and sufficient
condition for increased production, and yet, that such investment seems to contain within
itself the seeds of financial disaster for the investors.
It is clear that the volume of money incomes to capitalists won will be drastically reduced.
The amount that they have to apportion to original factors and to capitalists, too, is therefore also considerably decreased.
Thus, from the side of final consumers' spending, an impetus toward declining money incomes and prices is sent along the production structure.
In the meanwhile, however, another force has concurrently come into play.
The 20 ounces have not been lost to the system.
They are in the process of being invested in the economy,
their owners ranging throughout the economy looking for maximum interest returns on their investment.
The new savings have changed the ratio of gross investment to consumption from 318 to 100 to 338 to 80.
A narrower consumption base must support a larger amount of producers' spending.
How can this happen, especially since the lower-rank capitalists must also receive a lower aggregate income?
The answer is, in only one way, by shifting investment further up the ladder to the higher order production stages.
Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages,
while preserving uniform lowered interest differentials, cumulative price spreads at each stage,
is to increase the number of productive stages in the economy, that is, to lengthen the structure of production.
The impact of net saving on the economy, that is, of increased total savings,
is to lengthen and narrow the structure of production, and this procedure is viable and self-supporting,
Let us consider the price changes in the various stages and the processes by which they occur.
In the lower stages, prices fall because of the lower consumer demand and the resulting
shift of investment capital from the stages' nearest consumption.
In the higher stages, on the other hand, demand for factors increases under the impact of
the new savings and the shift in investment from the lower levels.
The increased investment expenditure in the higher levels raises the prices of the factors
in these stages.
It is as if the impact of lower consumer demand tends to die out in the higher stages and
is more and more counteracted by the increase and shift in investment funds.
The process of readjustment to lower price spreads caused by increased gross saving has
been lucidly described by Hayek.
As he states, the final effect will be that through the fall of prices in the later stages
The Changes in Cumulative Prices in the Various Sectors will lead to changes in the prices of the particular goods that enter into the cumulation of factors.
These factors are, of course, the capital goods, land and labor factors, and are ultimately reducible to the latter two, since capital goods are produced and reproduced factors.
It is clear that lower aggregate demand in the lower stages will cause the prices of the various factors there to decline.
The specific factors will have to bear the brunt of the decline, since they have nowhere else to go.
The non-specific factors, on the other hand, can and do go elsewhere, to the earlier stages,
where the monetary demand for factors has increased.
The pricing of capital goods is ultimately unimportant in this connection,
because it is reducible to the prices of land, labour and time and because the interest spread
indicates the mode of pricing of the capital goods. The ultimately important factors then are land,
labour and time. The time element has been extensively considered and accounts for the
interest spread. It is the land and labour elements that constitute the fundamental
The possibility of a labor factor will differ from one task to another. No one disputes this.
Indeed, if this were not so, the factor would be purely non-specific.
And we have seen that this is an impossibility.
Specific is here used to mean pure specificity for one production process.
Of course, there are different degrees of non-specificity for any factor.
The less specific ones will be more readily shifted from one stage or product to another.
Those factors which are specific to only one particular stage and process will therefore fall in price in the later stages and rise in the earlier stages.
What of the non-specific factors, which include all labor factors?
These will tend to shift from the later to the earlier stages.
At first there will be a difference in the price of each non-specific factor.
It will be lower in the lower stages and higher in the higher stages.
In equilibrium, however, as we have seen time and again, there must be a uniform price for
any factor throughout the economy.
The lower demand in the lower stages and the consequent lower price coupled with the higher
demand and higher price in the higher stages causes the shift of the factor from later
to earlier stages.
The shift ceases when the price of the factor is again uniform throughout.
We have seen the impact of new saving, that is, a shift from consumption to investment
on the prices of goods at various levels.
What however is the aggregate impact of a change to a higher level of gross savings
on the prices of factors?
Here we reach a paradoxical situation.
Net income is the total amount of money that ultimately goes to factors, land, labor and
time.
In any equilibrium situation, net saving is zero by definition, since net saving means
a change in the level of gross saving over the previous period of time, and net income
equals consumption and consumption alone.
Total income for original factors and interest can come only from net rather than gross income.
Let us consider the new ERE after the change has taken place to a higher level of saving,
ignoring for a moment the relevant conditions during the period of change.
Gross savings equals gross investment has increased from $3.18 to $3.38, but consumption
One has declined from 100 to 80, and it is consumption that provides the net income in
the equilibrium situation.
Net income is, as it were, the fund out of which money prices and incomes are paid to
original factors, and this fund has declined.
The recipients of the net income fund are the original factors, labor and land, and
Interest on Time.
We know that the interest rate declines.
This is a corollary of the increased saving and investment in the productive system, caused
by lower time preference.
However, the absolute amount of interest income is gross investment multiplied by the rate
of interest.
Gross investment has increased, so that it is impossible for economic analysis to determine
Whether interest income has fallen, increased or remained the same, any of these alternatives
is a possibility.
What happens to total original factor income is also indeterminate.
Two forces are pulling different ways in a progressing economy, an economy with increasing
gross investment.
On the one hand, the total net income money fund is falling.
On the other hand, if the interest decline is large enough, it is possible that the fall
in interest income will outstrip the fall in total net income, so that total factor
income actually increases.
For this to occur is possible, but empirically highly unlikely.
The one certain prospect is that total net income for factors and interest will fall.
If the total original factor income falls then, since we have implicitly been assuming
a given supply of original factors, the prices of these factors as well as the interest rate
will in general also decline.
That the general trend of original factor incomes and prices may well be downward is
a startling conclusion, for it is difficult to conceive of a progressing economy as one
in which factor prices, such as wage rates and ground rents, steadily decline.
What interests us, however, is not the course of money incomes and prices of factors, but
of Real Incomes and Prices, that is, the goods income accruing to factors.
If money wage rates or wage incomes fall, and the supply of consumers goods increases,
such that the prices of these goods fall even more, the result is a rise in real wage rates
and real incomes to factors.
That this is precisely what does happen solves the paradox that a progressing economy experiences
falling wages and rents.
There may be a fall in money terms, although not in all conceivable cases, but there will
always be a rise in real terms.
The rise in real rates and incomes is due to the increase in the marginal physical productivity
Productivity of factors that always results from an increase in saving and investment.
The increased productivity of the longer production processes leads to a greater physical supply
of capital goods and, most important, of consumers' goods, with a consequent fall in the prices
of consumers' goods.
As a result, even if the money prices of labor and land fall, those of consumers' goods
will always fall farther, so that real factor incomes will rise.
That this is always true in a progressing economy can be seen from the following considerations.
At any time, the wage or rent of the service of an original factor of production will equal
It's DMVP, the Discounted Marginal Value Product. This DMVP is equal to the MVP, Marginal Value
Product, divided by a discount factor, say D, which is directly dependent on the rate
of interest. The MVP in turn is approximately equal to the MPP, Marginal Physical Product
of the Factor times the selling price, that is, the final price of the consumer's good
product.
In this discussion we are considering the prices of consumer's goods in general or
in the aggregate.
The real prices of the original factors equal the money prices divided by the prices of
consumer's goods.
Strictly, there is no precise, praxeological way of measuring these aggregates, or real income, based on changes in the purchasing power of money, but we can make qualitative statements about these elements, even though we cannot make precise, quantitative measurements.
Now the progressing economy consists of two leading features, an increase in the MPP of original factors resulting from more productive and longer production processes,
and a fall in the discount or interest rate concomitant with falling time preference and increasing gross investment.
Development.
Both elements, the increase in MPP and the fall in D, impel an increase in the real prices
of factor services in a progressing economy.
The conclusion is that in a progressing economy, that is, in an economy with increases in gross
savings and investment, money wages and ground rents may well fall, but real wages and rents
will rise.
Historically, the advancing capitalist economy has coincided with an expanding money supply,
so that we have rarely had an empirical illustration of the pure process described.
We must remember that we have throughout been making the implicit assumption that the money
relation, the demand for and particularly the supply of money, remains unchanged.
The effects of changes in this relation will be considered in Chapter 11.
The only relaxation of this assumption here is that the number of stages increases, and
this tends to increase the demand for money to that extent.
One question that immediately presents itself is, how can the prices of factors decline
While the gross income remains the same, and gross investment even increases?
The answer is that the increase in investment goes into increasing the number of stages,
pushing back the stages of production and employing longer production processes.
It is this increasing roundaboutness that causes every increase in capital, even if
with unaccompanied by an advance in technological knowledge to lead to higher physical productivity
per original factor.
The increase in gross investment in particular raises the prices of capital goods at the
highest stages, encouraging new stages and inducing entrepreneurs to shift factors into
this new and flowering field.
The larger gross investment fund is absorbed, so to speak, by higher prices of high-order
capital goods, and by the consequent new stages of turnover of these goods.
The demand for money increases to the extent that each gold unit must turn over more times
in the increased number of stages, thus tending to lower the general level of prices.