12 Apr 2019

Capital & Interest in the Austrian Tradition, Part 1 of 3

Austrian School, Bob Murphy Show, Capital & Interest 5 Comments

If you are a professional economist, you should at least give this a listen starting at 37:10. That’s the second half of the episode where I explain how Bohm-Bawerk’s critique of the “naive productivity theory of interest” can be correct, even though mainstream models routinely conclude that r=MPK.

Of course, if you call yourself an Austrian, then you are obligated to listen to the entire thing no later than August 10, 2019.

5 Responses to “Capital & Interest in the Austrian Tradition, Part 1 of 3”

  1. Tel says:

    About Bohm-Bawerk’s tractor critique … let’s suppose I discover that rolling out black plastic sheeting between rows of vegetables will improve the productivity of crop yields by $500 per acre per year. At the time of this discovery, the same black plastic sheeting is used by the building industry and in various types of rubbish disposal and already has a market price … for argument’s sake suppose capital costs are $100 per acre to get the productivity gain, based on pre-discovery market prices. We could say that it lasts two years in the field before it needs replacement, and we can presume all other costs are built into the $500 per acre per year gain (for example extra labour to roll out the plastic is more than offset by less labour pulling weeds or something like that).

    Further suppose this technique becomes common knowledge and plenty of farmers start to use it.

    Bohm-Bawerk would be surprised unless the market price of black plastic sheet shot up to $1000 for what had previously cost only $100. If the cost was any lower, the plastic sheet would be greatly undervalued, given the equivalent rent value and all that. But why though? The existing manufacturers were making OK profits at $100 and they already have a market lined up … why not sell a bit more at the same price? Perhaps the price might even go up a little because of greater demand, but not a tenfold increase.

    What actually happens is that once a new capital productivity improvement is known and gets widely used, the market price of the crop comes down, and you hit physical diminishing returns on investment (putting down twice as much plastic doesn’t help) and it balances out again, so you don’t make a gain of $500 per acre anymore, you might make a gain of $60 per acre and the input price goes up a little bit to $110 per acre and the farmer ends up with a small positive return on investment. Essentially … the application of that particular factor of production keeps growing until it runs up against saturation at some point (both physical productivity limits and falling prices).

    Same applies to tractors of course … we saw after WWI when tractors were introduced, the price of tractors actually went DOWN driven by better mass manufacturing techniques, and the price of food also went down, because farmers were more productive … in a competitive market they push against the downward sloping demand curve and they stop buying tractors at the point where it isn’t worth having any more of them. Some farmers went out of business, unable to profitably supply into a falling market price of food. Demand for other factors such as diesel fuel, mechanics, etc goes up.

    Bohm-Bawerk’s argument only works on a temporary basis where a whole new capital good is released into a market and in that case, yeah those type of capital goods do tend to be expensive, but there’s a bunch of risk involved at the supply side and typically the suppliers want to encourage early adoption, so they don’t attempt to capture the entire profit. Think of smart phone manufacturers who probably made much better than normal market return for a while at least.

    • Bob Murphy says:

      Tel, did you just prove that nobody makes an interest return when they invest in inputs, in a production technique that’s been around for more than a year?

      • Tel says:

        I won’t claim credit for the proof … it’s a standard long run equilibrium result based on a competitive market.

        https://www.cliffsnotes.com/study-guides/economics/perfect-competition/long-run-supply

        Zero economic profits. The entry and exit of firms, which is possible in the long‐run, will eventually cause each firm’s economic profits to fall to zero. Hence, in the long‐run each firm earns normal profits. If some firms are earning positive economic profits in the short‐run, in the long‐run new firms will enter the market and the increased competition will reduce all firms’ economic profits to zero. Firms that are earning negative economic profits (losses) in the short‐run will have to either make some changes in their fixed factors of production in the long‐run or choose to leave the market in the long‐run. A perfectly competitive market achieves long‐run equilibrium when all firms are earning zero economic profits and when the number of firms in the market is not changing.

        Competitive markets plus technological advancement over time drives down the price of goods. What’s controversial about that? Seems a bit inconsistent to believe this applies to finished product consumer goods but strangely does not apply to capital goods in earlier stages of production. Am I missing an important distinction somewhere?

        • Transformer says:

          as far as I can see you are not distinguishing between profit (which market forces will eliminate) and interest (which will persist) from the new technologies.

        • Bob Murphy says:

          Tel, “economic profit” means profit above and beyond the market rate of interest. (This is admittedly a slippery concept in the real world.) It’s true that textbook discussions rarely stress this, but clearly it must be true that the prices of factors of production don’t get bid up to the “full value of the product” *measured at the moment of sale of the product*, but only its present-discounted value at the moment of purchase. You don’t see this distinction much in textbooks because they don’t assume production takes any time!

          Suppose there’s a zero-coupon bond that will pay $1000 in 12 months. How much would an investor pay for it right now? Not the full $1,000, even in a competitive market for bonds.

          Likewise, if there are some labor-hours, land, and raw materials that could be mixed together to produce a good that will sell for $1,000 in 12 months, even with competition nobody would pay a full $1,000 for all of those inputs right now.

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