Wednesday, November 24, 2010

Prices and Production, Lecture 2, Post 1

It's been a pretty busy week or two with the NSF application, so I haven't gotten a chance to jump into Lecture 2 of Prices and Production as easily as I was able to review Lecture 1. On top of that, readers know that this lecture can be pretty confusing at points. Talking through some of these difficulties with Jonathan and EdP has helped me understand the chapter better, which is great - that's what these reading groups are for. I have a collection of thoughts I want to share, though, in at least two posts.

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1. W.C. Mitchell: First, I want to reiterate a point I made earlier about Hayek's treatment of W.C. Mitchell (p. 225), which I think was a little much. Hayek writes "I cannot agree that Professor Wesley Mitchell is justified when he states that he considers it no part of his task "to determine how the fact of cyclical oscillations in economic activity can be reconciled with the general theory of equilibrium, or how that theory can be reconciled with the facts." On the contrary, it is my conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of a tendency toward equilibrium.". The statement is a little vague on the part of both Hayek and Mitchell. I'm not sure exactly what Mitchell means by "how that theory can be reconciled by the facts" (I'm not very familiar with him). Is he talking about working up a new theory that better fits the facts? If that's the case, then I think that's perfectly legitimate. If he means that he has no obligation to seek out a correspondence between fact and theory, then I don't agree with that. It's also unclear what "tendency toward equilibrium" Hayek is referring to, but I'm wary of the claim that we are forced to build on the equilibrium theory we've always had. Many other economists besides Mitchell were concerned about the correspondence between what he observed and the existing equilibrium theory. The two that I know best are Joan Robinson at Cambridge and Edward Chamberlin at Harvard. Both independently developed theories of monopolistic competition in 1933 precisely because of the perceived inadequacies of the "foundations" they had received in explaining the facts. Hayek sees his project as taking a foundation and moving forward with it. That's fine, but I can certainly sympathize with people who have less reverence for former foundations.

2. The time structure of demand: When I first read Keynes's account of Bohm-Bawerk's views on roundabout production (well, when I read it for the second time I suppose, because I didn't see as much significance in it when I read it the first time), it sounded really odd to me. I had by that point learned ABCT through Garrisonesque emphasis on the structure of production. Keynes, on the other hand, talked about roundaboutness in terms of the time structure of demand (demands that are less immediate support more roundabout production). That sounded weird, although the conclusions essentially worked out the same. What's interesting is that that's largely how Hayek approaches the question, at least in his discussion on page 226: "What I have here in mind are not changes in the methods of produciton made possible by the progress of technical knowledge, but the increase in output made possible by a transition to more capitalistic method of production, or, what is the same thing, by organizing production so that, at any given moment, the available resources are employed for the satisfaction of the needs of a future more distant than before." I think a lot of modern renditions of ABCT move away from this question of the time structure of demand, although many of these still note that facet of the theory (Garrison, page 48).

3. Assumed productivity of roundaboutness: Hayek asserts but does not explain why more roundabout methods of production are more productive. He writes "It is not necessary for my present purpose to enter at length into an explanation of this increase of productivity by roundabout methods of production. It is enough to state that within practical limits we may increase the output of consumers' goods from a given quantity of original means of production indefinitely, provided we are willing to wait long enough for the product" (pg. 227). I wish he had taken the time to demonstrate the point. Abstracting away from actual improvements in technology (as Hayek does and which I agree is appropriate to do), the primary impact that time will have on productivity is through interest costs and inventory costs. Indeed, these are the determinants of the relative productivity of a given "roundaboutness" when Keynes discusses Bohm-Bawerk (and I imagine these are the relevant factors in Bohm-Bawerk too). But there is no presumption that more roundabout methods are more productive. Does anyone know what Hayek is referring to here? Clearly, we may also get into his reasons for claiming this in future lectures.

4. Income, expenditures, and capital: I want to clarify for fellow readers that the numbers in Hayeks figures represent expenditures, not income. This is an issue that took some hashing out in this post on Jonathan's blog. Figure 2 is the clearest. The level of income in the economy (i.e. - GDP) is 40 here. The level of total expenditures is 120 (80 on intermediate goods, 40 on final goods). The savings rate, as far as I can tell, is 0%. Figure 3 is more confusing. Income is 30 in this figure because 10 is saved. Total expenditure is still 120 (90 on intermediate goods, 30 on final goods). What is confusing is that Hayek is still not including capital as a factor of production. So capital investment - which we normally think of as "final output", and income from capital - which we normally think of as part of income, isn't included at all! I'm hoping in subsequent lectures these will be brought in, but right now its a little confusing. We've just removed a portion of income because it's not counted as income to an "original factor of production", and we've removed a portion of output because it's not "consumer output" (although at another point - p. 236 - he says that capital is intermediate goods... so at that point it is included in the model, but it's still not a factor of production earning income!), so an important portion of economic output and income (i.e. - capital and capital's income) just evaporates from the model. On page 231 he writes "interest is then received by the owners of the original means of production with wages and rent", but then he completely neglects this point later when he has the original means of production earn 30 instead of 30 + interest. I'm guessing when capital is explicitly introduced later (as he promises) this will all get cleared up. But it's off to a muddy start.

5. Unused resources: Hayek acknowledges that the question of why some resources lay idle is something that needs to be explained (pg. 224). This is good, but he also insists that we should not start there. He writes "it is not true that the existence of unused resources is a necessary condition for an increase of output, nor are we entitled to take such a situation as a starting point for theoretical analysis". This is kind of an odd approach in my mind, particularly with his original point that we have to start from a foundation of theoretical equilibrium. Why should we expect unused, idle resources to emerge from a system that is assumed from the outset to be stable? Aside from frictions and disturbances, we generally wouldn't. So you can see where Hayek's business cycle theory is heading from the very beginning - by virtue of how he chooses to conduct his analysis, it's going to be some external force such as government that is going to be required to disturb the system, by virtue of how he sets up the problem. Hayek says the starting point has to be the full employment of resource (p. 224). Why? He gives no reason at all and it's not clear to me why we should assume that idle resources emerges from full employment of resources and theorize it as such. Hayek suggests we theorize such that full employment is normal and then explain why idle resources can happen. The alternative, of course, is to theorize such that full employment or idle resources are natural. What's especially strange about this point is that Austrians have always critiqued Friedman for his version of positivism, which rejects the need for realistic assumptions... and yet Hayek is here engaging in what I think can fairly be called "unrealistic assumptions" (Garrison did this too and it was one of my biggest complaints about him - for details, see this post).

6. The role of the entrepreneur: On page 236, I think there's an interesting discussion of the role of the entrepreneur, "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 of their respective stages of production in turning out intermediate goods of the same sort. Whether this is profitable, again, depends upon the prices obtained for the product 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." So again, the terminology is a little confused... profit is the difference between costs and revenue (so far so good), which means that it is a portion of the value added at successive stages of production. This would suggest that the entrepreneur is included in the "original factors of production". That's fine - it's a special type of labor, specifically it is labor that organizes the structure of production. What is still confusing, of course, is this reinvestment question. So now income from capital seems to be included in the original means of production (because it's the entrepreneur's profit). But since capital right now is still just intermediate goods (see p. 236) it's completely removed from the income figure (which, by 239, declines from 40 to 30). What you need is to bring capital and capital's income explicitly into the model. Garrison does this - Hayek may do this in the future.

7. Aggregates: I just want to note that this lecture is chock full of aggregates. One of the frustrating things to me about complaints from Austrians about using aggregates (aside from the fact that the complaint is simply misguided) is that they regularly use aggregates in their own work. Anyway, you should note the use of aggregates when you read and then maybe reevaluate how damaging aggregates really are and how sincere Hayek's later critique of Keynes on this front really was.

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OK - I should have another post on the capital structure itself as I finish the lecture. So far, this has been a very confusing presentation. I think there are much better modern renditions of ABCT than this (I would say the same for Keynes, btw - he has some great insights in the General Theory, but his exposition of the mechanics of the theory itself are not as good or clear as later revisions). Obviously I'd point readers to Garrison because I'm the most familiar with him - but aside from that I think he is widely recognized as being one of the best expositors of ABCT. His approach is not without problems, but I think it's tighter than Prices and Production so far. However - we are still near the beginning!

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