The Place of Interest in the Theory of Production - Book Report/Review Example

The Place of Interest in the Theory of Production Oskar Lange’s “The Place of Interest in the Theory of Production”, is on the topic on the place of interest in the general production theory. Before embarking on examining what Mr. Lange has tried to show in his paper, it would be nice to say a few words about Mr. Lange, the author of the paper I have chosen for the purpose of discussion. Oskar Lange was a Polish lawyer and economist who had experience teaching at the University of Michigan and at the University of Chicago (http://cepa.newschool.edu). He was recognized as having socialist tendencies and was “known for advocating the use of market pricing tools in socialist systems and providing the earliest model of market socialism” (Wikimedia Foundation, Inc., 2008). He made his vast contribution to the field of economics during the period of 1933 to 1945, which was the period of his American interlude and although he was a very passionate socialist, he has strong belief in the Neo-classical price theory (http://cepa.newschool.edu). This paper will look at one of his famous and noteworthy accomplishments, the paper “The Place of Interest in the Theory of Production”, which was published in the year 1936. A clearer understanding of this paper necessitates some background of the general theory of production, particularly, the Neo-classical school of thought. It is so because, Lange’s output have some basis from this theory. In fact there was both integration to and criticism of the Neo-classical theories of production. The Neo-classical thought can be deemed a successor of the classical economic thoughts of Adam Smith and David Ricardo, the Utilitarianism by John Stuart Mill, and lastly the marginalism or the marginal theory of value. The Neo-classical era has evolved with the pioneering works of William Stanley Jevon, Carl Menger and Leon Walras (Wikimedia Foundation, Inc., 2009). I will particularly discuss the Paretian system (developed by Vilfredo Pareto) versus the Walrasian system (conceptualized by Leon Walras). Pareto, himself summarized their work saying, “the principal subject of our study is economic equilibrium”. Particularly, it aims to highlight that “the equilibrium results from the opposition of men’s tastes and the obstacles in satisfying them”. It has particularly focused on “agent optimization in a price-taking, multi-market scenario – and thus emphasis on differentiability and efficiency” (http://cruel.org) . Pareto wished to deviate from the models built by Walras, although he used the tools of this particular predecessor. Specifically, the highlight of the Paretian system is the use of “taste-and-obstacle”structure rather than the supply and demand functions (http://cepa.newschool.edu). He used a two-sector model to arrive at an equilibrium although it can also be expanded to a multi-sectoral model with m factors, n goods, F firms and H Households, then he proved to have achieved an equilibrium by arriving at a point wherein the total number of equations equalled the total number of unknowns (http://cepa.newschool.edu). Leon Walras introduced the general equilibrium model with production in his work Elements of Pure Economics. It ceased to be subscribed by many scholars however, as they opted for the Paretian model (http://cruel.org). This has been resurrected by the works of Gustav Cassel, to be later known as the Walras-Cassel model. This work “yields a completely neoclassical subjective theory of value based on scarcity, rather than a Classical objective theory” (http://cepa.newschool.edu). Generally, we can see that the Walras-Cassel model is a system of simultaneous equation so that there is no direct determination of one variable to another. The equilibrium prices and equilibrium quantity have no causal effect to each other because they are determined jointly by the model. With exogenous data of preferences of households, endowments and technology, the model does not directly say that “prices determine the cost of production or cost of production determines prices” (http://cepa.newschool.edu). The Walras-Cassel model also suggests that market demand is equals to supply in both the factors and goods markets (Ahn). Before we delve into the contents of the study, it is necessary to provide the fundamental concepts used by Lange. Among these things, some of the important ones are the basics that surround the production theory. These are the basics that will put the discussion of the topic into a definite perspective. In his paper, Lange has tried to make a clarification of the foundation of the existing interest theory. He actually has tried to restate some fundamental propositions of the existing theory of interest by making special reference to the general theory of production. Generally any kind of association between interest theory and theory of production seems to be incomprehensible. Lange has found that unless a close connection between the interest theory and the general theory of production is established, there would remain a huge problem while discussing a very complicated topic on whether net productivity of capital actually exists. In Lange’s paper, he has tried to explain in a much organised way the place of interest in the general production theory. For doing that he has made some very simple assumptions to bring some considerable simplification in his study. He has assumed that in the economy only one commodity is produced using only one original factor of production, i.e. Labour, and only one real capital good. He thinks that this kind of simplification is also capable of allowing a generalization later with taking into account the case of multiple final goods, multiple original factors of production, and multiple real capital goods without imposing any kind of logical difficulty. The study had some limitations. One is that it is restricted on the case of circulating capital and the delay period at which some factors are applied in production are treated as fixed. Circular factor was meant in this study as a factor which is necessary in the production of the same kind. Specifically, he mentioned about the axe which is necessary in the production of another axe. It is also confined to a market with free competition and that the factors of production are entirely substitutable. The study also rules out the special influence of money creation. Lastly, it rules out the element of risk and it used the rate of interest as a measure for the rate of net interest. After making the above simplified assumption, he has first made an attempt to find out the conditions of maximum net output. For doing that he has considered the case of the production of a final commodity wood which requires labour as original factor and some equipment (say axe) as the real capital. The equipment is called by Lange as the circulation of the replacement of the last equipment used in a period of time. In regard to this, Lange was seemly also very critical of mainstream neoclassical as time is not included in the model. Lange has done this by dividing labour input into direct and indirect labour. The labour used in the production of the final commodity has been assumed to be as direct labour, and the labour used in the production of equipment was considered to be as indirect labour. Lange then made an effort to find out the necessary conditions for maximization of profit in a neo-classical economy in which entrepreneurs produce that level of output which maximizes their profit. In a capitalist economy profit maximization is the main motive of the producers. Lange has restricted his study only to the case where free competition exists among entrepreneurs. He then set up the Lagrange method of finding the maximum with two production functions, incorporating labor used in both the production of the final commodity (l) and the indirect labor used in the production of equipment (l’), and the equipment used in the production of final commodity (m) and the one used in the production of the new equipment (m’). By carrying out a maximization exercise applying Lagrange method, Lange has obtained two conditions for the maximization of net output – (1) the marginal net productivity of the circular factor would have to be zero, and (2) marginal productivity of direct labour has to be equal to marginal productivity of indirect labour. The fulfilment of the second condition necessitates a suitable division of labour between the production of the final good and the production of the equipment. Once an appropriate division is obtained, there will be no impetus to change the distribution in any direction. Lange found that in an enterprise economy, which is competitive, all the firms simultaneously attain their maximum profit when at the point where marginal productivity of indirect labour becomes equal to the marginal productivity of direct labour. At this point, there will be no tendency to move to any direction as any change will result in diminishing output. On the basis that direct labour can be transferred to indirect labor, he further proved that the decline in productivity due to transfer of direct labor to indirect labor will now be conceived as the marginal cost of indirect labor. Since it is so, the marginal net productivity of indirect labor will be the difference between the marginal productivity of indirect labor minus the marginal productivity of direct labor, which can either be positive, negative or zero. Applying a mathematical exercise for finding out the conditions of profit maximization, he has found that the same well known conditions of profit maximization also holds here, that is prices of each factor of production should be equal to the value of their marginal product. As far as net productivity of real capital is concerned (which he considered to be equipment in his study), Lange through his mathematical exercise has found it to be equal to “marginal net productivity of indirect labour in terms of finished gross divided by marginal gross productivity of indirect labour in terms of equipment (real capital)”. Since the latter term is considered to be always greater than zero, marginal net productivity of real capital always has the sign same as that of marginal net productivity of indirect labour. It has been found that if anyone wants to increase the amount of real capital, then he has to make a transfer of labour from the final good production to the production of equipment. But this results in a temporary fall in the production of final commodity which get restored once the newly made equipment is installed in the production process. This is the point when Lange introduced a new term, ‘money capital’, which created a place for interest in the production process. Money capital is nothing but the amount of money that is required by the firm to buy the optimum amount of inputs for maximizing their profit. It is however not always the case that all the firms in the competitive enterprise will have that exact amount of money that is required for pursuing the optimum production process. If there is a shortage of money capital for any firm then he will not be able to use optimal production method, and therefore he will be unable to maximize his profit. In this case, the firm cannot employ the amount of factors of production which equalise the value of the marginal product of a factor to its price. But there is one way out of this situation. Lange has assumed that total money capital in the industry is sufficient for all firms to produce profit maximizing level of output. In his model, he assumed that the entire industry has a fixed amount of money capital at its disposal. It is from this pool of industry fund that each firm might source his money capital at an interest. We can say that it is at this point where the place of interest enters in the theory of production. Interest was deemed the cost of money capital so that the law of supply applies to this model accordingly. As the money capital becomes abundant, the rate of interest declines. Additionally, there exists free competition in the lending business. Therefore, interest rate charged is same for all. Once the interest rate is introduced, it has to be incorporated in mathematical exercise for profit maximization, to be more specific into the cost function of the firm. Once interest rate in incorporated, the profit maximization conditions will face a little change. Now, for maximizing profit, the input prices have to be equal to the discounted value of the marginal products of inputs (discounted at the given interest rate). With the explanation of the interest rates in terms of the money capital, Lange is also attempting to incorporate interest into the production theory to show the existence of disequilibrium. As Lange explained, the shortage of capital will hinder the firm from performing in its optimal state. Therefore, with the interest rate included in the equation, it will be an index to show the amount of inefficiencies occurring. Along with this Lange has also found an important feature of interest rate. He has found that under profit maximization in a free competitive market the rate of interest is actually equal to the marginal net productivity of real capital, which in turn is equal to the marginal profitableness of the money capital. Interest rates in the context of monetary capital is more often referred to by the other authors as incorporating interest rates on the real capital but this has misled readers into the same context as the monetary capital. Douglas R. Shaller has referred to Lange’s article in Shaller’s paper, “Working Capital Finance Considerations in National Income Theory” regarding the need of acquiring monetary assets in order to offset the cost associated with the revenue and expenditure flows caused by time-consuming production. Shaller also indicated that the firm will be willing to pay up to the amount dπ/dk times the change of k (Shaller, 1983). This is the amount of profit obtained due to the increase in money capital. Since Lange’s study rules out money creation, the only way that money capital is increased is through savings. This is where the place of interest explains the reason Shaller referred to Lange’s article. As indicated in Shaller’s article, if there is an increase in the real interest rates, it will cause the firm to respond with a decrease in output. As what Lange has been trying to show in his paper regarding the interest rate, with the increase in real interest rates means that there is an increase in inefficiencies as the interest rate is the measurement of disequilibrium. When the firm is not operating in an efficient state, the firm will result in a decrease of output. One thing has to be kept in mind: all exercises which have been taken up to find out the fundamental proposition of interest theory from general production theory have been done in a timeless manner. But it is well known fact that interest rate has some time dimension. Lange has been trying to indicate the position that the interest has in the production process by showing that if time is included in the equation of the production theory, the interest would be acting as an index of measurement between the current level of output and the optimal level of output. Lange thinks that interest rate is an index of disequilibrium. In addition, he also explains why there is disequilibrium. The main problem associated with interest is essentially the problem of resource allocation. The basis of interest rate has been found to be the shortage of capital which does not allow the producers to adopt optimal production method. Once shortage of capital gets disappeared from the framework, the marginal productivity of indirect labour becomes equal to direct labor’s marginal productivity. Thus, Lange has integrated the neoclassical equation into paper to support his argument about the importance of time frame in the context of production theory. He deemed that the neoclassical has neglected the input time. Lange has shown in this article how the interest plays a role in the theory of production where the interest is the index to show how big the disequilibrium is. Works Cited (n.d.). Retrieved April 1, 2009, from http://cepa.newschool.edu: http://cepa.newschool.edu/het/profiles/lange.htm (n.d.). Retrieved April 2, 2009, from http://cruel.org: http://cruel.org/econthought/essays/paretian/paretequil.html (n.d.). Retrieved April 2, 2009, from http://cepa.newschool.edu: http://cepa.newschool.edu/het/essays/paretian/paretequil.htm Ahn, R. (n.d.). Retrieved April 4, 2009, from http://www.cis.upenn.edu: http://www.cis.upenn.edu/~mkearns/teaching/cgt/ahn.ppt. Shaller, D. R. (1983, March). Retrieved April 4, 2009, from www.jstor.org: http://www.jstor.org/stable/1803933 Wikimedia Foundation, Inc. (2008, September 15). Retrieved April 1, 2009, from http://en.wikipedia.org: http://en.wikipedia.org/wiki/Oskar_Lange Wikimedia Foundation, Inc. (2009, March 29). Retrieved April 2, 2009, from http://en.wikipedia.org: http://en.wikipedia.org/wiki/Neoclassical_economics Read More