The Place of Interest in the Theory of Production - Term Paper Example

The Place of Interest in the Theory of Production The concerned work, “The Place of Interest in The Theory of Production” seeks to discuss and analyze one of the well known papers by Oskar Lange. The chosen paper is on the topic of the place of interest in production theory. Before embarking on examining what Mr. Langer has tried to show in his paper, it would be nice to say a few words about Langer, the author of the paper I have chosen for the purpose of discussion. Oskar Langer was a very famous economists and diplomat. He advocated the use of market pricing tool in a socialist economy. Mr. Langer was the person who offered the first model on market socialism. He made his most of the contributions to the vast field of economics during the period of 1933-1945, which was the period of his American interlude. Although he was a very passionate socialist, he has strong belief in the Neoclassical price theory. The present paper will look at one of his famous papers “The Place of Interest in The Theory of Production”, published in the year of 1936. The present paper will actually make an attempt to highlight various things that will make the topic of the place of interest in production theory a bit more clear to the readers. The targeted audience for the present paper is those who find it very much complicated to make a connection between interest theory and theory of production. Very often, many people find it difficult to discuss fundamental propositions of interest theory with making reference to production theory. They do not even realize that a close connection can be set up between these two theories. To build a clear understanding regarding how this theories are interconnected, how fundamental proposition of interest theory can be restated in terms of production theory, Oscar Langer’s paper that have been selected seems to provide a great help. There are a number of things that can be learnt from the production theory. 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. The interest theory is generally found to put its main focus on the amount that is to be paid by the borrower to the lender against the borrowed money. What be the form of asset that is borrowed from the lender, the interest rate that is charged is based on the total value of the asset. The interest rate theory is not a new concept; its origin can be traced back to the period of 1500 B.C. during the period when there existed Egyptian and Sumerian civilization. Some of the famous interest rate theory can be mentioned here. The General theory of employment interest money, loanable funds theory of interest, time preference interest theory, and classical interest theory are some of the important theories of interest among them. Production, on the other hand, is defined in macroeconomics as a process of converting input into output. The factors that go into the production process include rawmaterials, labour, capital, entrepreneurship etc. Oscar Lange paper actually has tried to show how under sucha production set up interest rate can be introduced. (Reisman; Keynes; Lutz; Johnson) 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. Langer 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 his paper, “The Place of Interest in The Theory of Production”, 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 assumption 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, knows to be as Labour, and only one real capital good. He has been of the opinion that this kind if 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. 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 Langer as the circular good as it won production required labour as well as same kind of equipment. Lange has further gone on 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. 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 fulfillment of the second condition necessitates a suitable division of labour between the production of final good and the production of the equipment. Once an appropriate division is obtained, there will be left no impetus to change the distribution in any direction. The two maximization conditions together determine the level of optimum equipments to be used in the production of the equipment itself as well as in the production of the final output. In his study, while analyzing the issue of maximization of net output, Lange has also found out that “the marginal net productivity of indirect labour is equal to the difference between the marginal productivity of direct and indirect labour” as the marginal cost of indirect labour has been found to be equal to the marginal productivity of direct labour. As far as net productivity of real capital is concerned, which he considered to be as 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)”. (Lange, 11) Since the later 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. Now, Lange has shifted his focus on real interest rate. Really interest rate is generally defined as the ratio of real capital’s marginal net productivity to marginal cost of real capital itself. From the second net output maximization condition, the real interest can be found to be equal to zero when out gets maximized. The real interest rate becomes positive real capital decreases from its optimal level, and it becomes negative when real capital become greater than the optimal value. Lange has argued that real interest can be used as a useful index which indicates the distance between the existing distribution of labour resources in the production of final good and production of real capital from the optimal allocation of labour for producing maximum level of net output. Lange has then made an effort to find out the conditions for maximization of profit in a capitalists 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. Applying mathematical exercise for finding out the conditions of profit maximization, he has find that the same well known conditions of profit maximization also holds here, that is prices of each factor of production should be equal to their marginal product. After carrying out a rigorous mathematical exercise, Lange has found that in an enterprise economy, which is competitive in nature, 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. This is the point when Lange has introduced a new term, ‘money capital’, for paving the way for making 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. 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. There also exist lenders who are ready to lend money to the entrepreneurs who are suffering from shortage of money capital. Additionally, there exists free competition in the lending business too. Therefore, interest rate charged is same for all. Once 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). Along with this Lange has also found out 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 equal to the marginal profitableness of the money capital. One thing has to be kept in mind that 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. But time is not the outstanding feature of the interest. 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. Then interest will also disappear. Works cited Johnson, Harry G. Macroeconomics & Monetary Theory. London: Gray Mills. 2006 Keynes, John Maynard The General Theory of Employment, Interest and Money. Basingstoke, Hampshire: Palgrave Macmillan. 1936 Lutz, Friedrich A. The theory of interest. New Brunswick, N.J. : AldineTransaction, 2006 Oskar, Lange. "The Place of Interest in the Theory of Production", Review of Economic Studies, 1935, Vol. 3, 1 Reisman, George, Capitalism: A treatise on economics, Ottawa:Jameson Books, 1998. Read More