 Okay, our next lecture is gonna be Dr. Jeffrey Herbner. This is second time at the podium today. His lecture now is on capital interest. Jeff? Hey, the main task in this lecture is to complete the discussion from earlier this morning about economic calculation where we saw that in economic theory we start with preferences, we start with the human mind, we start with the human person and from there show how from judgments of the human mind all of the different aspects that we normally refer to as economic come into being demands and supplies our actions in other words and then prices based upon those and then once we get prices of consumer goods how they are imputed to the factors of production and then when we have factor prices how entrepreneurs use these prices as a basis for performing economic calculation first of net income or a gross profit their revenues from producing output relative to their costs of production in order to economize the use of factors of production in the division of labor and then what we want to focus on especially in this lecture is the second form of economic calculation, which is the calculation of equity or net worth the balance sheet that the entrepreneur Constructs to show assets relative to liabilities and the net worth or equity involved in the operation and as we'll point out this calculation the entrepreneurs used to Determine whether or not certain asset acquisitions or combinations Either add to equity or subtract from it and therefore they can make capital investment decisions in a way that also economizes and now in order to Get to that discussion Let's backtrack and go back into some of the more basic Principles and then we'll build from these and perhaps I should just say also one note of introduction on interest the title of the Talk is capital and interest so Interest comes in Perhaps you can see this right away interest comes in with respect to the intertemporal dimension of capital So once we have durable goods then if we're going to properly price them we have to take account of the intertemporal Aspect that is to say we have a capital good or or a plot of land or Durable consumer goods that will generate valuable Services for us in the future. How do we value them today? How do we assess their value and make it to commensurate with the value of things that are non-durable? So that's where the discussion of interest come in comes into the picture Okay, so let's start with capital goods So we'll backtrack all the way just to these basic principles. We had talked this morning about means that we use to attain our ends we can now notice the Distinction between two different basic types of means their consumer goods on the one hand Consumer goods directly Satisfy our ends in one actions. We take a ham sandwich and we eat it and that's a consumer good because our end is attained Then there are producer goods as distinguished from consumer goods producer goods only indirectly satisfy our ends They do this by of course producing consumer goods that then directly satisfy our ends Within producer goods we have What Rothbard calls original factors of production and then Produced factors of production the important distinction here is that original factors of production are independently productive plot of land labor These are original factors of production produce factors of production Of course are since they're produced by other factors of production are not independently productive their Productivity and the value that they have of this productivity will be imputed back to the factors of production that produced them But this won't be the case with labor and with land Okay, then we have the causal laws that relate to producer goods as means to attain ends and we want to pay special attention just to two Two aspects of these causal laws First we can talk about the causal laws that exist within each production process So if we have a we have a factory producing Honda civics. We have an ice cream shop producing chocolate ice cream cones Whatever the particular production The complementary factors of production that have been brought together by the entrepreneur happen to be in this production process then there is some Alternative for the entrepreneur to vary this complementary set of factors of production so an automobile production could be arranged in a More capital-intensive manner or in a less capital-intensive more handmade production process And and so on right in almost every particular Production process we might imagine they're varying proportions that the complementary factors can be combined in without losing all output You still get you still get some output So it's possible to calculate what we call in economics the marginal physical product of each factor of production What a unit of it adds to output So just to give you a simple illustration of this. Let's say I want to mow my lawn and I can do this in with many different sets of complementary factors of production So I can just buy a push mower and you know, maybe it takes two hours of my labor services I have a mowed lawn If I want a more capital-intensive production process I could buy a riding lawn mower And then maybe it only takes me a half hour of labor right and combining things in a different way I could buy one of those old ever seen those old real mowers You know that are they just they turn on a reel they're sort of Torqued like DNA and they they spin and cut So I could buy one of those real mowers I could get you know a pair of scissors and go out I wanted to you know economize on capital I could do it that way And as we said before the way in which I would choose this in my own personal action is based upon my My preferences right my my subjective values. So how I see the economizing Alternatives how I judge the value of the different alternatives, but the point here simply is that we can vary the Factors of production that we use to accomplish the same and and therefore these become choice variables for us And then there's certain causal laws that are in place with respect to these choice variables We wish to again examine these to some extent Now the second aspect of any production process that we want to note is that different factors of production will have different specificity and This too then becomes part of the choice nexus for an individual deciding Which set of complementary factors to use in any particular production process? specificity refers to whether or not if we Transfer the use of the factor out of this production into something else Whether or not that factor retains its productivity if it loses all of its productivity when we shift it out of the production process That we've put it into then we say it's highly specific to that production process So for example a push mower is I think at least more specific Than a riding lawn mower Because a push mower as far as I know will do only thing but mow lawns It won't do anything else right if I can't use it to produce type documents or to You know to drive to transport me to a work or something up Maybe with great ingenuity I could but you can't just do it with the with the push mower itself But a riding lawn mower you could do different things with right you don't have to mow the lawn You could push snow with it you could I guess if you were careful you could Write it to work or you know do other sorts of things. So so it's a little bit less specific And if we think about the if we think about different factors of production as we define them before labor Natural resources or land and capital goods There's a general progression of specificity labor tends to be the least Specific of all the factors of production generally speaking you can find particular cases where this isn't so land tends to be somewhat more specific and Capital goods tend to be the most specific by the way. This is precisely why when we have booms and busts in the economy that the most problematic part of Reallocating factors of production during the bust is not labor Because labor after all is non-specific or relatively non-specific. It's capital goods It's capital goods whose prices have to adjust more radically to make it profitable to re-employ them in areas Aligns of production that they have not been designed to for efficient production Whereas labor can move more easily So other things the same This creates the problem, right? This is something that non-Austrian schools of thought tend to overlook entirely the whole problem of the Capital structure and how it has to be realigned when we go through the boom and the bust And then finally, let me mention durability the durability of a factor then is also An element that has to be taken into account when a person decides what production process will I put together to engage in this In the attainment of this end Because different to factors of production will have different degrees of durability The different degrees of durability will then have different inter temporal Implications, so the riding lawnmower again might last for 10 years the push mower might last for 20 And so whether or not you invest in one or the other might depend in part upon that durability And then again, we'll see how this plays out in our discussion Okay, now we're for our purposes in this lecture. We're more concerned not with this This production process for each good. We're more concerned with the production processes for the entire economy What Rothbard calls the structure of production or what I've called on this slide the capital structure So not only is it true that in each production process for each good We have different complementary factors combined together to produce the good So for example, we have our Honda Civic and there's some Honda factory and I don't know Canada or wherever they make these And in the factory, they combine natural resources. They have land that the factory sits on maybe other natural resources labor A certain amount of time is involved and then there are all these capital goods, right? They're fenders and tires and steering wheels and seats and engine parts and so on and so forth and Then you have the factory and the assembly line and with the labor and so on and so forth and all the production processes being undertaken In order to produce the car but since capital goods are produced factors of production the fenders the paint the tires they have to be produced as well in a separate production process and so we have a Production process prior to the assembly of the car where the where the fenders are made out of steel, right? and then the paints are made out of oil and dyes and the tires are made out of rubber and steel cords and so on and so forth and It doesn't take too much imagination to see that these stages of production progress to fairly high degrees If many many stages of production not just these lower, you know so-called lower stages of production but the production process can be traced back to Higher and higher stages of production until we eventually reach the extraction of raw materials So we mine iron ore out of the ground ship it Process it then we make steel out of it and then we ship the steel and we make a steel fender out of it And then we make the once we have the fender we ship it to the auto factory and we make the car So the whole economy can be depicted by this production structure. The production structure is the economy It's all economic production in the economy. This is to put it differently. This is the macro economy Once again, you can see the distinction between the Austrian treatment here and the mainstream treatment Especially it's a sort of naive Keynesian treatment where the macro economy is just a aggregate supply you know or C is equal to To our Y is equal to C plus I plus G or something like this, right? The degree of aggregation in these models in the mainstream obscures all of the insights that can be gained by Recognizing the that the economy is actually all of these micro economic process all of these Intertwining economic processes that are producing as we sometimes say heterogeneous capital goods, right different capital goods in different ways or Entrepreneurs are overseeing all of this in each of the different production processes and coordinating all the production and so on This is what we have to grapple with at least in part in macro economics Now let me mention just a few of we might call these features of this capital structure or the of the production structure Again, it doesn't take too much imagination to see that this this capital structure or the economy in its production aspect is extremely complex The the estimate is that there are several million different types of consumer goods produced in the American economy there was some Computer geek who wanted to try to actually count the number of different Kinds of products that are produced in the American economy and you got the bright idea of just looking at all the different barcodes Aren't these all registered somewhere can't you just find them and just sort of count? How many of them are there? He counted them and he came up with over a billion now, of course that would include presumably producer goods as well as consumer goods, but since it's a vast complexity to the capitalist production structure far Beyond the capability of a human mind to even comprehend let alone design now secondly, this structure of production is flexible even though there's structure to it it can be changed and entrepreneurs Who are overseeing each production process then are in a position to use economic calculation and appraise mid based upon it To determine the economy economizing ways in which to change production To reallocate factors of production. So let's say just in our example the Honda Civic Let's say that the Honda Civic is produced in three different colors by Honda red white and blue and They find that the blue sells better than the white and So they they'd like to adjust to these consumer preferences. They anticipate that they'll persist in the future By producing more blue Honda Civics So this is easy for them to do, right? It's a simple matter for them to simply call up their paint suppliers And say look we need more blue paint But let's get a contract. You know, what would we have to pay to get another shipment? And if their current supplier doesn't wish to do this doesn't want to make this kind Hey, wait, we've got a contract for white, you know, forget it. I'm not gonna I'm not gonna change They'll just call somebody else Then more dyes have to be made to make more blue paint, right? It's in the same process as set in motion And since entrepreneurs make their profit by anticipating these changes, they're already doing this But before the demand is hit before they find out that more Blue cars are being preferred by consumers. They've already predicted this. This is how they earn their profit and capitalize themselves and stay in business Now finally, let me just mention that this structure is obviously then a structure. It's coordinated, right? It hangs together. It has a Structure to it. It isn't completely malleable, but has a certain rigidity to it but this This a coordination we can see again just by thinking of the simple diagram is brought about by the same basic process as we spoke of earlier today, it's brought about by the desire for participants in human action always to obtain a preferable state of affairs To engage when they're engaged in social interaction to engage in mutually beneficial Associations mutually beneficial trades, right? And so this happens of course as businessmen trade with other businessmen is the entrepreneurs trade with other entrepreneurs This is how the whole structure of production gets coordinated. How do we know? hear this from political science majors or Politicians, you know, how do we know that we're going to get the right amount of iron mind then we have to control this from Washington You know, what if what if the greedy entrepreneurs produce too much and so on? Well, no the economic theoretical Understanding of this is that it's precisely because entrepreneurs engage in mutually profitable Adventures right the iron producer produces the right amount of iron for the steel manufacturer to buy because the steel manufacturer makes it profitable to produce that amount of iron no more no less no Not different kinds, but the kind they need to make us, you know to sell make steel fenders and sell them to the auto companies And so on so we see this imputation process of value that we spoke about before permeating the entire structure of production Now let me say just one one last feature of the capital structure when we think about it is the macro economy This is one of Murray Rothbard's great points is that it's quite obvious that the macro economy that the production activity in the macro economy is heavily weighted toward the production of producer goods Production of consumer goods is only a small part of it for every consumer good that's produced You have a huge number of stages of production of the production of producer goods that are necessary to complete it of capital goods Necessary to complete it the fixation that the Keynesians have on on consumption is misplaced It simply isn't true that consumption is 70% of the you know as they say 70% of the economy It's not true. It's 70% of of the net production But not 70% of the gross production, right? The production of all things in the economy most of it is the production of capital goods and That that's seems like it would be important to know this right and incorporate it into your macro analysis Okay, now let's turn to the rate of interest Because we because it's quite obvious that the physical Arrangement of the different factors of production is not sufficient for economizing decisions to be made about how how to choose between the different production processes and you know These choices of how much iron to mine and so on and so forth that we spoke about before We need valuation or we need we need valuation first from the consumers and then appraisement prices for the entrepreneur to make these decisions and As we begin then to move from capital goods to capital So here's our distinction between these terms capital goods refers to the physical Producer goods capital refers to their monetary value Capital is just a sometimes we say capital value. We're just referring to their Monetary price and as I mentioned before one key element of the Price of a capital good will come from its durability. It's inter temporal Delivering of services and so this is what gets us to the interest rate Now on Wednesday, we'll talk about the interest rate in some in some depth So we're gonna kind of just mention the high points here of an interest so you have questions about this We'll address them in the lecture on Wednesday on the pure time preference theory of interest Okay, the rate of interest starts just like all Appraisement elements start with Preferences start with mental judgments. What is the mental judgment from which the interest rate emerges? It's what we call time preference and time preference is the preference that we have To satisfy a given end sooner as opposed to later So it's a preference that everyone has To obtain a given satisfaction sooner as opposed to later Now if we have this preference, then it follows that there would be what Mises calls the originary interest When we trade present money for future money Present money will trade at a premium. This is because if we command present money We can satisfy a given end right now in the present if all we have is future money Well, that's not preferable right to satisfy that same end in the future So a given amount of present money will trade for a premium For a given amount of future money and again, we'll talk more about this in the lecture on Wednesday So this is where the interest rate comes from We take this simple example. Let's say we have someone with a preference rank We're here on the top because of time preference a thousand dollars today is preferred ranked above a thousand dollars in a year But there might be some amount of money in the future that would rank above a thousand dollars today So for this guy, it's twelve hundred and fifty dollars So this guy would prefer to get twelve hundred and fifty dollars in one year as opposed to a thousand today But just like everybody he prefers a thousand today to a thousand in one year and so this it is this preference then that gives rise to demand and supply Lending and borrowing and then the rate of interest now notice that when we Do a simple calculation if we take this 25 percent premium That this person has for future money relative to present We can see that once an interest rate is formulated then what the interest rate does is make future money and present money equivalent It tells us how much present money is equivalent to how much future money So if the interest rate is 25 percent if I have a thousand dollars in my hand I can lend it out on interest end of a year. I have twelve hundred and fifty dollars those two are equivalent sums, right I Now that therefore can calculate the present value of future money I know what a sum of future money is worth in present money Because the interest rate makes it comparable. I have I can take either option, right? I can trade at par either twelve hundred and fifty dollars in the future Which I might get from selling something in the future for a thousand dollars today So that that's what these calculations show right just simple the simple calculation of future value the present value compounded by by the rate of interest and the present value the future value discounted By the rate of interest these are equivalent calculations Okay, then we want to move to the time market where the interest rate is determined So this time preference is the basis for the time market and just like in any market trade depends upon people having different preferences and As long as their preferences are different There's a possibility for mutually advantageous trade and the same thing then can happen with the trade of present money for future money So let's take this example the market clearing rate of interest some of this relies upon what we talked about this morning Let's say we have this bar to our person a and in the Items in parenthesis are things that the person does not have so this person does not have a thousand dollars of present money and This person is willing to trade At the a premium of three hundred dollars thirteen hundred dollars of future money for a thousand today or if this person were purchasing Borrowing a present present money, they'd be willing to acquire this thousand dollars of present money for a future payment of 1250 And so the time preference premium is 25 percent Borrow or B is a little less eager to borrow Because borrower B is only willing to pay a 15 percent premium to acquire the present money the thousand dollars Today he's willing to pay 1150 in a year and borrower C is the least eager borrower willing only to pay a 5 percent premium Lender X then has lower time preferences as we say right less intense preference for the present So notice the lender X is willing to accept a 5% premium in future money to surrender in trade a thousand dollars of present money So he's the most eager lender Y is less eager only willing to lend it a 15 percent premium and Lender Z is the least eager only willing to lend it a 25 percent premium So borrowers have higher time preferences. They're willing to pay larger premiums in order to acquire present money Lenders have lower time preferences. They're willing to accept lower premiums to make these trades The interest rate emerges the market clearing rate emerges just like it does for goods Then it would be that rate Where the quantity demand of present money the quantity demand lent and the quantity demand borrowed are equal At higher interest rates, there'd be an excess supply of lending over borrowing and unsatisfied lenders at Lower interest rates. There'd be an excess demand and unsatisfied borrowers That's why there aren't interest rates above or below the market clearing rate That's why the market clearing rate of interest emerges So this is how we go from preferences to the market clearing interest rate Now the next step is just to point out that In the time market if the time market again is all the lending of present money for future money That occurs in in human life in society We can divide the time market into two components their credit markets And credit markets then are where credit transactions are made where people make a contract To lend and borrow future present money for future money So we have a contractual obligation to pay back for the borrower to pay back Future money of a stipulated amount given that we've been lent Present money of a given amount. So we have credit markets on the one hand these credit markets can further be broken down into Lending that goes to consumers the consumer loan markets So there would be mortgages and auto loans and credit cards and so on and so forth in the consumer loan markets These are part of the credit markets And then there would be producer loan markets where entrepreneurs borrow in order to buy producer goods instead of consumers borrowing in order to buy consumer goods and You know, this is there's the AAA corporate bond market the junk bond market and so on Then the second part of the time market is the structure of production itself So in the structure of production in production processes the capitalist entrepreneur Advances money to the owners of factors of production Goes through the production process and then sells the output sometime in the future Earning the revenue from the customer for the sale of the good So there's a lending borrowing relationship That exists within most production processes again, this isn't a necessary feature of production processes in the market, but it's a typical because Workers have higher time preferences than the capitalist entrepreneur They want to be paid every week or every two weeks or every month. They're not willing to you know auto workers not willing to Produce a car and then wait for eight months for the car to be sold Right now willing to go to work every day and then okay when that when that car is sold you'll be paid your wages No, typically they want to be paid up front They want to be advanced the money and when they are advanced the money That's part of the time market and of course the capitalist entrepreneur because he or she is lending We'll be earning the rate of interest There's an interest return that's earned by the capitalist entrepreneur for investing These present funds and advancing them to the owners of the factors of production Going through the production process and then receiving the future money and the payment when the good is sold So the capitalist entrepreneur earns the price spread between The stages of production In our in our original diagram Okay, now with this is background we can go to capital value and the What we're after here, which is the purchase price of capital goods now the intermediate step here is to talk about the the rental price of Capital goods so factors of production can have rental prices Where all that's being bought is a unit of service of the good wages are like this obviously right? so we have have a Ice cream parlor owner and he hires a scoopmeister, you know the work and just you know pays daily or weekly for the services of The labor that's being bought Maybe he rents his equipment as well. He could rent the freezers in which case he would just pay a rental price He would pay just for the service of that capital good But he could buy the He could buy the the freezer. He could buy his His store, you know the physical building and so on and so forth Or he could rent them so their rental prices on the one hand and then purchase prices on the other So let's think about rental prices first Of factors of production and then we'll talk about the purchase prices Now the entrepreneurial demand for the factors of production will be what determines the rental price It's like the demand for anything determines its price and as we've seen already the entrepreneurs demand depends upon what effect The possession of the unit of service of this capital good has on revenues and costs have a little effect net income So the entrepreneur must estimate if I hire a unit of service of a factor of production. What will it add to my revenues? Depending on what it adds to revenues. He'll be in a position and to estimate what it is He should pay you know what he's willing to pay to hire that factor of production now to take a an example to illustrate this Let's use Derek Jeter Okay, we got Derek Jeter new shortstop in New York Yankees, right? and Let let's say this is the sake of the argument and I think this is actually the case let's say he has an annual contract and I think 2011 his contract is for fourteen point seven million dollars Now, how do the how did the entrepreneurs that of the Yankees come up with this number? Where they get that? Why do they think that they can pay Jeter fourteen point seven million dollars? Why not twelve million? Why not twenty million? Where does this number come from? And the answer is this number comes from their estimate of what they believe Jeter is adding to the revenues of the Yankees So Jeter plays right he gets certain number hits come some fans come out just to see Derek play He gets his three thousandth hit. So so now you can sell Derek Jeter bobbleheads with you know I got three thousand hit signs on them or whatever. So there's memorabilia. There are playoff revenues and so on and so forth This is how they do it They're they're the entrepreneurs they can figure this out They can make these estimates by the way if if the guys who run the Yankees can't make these estimates then They won't be owners of the Yankees for long, right? There'll be other other people happy to step in and take over Who can better perform this function and in fact the capitalists will ensure this because they'll decapitalize as we'll talk about in a minute The entrepreneurs are unable to perform in terms of generating net income and net worth Now here's the here's how the interest rate plays into this Let's suppose again just for the sake of the argument and then we'll add some complexities to it, but let's suppose just for the sake of the argument that the Entrepreneurs of the Yankees think you know we we think that Derek Jeter By adding his performance by his marginal physical product over the year of getting a certain number of hits and on base percentage and The way he lifts the other players performance and his defense and whatever Well, we'll add fourteen point seven million dollars to the revenues of the Yankees This is in the sale of tickets and playoff revenue and memorabilia sales and so on and so forth Let again for the sake of the argument. Let's just assume that they think what would we be willing to pay Jeter up front? To you know in April on April 1st We paid him his full contract up front to get this revenue stream That's going to exist for several years but still be selling you know memorabilia and so on maybe for several years Well in order to answer that they would have to Discount the future revenues, right? What would it be worth to have Derek Jeter generate a million dollars worth of playoff revenue in October? What it what what's it worth to the entrepreneurs to pay him in April to do that? Well, not a million dollars It's something less than that the discounted value of it Because after all they could just take their capital invested in the credit markets and earn that interest return, right? Why invested in Derek Jeter if you're not going to earn that return? Okay, so The demand for the entrepreneur depends upon the discounted marginal revenue product as we say of the factor How much revenue the factor generates much additional revenue that factor generates by having the factor employed? discounted by the time The intertemporal time delay between paying the factor and receiving the revenue Now Derek Jeter of course there there all sorts of complexities in the contract, right? He gets playoff. He gets a portion of the playoff revenue. He gets bonuses and so on performance bonuses Those wouldn't be as heavily discounted, right? Because they won't be paid till November whenever the performance is forthcoming So there are all sorts of nuances involved in the contract, but the basic principle is still the same if you're going to advance money The capitalists will not do this unless they're going to earn interest and Therefore they're going to discount what they're willing to pay in the present From what they think they'll earn on the investment in the future. This is then determines the rental price So let's take a just a Simple numeric example of this. Let's suppose we have Here our net income revenue minus cost and we have these marginal revenue products for the three different factors capital land and labor to be received in one year when the Interest rate is 25% So in one year the good is going to be sold for $17,500 the sum of the marginal revenue products of all the factors that go into producing it and the question is how much will the Capitalist entrepreneur pay today in order to get this 1750 if the interest rates 25% and the answer is 14,000 They'll be willing to pay $8,000 to buy the capital good 4,000 to get the land 2000 to get the labor and When they do this they'll earn $3,500 which on their investment of 14,000 is 25% You see this is a crucial point right when the capitalist invests in a production process We're setting profit aside. We're setting the entrepreneurial Uncertainty and the profit earned from anticipation. We're setting that aside in this example The entrepreneur the capitalist entrepreneur is earning the interest rate He's earning an interest return Precisely because what he's doing is advancing money to these factor owners He's just lending and for that lending he earns the rate of interest So this is reflected in in the production process Because it's reflected in the in the value of these factors of production And which ones then will be used in different production processes and which ones will be produced more heavily and so on now Given given then that this is the this is what stands behind demand for the factors of production for the rental services of the factors of production we won't have time to go through this but You know we check out a man economy and state and you can see the logistics of this It's pretty easy to show that they're just like there are for consumer goods. There'll be a downward sloping demand curve for The entrepreneurs buying the factors of production and an upward sloping supply curve by the factor owners supplying it This means that the there'll be a market clearing price, right? because just as in all cases if if you start at really high prices and at very high prices you have excess supply as You lower the price the quantity demand goes up and the quantity supply goes down and eventually the two will meet Eventually the market will clear and then if as you push the price down even further, you know Hypothetically right the quantity demand will increase above the quantity supply. You'll have excess demand So the so the market will clear just like it will in consumer goods markets and At that market clearing price the There'll be a discounted marginal revenue product That emerges for the factor of production will be will be a you know a going wage rate Let's say for manual labor that exists throughout the economy for that type of manual labor no matter where it's allocated because if it had a higher price somewhere else it would be reallocated there and then The greater profitability of the activity where the price is lower would eventually adjust So this is just part of the production adjustment process Okay, now let's go on to the purchase price of the capital good. This is what we want to get We want to get at and here we move on to the economic calculation of net worth or or equity This is actually simpler once you follow the rental price argument. It's simpler to do the purchase price Because the purchase price of a of a durable good or a capital good Within the context of economic calculation What is the entrepreneur willing to pay to buy a capital good outright as opposed to renting it? Would just be the sum of the discounted marginal revenue products that are generated by that capital good over time So what is the ice cream vendor willing to pay to buy his? His a freezers. He's willing to pay the revenue that's generated by having the freezer as opposed to some other combination of factors of production Over the life of the freezer all of those revenues discounted to the present, right? What he's willing to pay and present money to buy this thing Therefore when he buys it as he uses it over time, he'll earn the rate of interest Because he paid the discounted marginal revenue product and he's going to earn the marginal revenue product in production Okay, so the entrepreneur cannot this is the sum of the discounted marginal revenue products over time So let's say we you know, we have this capital good and it generates Five years of marginal revenue product discounted at these values Then what the entrepreneur would be willing to pay today to buy this capital good is 37,500 dollars the sum of these marginal revenue products discounted He's not willing to pay more than that because if he did his net worth would be negative, right? Now he'd like to pay less than that But he isn't able because of competition of other entrepreneurs other entrepreneurs will be bidding for the Services of these factors of production too and we'll prevent him from earning exorbitant profit or exorbitant equity in this case by underpaying right for the for the Purchase of the capital good by the way just as an aside. I mentioned already we were setting aside where Well, we're sitting aside the source of the entrepreneurs profit Entrepreneurial profit is earned for better Anticipation on the part of the entrepreneur for what the actual marginal revenue products will be in the future, right? What the proper discount rates will be in the future? We're Just setting that aside. So we're just talking about the capitalist who's lending into this process and earning an interest return And so that's again undertaken in other lectures Okay, so now let's just apply this to economic calculation We've got the two forms now of economic calculation net income and net worth and As we spoke about this morning the entrepreneur Or the entrepreneurs in the economy use Net income the calculation of net income or being gross profit in order to make production decisions Given that they have an existing Operation with with complementary factors of production They need to know what goods should we produce the ice cream vendor or what flavors of ice cream? You know, how many workers to hire? What should their shifts look like? Where should we locate the building? Or the facility of what do you know? Where do we buy our? Or lease our equipment from and so on and so forth is making all these production decisions thinking through the questions of how to allocate the factors of production and And this is we spoke about this morning. This is done What's behind what's being brought forth behind this That's being done in this process is the satisfaction the better satisfaction the more full satisfaction of our preferences It's economizing right every time the entrepreneur's profit He's he's taken resources. He's bid resources away from other entrepreneurs who would have produced them to produce some other good That is preferred less by consumers and he's devoted These factors of production to a production process that the consumers prefer more How do we know this he's earning profit the consumers are paying more to buy his good than they are to buy his competitors Goods relatively speaking right relative to the factors of production being used Now with net worth what the entrepreneurs use net worth as an economic calculation to Determine is capital investment So here the question is What what asset? combinations Will the entrepreneur bring under his or her direction? how are the different assets combined under an entrepreneurial group and Overseen by this entrepreneurial group Why why should we have a general motors that has this particular? divisional Combination of assets, you know the Chevy division and so on so how did the owners of general motors? Maybe isn't the best example, but let's assume that they weren't bailed out. How would the Owners of General Motors figure out, you know, we're going to shutter the Pontiac division and not the Chevy division We're going to sell off these assets or we're going to mothball these assets What was the division that they sold to spiker motors Sold one of their divisions to spiker motors. I can't remember the name Don't think it was Hummer. It was well Saab it was Sam. Yeah, right. So how did they decide this right? How did how did the owners of spiker motors decide? Look, you know, we if we buy these assets We will increase The value of our company Well, they're doing economic calculation of net worth right they're saying if we have these assets They're actually worth more under our direction than they are under the direction of those bailed out You know old old guard fogies at General Motors We know how better to satisfy consumer preferences with these assets than they do and if we buy them The value of them will actually be greater and since the liability We have to pay to buy them away from these losers is lower than the value when we get it We've added to our net worth So that's what is going on with net worth Calculations with capital value calculations Now this This determination of capital value then is the basis for The allocation of capital funding into the acquisition of assets and the end of course the production and acquisition of assets and As Mises was fond of saying the pinnacle of capital allocation is the stock market So let's just follow through with this discussion of capital valuation to think about how it relates to the stock market So common stock is just ownership shares in the net worth of a company. That's why they're called equities, right? Stocks are equities. It just means that whoever possesses the equity has a pro-rata Ownership share of the equity or the net worth of the firm Obviously then the price of a share of stock will go up and down depending upon the equity or the net worth of the firm So if the firm better satisfies Consumer preferences through production and earns net income if they have earnings, right? Their stock price will go up if they acquire assets that are worth more than their liabilities Their stock price will go up right as they add net worth or equity in that fashion To their operation so there's a there's a basic connection between stock prices and net worth and A basic connection between net worth and the satisfaction of our preferences like these are all logically in the stream of explanation That we started on this morning now This doesn't though explain how stock markets allocate capital What Mises said is that the pinnacle of capital allocation not the pinnacle of just saying what capital is right? Saying oh this firm has this much capital because it's its stock price is X and it has this number of shares outstanding And so it has a capitalization value of Y. It's not that right and this comes about of course through stock investor Expectations the stock speculation right investors Invest in these companies and they buy shares of stock anticipating that in the future This entrepreneurial group will actually increase the net worth of the company through earnings and asset acquisitions and Cost-cutting and so on and so forth all of these measures right so we have outside Outside of the of the enterprise we have outside investors who are determining actually the capital value of these companies my pet example of this of course is Amazon Remember when Amazon dot-com started up in the mid 1990s for almost 10 years. They never earned any profit Never earned it right never had any positive net income statements, and if their stock price kept going up and up and up Well How's it what's going on? Well, what's going on is? Outside investors saw the potential here and they continued to bid for the ownership of what they believe would be the forthcoming future net worth of Amazon and What they did is bid the stock price up to day which capitalized Bezos today Right, so if the stock price is bid up to day the this just means that the assets that the company owns that the entrepreneur's own Is greater today they can actually take these assets and sell them at those elevated prices today to these other people right and If your assets go up and your liabilities haven't changed because the entrepreneurs are bidding your assets up Well, you can now you can take on more liabilities, right? You can capitalize that value just by taking on debt It's just like in the housing boom when You know all the housing prices were being bid up around mine That the my housing price might have gone from something like two hundred thousand dollars to three hundred I Could have actually sold my house at the top of the boom maybe at that price But I don't have to sell my house in order in order to Capitalize myself from that increased asset value right I can take out a second mortgage. I by the way didn't do this For obvious reasons But but but this is the way the process works right for entrepreneurs as well Okay, now let me finish by talking about the distinction between capital accumulation that's undertaken in the normal process of economic progress and the Boom bus cycle so capital value is an integral part of this discussion as well So economic progress is set in motion by a lowering of time preferences on the part of people Where when people lower their time preferences then they shift the allocation of their resources away from producing Consumer goods more directly Towards producing capital goods so they save and invest more and they consume less And so the the additional spending then so this additional saving and investing goes through credit markets typically Interest rates are lowered Entrepreneurs borrow or they're able again to advance funds more readily at lower interest rates in production processes So they step up production processes because the entrepreneurs are buying more capital goods remember in our capital structure diagram We're shifting demand from the lower stages to the upper stages So the prices of the upper-stage goods are rising the capital value of those things are going up Capital value of a steel mill is going up or the capital value of an iron mine is going up And so production begins to move towards what is now more profitable right these these longer more productive production processes that are in set in motion by our Preference under the assumption our preference to intertemporally Reallocate resources away from more immediate Satisfaction of consumptive ends to Further in the future satisfaction of consumer ends Now the production structure as we suggested before is built up along particular lines of production in the capital structure, right? It isn't just a macro an aggregated macro effect where we all we have in the process is shifting from C to S right in the in the C plus I plus G or C plus S plus G Equation now it's it's that particular lines of production will be increased depending upon what in particular is being preferred more highly So it could be that you know production is being geared up to As I suggested maybe expand the production of certain raw materials like coal or Oil, you know the really economizing fuels and Or it might be something else. It might be that New technologies are being invested in which will lead to the eventual production of better computers or some other such thing so so this is all sustainable as Roger Garrison likes to say precisely because it's satisfying our preferences our time preferences have gone down The capital values in the economy change based upon this because our demands are changing throughout the economy Interest rates are also changing And this is just reflecting the way our preferences have been altered Now when we think about the boom bust process It superficially appears similar, right? The boom starts because interest rates are lower more funds that more credit is being extended As the interest rates go down capital values rise funds the borrowed money starts to pour into particular lines of Capital or do durable consumer goods perhaps Housing and so on as steel production and timber Operations and what have you and so there's a superficial similarity between the two processes but They're set in motion in entirely different ways and it isn't again too difficult to see the distinction here Economic progress is set in motion by a change in our preferences and therefore as production patterns change to satisfy our preferences They're sustainable precisely because they satisfy our preferences With credit expansion through monetary inflation the the Economic calculation that entrepreneurs are engaged in it is is not set in motion by a change in our preferences Our preferences haven't changed at all. It's set in motion by monetary inflation and credit expansion So we get a different cause setting this process in motion and what makes it of course unsustainable Is precisely that this new pattern of production this new structure of production is being produced by The process of the credit expansion does not in the end satisfy our preferences our time preferences are different From the pattern of production from the extended longer production processes that are being stretched out by the capital Expansion process and so eventually Something has to give right We can't go on forever producing a line of production that will not satisfy our preferences Eventually these two will come to a head so to speak and something must give and in the market economy as we well know Well, and in human life in general what gives are the physical things The cause of all of all the physical attributes of our actions are The ends that we wish to satisfy The preferences that we have will dominate in the end This precisely because it couldn't be otherwise as long as we have some semblance of a market economy where we're You know permitted to spend our income and have our preferences expressed and so this we say that the boom process is Self-reversing It goes on for a while But eventually something occurs that Indicates to the capitalist investor that this whole process of building up these lines of production are not going to match our preferences These are not going to be profitable lines of investment pretty soon And you better get out now right and the crash comes and the correction of the capital values and so on That that are necessary then to re-employ all the mal-invested capital structure into Lines of production that then do prove to be profitable according to our preferences as they emerge in this future period So again, I've exhausted my time and we'll stop here. Thank you