The Encyclopedia of Economic Principals

Chapter 98

Austrian, Institutional, and Evolutionary Political Economy

Discounting, discovery, dispersed costs and the path of new money.

Four of the chapter's worked examples, made interactive: cheap credit and long projects, arbitrage profit and imitation, prices that draw on dispersed costs, and who gains from new money first. All numbers are the chapter's hypothetical values.

Every example here is a constructed teaching example: it uses the hypothetical numbers of the chapter's worked examples, plus a few values added for comparison and labelled as such in each panel. Nothing here measures a real market, firm or household.

Demonstration 1 of 4

Credit terms and the long project

Why does a lower interest rate favor the longer project?

Discounting bites harder the further away a payoff is, so a lower rate raises distant values most. If the low rate comes from credit rather than saving, the long projects it starts may not be completable.

Equation, written in LaTeX: i_m<i_n

Equation, written in LaTeX: i_m<R_j<i_n

Scroll sideways for the whole equation

Each project costs $100 today. The short project pays $112 in one year; the long project pays its payoff in four years. r is the discount rate; at the saving-consistent rate it is 10 percent.

Predict first. Lower the rate from 10% to 6%. Which project gains more value?

Your prediction

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Figure: Credit terms and the long project. Two bars against a $100 cost line: short project $101.82, long project $95.62 at 10%.
Discount rate: 10%, Long project payoff ($): 140
Constructed example: the chapter's hypothetical values are cost 100, payoffs 112 and 140, and rates of 10 and 6 percent; a rate of 8 percent and a long payoff of 130 are added.

Calculated values

PV short
$101.82
PV long
$95.62
Projects started
Only the short project

Hypothetical teaching numbers, not data. At 10% the short project is worth 112 / 1.10 = 101.82 dollars and the long one 140 / 1.4641 = 95.62 dollars, so only the short project covers the $100 cost. A lower rate raises the distant payoff's value most, which is why cheap credit lengthens production plans.

Worked steps

  1. PV short = 112 / 1.10 = $101.82
  2. PV long = 140 / 1.10^4 = 140 / 1.4641 = $95.62
  3. Against cost $100: only the short project covers its cost

Use the idea

When cheap credit makes long projects look viable, ask whether saving, not only lending, will release the resources to finish them.

Where the conclusion applies

Certain payoffs and a single rate for each horizon, as in the chapter's hypothetical comparison.

Check your understanding: At 8% with payoff 140, which projects pass?
Short: 112 / 1.08 = $103.70; long: 140 / 1.08^4 = $102.90. Both pass.

Chapter 98 source: section "Austrian malinvestment cycle".

Demonstration 2 of 4

Arbitrage, imitation, and entry barriers

How much does an entrepreneur earn by linking growers and restaurants, and what does a rival do?

The first trader profits from a price gap nobody had noticed. Imitators compete the gap down, raising grower receipts and cutting restaurant prices; the profit was the reward for discovery.

Equation, written in LaTeX: \pi=q(p-c)-f,

Equation, written in LaTeX: 800(1.10-0.30)=640

Equation, written in LaTeX: 800(0.95-0.40)-320=120

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q = 800 kilograms a week, c the price paid to growers (who value surplus produce at $0.10), p the price charged to restaurants (who would pay up to $1.50) and f the weekly route cost.

Predict first. A rival forces prices to $0.40 and $0.95 on a $320 route. What is the incumbent's profit if it matches?

Your prediction

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Figure: Arbitrage, imitation, and entry barriers. Bars: spread $640, route cost $400, profit $240, grower gain $160, restaurant saving $320.
Price paid to growers ($/kg): 0.3, Price charged to restaurants ($/kg): 1.1, Weekly route cost ($): 400
Constructed example: all values (800 kg, prices 0.30, 0.40, 0.95 and 1.10, routes 400 and 320, disposal 0.10, willingness 1.50) are the chapter's hypothetical numbers; mixed combinations are added.

Calculated values

Spread revenue
$640
Profit
$240
Grower gain over disposal
$160
Restaurant saving
$320

Hypothetical teaching numbers, not data. Buying at $0.30 and selling at $1.10 moves 800 kilograms, and the entrepreneur keeps 800 x 0.80 - 400 = 240 dollars a week. Growers gain $160 over disposal and restaurants save $320. Imitation narrows the spread and passes more of the gain to both sides.

Worked steps

  1. Spread = 800 x (1.10 - 0.30) = 800 x 0.80 = $640
  2. Profit = $640 - $400 = $240
  3. Grower gain = 800 x (0.30 - 0.10) = $160
  4. Restaurant saving = 800 x (1.50 - 1.10) = $320

Use the idea

Read a large margin on a new route as a signal that invites entry, and ask what entry costs stop imitation.

Where the conclusion applies

Fixed quantity and willingness to pay, as in the chapter's hypothetical produce market.

Check your understanding: Grower price $0.40, restaurant price $1.10, route $400: what is profit?
800 x (1.10 - 0.40) - 400 = 560 - 400 = $160.

Chapter 98 source: section "Entrepreneurial discovery".

Demonstration 3 of 4

Prices elicit dispersed costs

How much cheaper is curtailment when a price, not a rule, decides who cuts back?

A payment above a plant's own cost makes it volunteer, so the cheapest plants curtail first without the operator knowing their costs. A uniform rule spreads the cut over costly plants too.

Equation, written in LaTeX: 4(20)+2(50)=180

Equation, written in LaTeX: 2(20)+2(50)+2(90)=320

Scroll sideways for the whole equation

Plants A, B and C can each give up 4 MWh at private costs of $20, $50 and $90 per MWh. The operator knows only the total it needs.

Predict first. At 6 MWh, how much more does equal assignment cost than the scarcity price?

Your prediction

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Figure: Prices elicit dispersed costs. Step cost curve for plants A ($20), B ($50) and C ($90), 4 MWh each; shaded blocks show who curtails 6 MWh, total cost $180.00.
Required curtailment (MWh): 6, Mechanism: Scarcity price
Constructed example: the chapter's hypothetical values are three plants at $20, $50 and $90, 4 MWh each, and a 6 MWh requirement; requirements of 4 and 8 MWh are added.

Calculated values

Mechanism
Scarcity price
Total cost
$180.00
Cost with a scarcity price
$180.00
Extra cost
$0.00

Hypothetical teaching numbers, not data. To curtail 6 MWh, a scarcity payment between 50 and 90 per MWh calls on the cheapest plants first; the resource cost is 4 x 20 + 2 x 50 = 180.00 dollars, against $180.00 with a price. The price works because it draws on costs only each plant knows.

Worked steps

  1. 4 x 20 + 2 x 50 = 180.00
  2. A scarcity payment between 50 and 90 per MWh elicits exactly 6 MWh

Use the idea

When the information needed to allocate a cut is private, compare an offered price with an assigned quota by what each would cost given those private costs.

Where the conclusion applies

Truthful responses to the posted payment and fixed costs per MWh, as in the chapter's case.

Check your understanding: At 8 MWh, what do the two mechanisms cost?
Price: 4(20) + 4(50) = $280; equal assignment: (8 / 3)(20 + 50 + 90) = $426.67.

Chapter 98 source: section "Dispersed-knowledge problem".

Demonstration 4 of 4

Who gets new money first

Does it matter who receives new money first?

Fixed supplies absorb the first round of new spending as higher prices for whatever the first recipients buy. Later circulation spreads the effect, but the incidence of the first round depends on the injection channel.

Equation, written in LaTeX: \Delta M

Scroll sideways for the whole equation

Supplies are fixed at 100 land claims ($100 each) and 1,000 food baskets ($10 each). Delta M is new money spent in the first round by its first recipients.

Predict first. If the 1,000 goes to households instead of land investors, does a nonrecipient lose food in the first round?

Your prediction

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Figure: Who gets new money first. Price index bars before and after the first round: land $110.00, food $10.00 after $1,000 goes to land investors.
Money injected ($): 1,000, First recipients: Land investors
Constructed example: the chapter's hypothetical values are 100 claims at $100, 1,000 baskets at $10 and an injection of 1,000; injections of 500 and 2,000 are added.

Calculated values

Land price
$110.00
Food basket price
$10.00
Nonrecipient food loss
0.0%

Hypothetical teaching numbers, not data. The $1,000 goes first to land investors, who spend it on land, so the land price becomes (10,000 + 1,000) / 100 = 110.00. Land ends the first round at $110.00 and food at $10.00, so a nonrecipient loses no food in the first round. The same injection changes relative prices differently depending on who receives it first.

Worked steps

  1. Land price = (10,000 + 1,000) / 100 = $110.00
  2. Food price stays $10, so nonrecipients lose no food in the first round

Use the idea

Ask who spends new money first and on what before assuming a monetary expansion raises all prices together.

Where the conclusion applies

Fixed supplies and one round of spending, as in the chapter's hypothetical month.

Check your understanding: With 2,000 injected to households, what is the basket price and the nonrecipient loss?
12,000 / 1,000 = $12; loss = 1 - 10 / 12 = 16.7%.

Chapter 98 source: section "Cantillon effects".