I’ve been reading up on the ABCT lately, and a huge amount of it is centered around capital theory. Here’s my understanding of the difference between higher order and lower order capital. It would be great if people could correct me, or add to it so that I can fully grasp what is meant.
Essentially, higher order goods are further away from the consumer along the chain of production. I use the example of a baker. If a baker experiences a rise in demand, in the short term he may employ more people in his bakery, but will suffer diminishing returns to scale as the capital to labour ratio has fallen. Such a process cannot continue indefinitely, and is only a short term remedy to deal with higher demand.
In order to invest in the long-term, the baker must either buy new equipment (ovens), or perhaps even expand his bakery to have more space for the additional equipment and employees. This would be a long term and expensive investment.
Is this fundamentally correct or have I mis-interpreted something? Is there a better example to illustrate the austrian capital theory? Does anyone have a link to some article differentiating between the two? Usually I just use google but searching for “Austrian Capital Structure theory” has yielded few results.
It’s a good question. I think your idea is correct. Also, to drive it home further, look at it from a more global economic perspective. As interest rates lower and savings and investment increases, entrepreneurs, rather than opening a new bakery, or buying new bakery equipment, which is still pretty close to the consumer and consumption demand, to take it to an extreme, may instead invest in expanding copper wire production, or copper mining. Copper wire, when used in motors, which are used in machines in plants that manufacture other machines, is a very high order capital good. So in the extreme view, resources such as land and labor and capital goods are directed towards efforts that are far removed from the ultimate consumer. But i’d say you’ve got the idea of it.
I’d suggest that you start by reading chapters 5 through 9 in Man, Economy and State by Murray Rothbard.
One distinction that Rothbard fails to emphasize, but that I think is important, is the difference between durable and non-durable goods. Durable consumer goods, such as houses, share some characteristics with capital goods. I would also classify non-durable goods used in production, such as flour and salt in your example, as capital goods. If too little wheat is planted today, it will result in increased prices for baked goods several months from now. The Structure of Production by Mark Skousen does a good job of providing prospective on these issues.
Once you have an understanding of the basics, I’d suggest researching the topic of supply chain management for further insight.
It’s not that complicated. Higher order goods are goods whose payoff are farther into the future than lower-order goods. In order to enjoy an apple, one must only eat it. The payoff is immediate. But in order to enjoy an apple tree, one must wait for the apples to grow and to be picked. The apple tree itself is not a consumable good. The longer the time-span between the expenditure on the good and the good being sold to the final consumer, the higher the order of the good.
An iron mine, for example, is an extreme-high-order good, as iron must first be made into steel, then into machine parts, then into machines, then those machines make a final product, and once that final product is sold, the expenditure on the iron production is justified. Whether or not it was worth waiting all this time to get that good depends on the social rate of discount. This is why manipulating the rate of interest affects higher order goods more than lower order goods.