Lesson 7 of 8
Hayek's later mechanism
A small rise in a product's price lifts the annual profit rate far more on short investments than long. Hayek's own table, and the fight it started.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The Ricardo effect is Hayek's name for an old proposition: a rise in wages relative to product prices pushes firms towards machinery, and a fall pushes them back towards labour.
- His table shows why the push is so uneven. A 2 percent rise in the product price lifts the annual profit rate from 6 to 7 percent on a two-year investment and from 6 to 30 percent on a one-month one.
- He offered it as the reason a rise in consumers' goods demand late in a boom reduces rather than increases investment. That claim was disputed at length and was never settled.
By 1939 Hayek had decided the account in Prices and Production needed a different engine for the turning point. The essay that opens Profits, Interest and Investment, published that year, supplies it.
Hayek's own table, redrawn
- Two years7 percent
- One year8 percent
- Six months10 percent
- Three months14 percent
- One month30 percent
The proposition
Hayek says the substance is the familiar Ricardian point that a rise in wages encourages capitalists to substitute machinery for labour, and the reverse. He cites Ricardo's Principles, chapter I, section V.
His restatement is in terms of turnover. The profit earned on one turnover of any amount of labour is the difference between the wages paid and the price of what that labour produces. A rise in the product's price adds the same proportion to the profit on every turnover, regardless of how long the turnover takes.
But the annual rate of profit divides by the time. So the same addition, expressed per year, is enormous for labour invested for a month and small for labour invested for two years.
Reading the table
Start with 6 percent a year everywhere, and a rate of interest of 6 percent. Now let the price of the product rise by 2 percent, wages unchanged, which is the same as saying real wages fall.
Hayek's figures give the annual rate of profit after the change as 7 percent on the two-year investment, 8 on the one-year, 10 on the six-month, 14 on the three-month and 30 on the one-month. The effect on the shortest investment is a multiple of the effect on the longest.
The consequence he draws is that firms will use relatively more direct labour in the late stages and relatively less machinery and preparatory work, for any given output.
Why he needed it
Because it reverses the intuition that a boom in consumer demand is good for investment. If a rise in consumers' goods prices makes short investments far more profitable than long ones, then late in a boom the rise in consumer demand pulls resources out of the early stages rather than pushing more in.
That is the same conclusion as the earlier book reached through the loan market, arrived at through the profit rate instead.
The argument it started
A long one, and it did not conclude. The objections that were raised against it run to the assumptions the table needs: that wages are sticky in money terms, that firms respond to the annual rate rather than the total, that capital is free to move between techniques at short notice, and that the short-run response Hayek describes is the one that dominates.
Hayek himself kept revising the argument across several papers rather than settling it. A reader should treat the Ricardo effect as a proposed mechanism inside the tradition that its own members argue about, not as a settled part of the theory. The course on the case against this theory takes the criticism at full strength.
Check yourself
What is the Ricardo effect, in Hayek's statement of it?
- That interest rates determine wages
- That a rise in wages relative to product prices pushes firms towards machinery, and a fall pushes them back towards direct labour
- That rents rise faster than profits
Show the answer
Answer: B.
He attributes the substance to Ricardo's Principles, chapter I section V, and restates it in terms of the rate of profit on turnovers of different lengths.In Hayek's table, what does a 2 percent rise in the product price do?
- It raises every annual profit rate by 2 points
- It raises the annual rate from 6 to 7 percent on a two-year investment and from 6 to 30 percent on a one-month one
- It lowers profit on short investments
Show the answer
Answer: B.
The addition to profit per turnover is roughly the same, and dividing by the length of the turnover is what produces the asymmetry.How should a reader treat the Ricardo effect?
- As the settled core of the theory
- As a proposed mechanism that members of the tradition argue about, resting on assumptions that were disputed and never settled
- As a claim Hayek withdrew
Show the answer
Answer: B.
He kept revising it across several papers. The disputed assumptions include sticky money wages, firms responding to the annual rate, and capital moving between techniques at short notice.Sources
- Hayek, Profits, Interest and Investment, 1939, the title essay, sections 2 and 3, for the statement of the Ricardo effect, the attribution to Ricardo's Principles chapter I section V, the worked table of profit rates on investments of two years, one year, six months, three months and one month after a 2 percent rise in the price of the product, and the conclusion that a rise in the product price leads to relatively less machinery and relatively more direct labour.
- Hayek, Profits, Interest and Investment, 1939, the title essay, sections 8 to 11, for the application to the later stages of a boom and the decline of investment.
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture III, for the earlier account of the same turning point through the loan market.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The figures in the table are Hayek's own illustrative numbers in a worked example, not measurements of any economy. The bar chart redraws them and adds nothing.
- The Ricardo effect was contested from the moment it was published and the argument was not resolved. This lesson reports the mechanism and names the assumptions under dispute; it does not adjudicate them.