Lesson 1 of 8
An economy in sequence
Five firms, one product, round numbers. Who pays whom, what each stage adds, and why the total of payments between firms dwarfs the shop's takings.
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.
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In one minute
- Production is a sequence of firms, each buying the previous stage's output and adding labour and land to it.
- Money flows the other way, from the shopper back up the chain, and it changes hands once at every stage.
- Payments between firms in a period are far larger than payments by consumers, and this is arithmetic rather than a paradox.
Take one consumer good and follow it backwards. Somebody sold it. Somebody assembled it. Somebody made the parts. Somebody refined the material. Somebody dug it up.
What each stage sells in one period
- Stage 5, extraction20 units
- Stage 4, refining40 units
- Stage 3, components60 units
- Stage 2, assembly80 units
- Stage 1, the shop100 units
The chain, written out
Stage 5 buys nothing from another firm. It hires labour and rents land worth 20 and sells its output for 20.
Stage 4 pays 20 for that output, adds 20 of its own labour and land, and sells for 40. Stage 3 pays 40, adds 20, sells for 60. Stage 2 pays 60, adds 20, sells for 80. Stage 1 pays 80, adds 20, and sells to consumers for 100.
Add up what was paid to labour and land across all five stages: 20 five times, which is 100. Add up what consumers paid: 100. Those two are the same number, and they are the same number for a reason. Every unit of income was paid by some firm, and the whole of it came back as consumer spending.
The number that surprises people
Now add up what firms paid each other: 20 plus 40 plus 60 plus 80, which is 200. Twice what consumers spent.
Hayek makes this point in the second lecture of Prices and Production and notes that Adam Smith denied it, in the first chapter of book two of The Wealth of Nations, on the ground that whatever a dealer buys is ultimately destined for a consumer. Hayek's reply is that most goods are exchanged several times against money before reaching a consumer, and that the ratio of total producer spending to consumer spending is exactly the average number of times.
Here the ratio is two. That is the average number of exchanges, not a statement that anybody spent too much.
What changes when the chain lengthens
Add two stages at the remote end and nothing about the shop changes. The customer still pays for one item.
But the number of separate sales between firms rises, the total of payments between firms rises with it, and the time between the first application of labour and the finished article gets longer. The composition of what exists at any moment shifts towards things that are not yet consumable.
That shift is the subject of this whole course, and it is what a change of interest rate is supposed to bring about.
The useful habit
When you read that investment rose, ask which stage. When you read that a company is capital intensive, ask how far its output sits from a shopper. The answer is often visible in a filing: what a firm sells, who buys it, and whether that buyer is a person or another firm.
Check yourself
In the chain above, what is total income paid to labour and land?
- 200 units
- 100 units, which is also what consumers spend
- 300 units
Show the answer
Answer: B.
Each of five stages pays 20. Every unit of income was paid out by some firm and returns as consumer spending, which is why the two totals match.Why do payments between firms total twice what consumers spend?
- Because firms overpay each other
- Because goods are exchanged against money several times before reaching a consumer, and the ratio is the average number of exchanges
- Because intermediate goods are taxed twice
Show the answer
Answer: B.
Hayek makes exactly this point against Adam Smith in lecture II, and the ratio in this chain is two because there are two exchanges on average.What happens to the shop's takings when two stages are added at the remote end?
- They double
- Nothing. The customer still pays for one item, while payments between firms and the time to completion both rise
- They fall to zero
Show the answer
Answer: B.
Lengthening changes the composition of what exists at any moment towards goods that are not yet consumable, without changing the final purchase.Sources
- Hayek, Prices and Production, first published 1931, second revised edition 1935, lecture II, sections 5 to 8, for the definition of intermediate products, the division of a continuous process into stages, and the argument that payments for producers' goods exceed payments for consumers' goods by the average number of times goods change hands.
- Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776, book II, chapter I, is the passage Hayek is answering, and Hayek cites it there.
- Menger, Principles of Economics, German original 1871, English translation 1950, chapter I, for goods of higher order, which is the ordering this chain illustrates.
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.
- Every number here is an invented round figure chosen so the chain can be added up by hand. No industry is described, and real supply chains branch, loop and share inputs rather than running in a line.
- Counting stages is a device. Hayek introduces it as a substitute for a continuous process because it is easier to follow, not because production comes in discrete steps of equal length.