Nassau Senior Capital and Interest

Nassau Senior Capital and Interest

Senior also extended Ricardo's real-cost analysis by adding the cost of "abstinence" to the cost of labor. In the somewhat para­doxical statement of his third postulate, Senior hinted at the fact that round­about methods of production are more productive than direct methods in the long run, a fact that the Austrian economist Bohm-Bawerk greatly clarified at a later date. "Roundaboutness" means postponing produc­tion of consumption goods by using labor and raw materials first to produce capital goods, which are then used along with labor and raw materials to pro­duce more consumer goods than could have been produced in the first place with labor and raw materials alone. A classic example of increased efficiency from roundabout production might be drawn from the story of the fictional hero Robinson Crusoe. A person stranded on a deserted isle must face the eco­nomic necessity of securing food. Assuming that an island stream contains a bounteous supply offish, the most direct method of production to adopt would be to catch fish by hand. However, if the person postponed fishing long enough to fashion a pole and hook or a bow and arrow (crude forms of capital goods), he or she would catch more fish at a faster rate than would be possible using the most direct, but least efficient, method.

Although the example is simple, the same principle holds when time is taken to accumulate more sophisticated capital equipment in advanced economies. By "abstinence" Senior meant refraining from current consumption in order to accumulate capital, or "intermediate" goods. This is the key to the third postulate: "that the powers of labour, and of the other instruments which pro­duce wealth, may be indefinitely increased by using their products as the means of further production." But since capital goods do not satisfy consumer desires directly, there is a sacrifice involved in postponing consumption unless they received a reward. Senior's contribution to capital theory was to identify this reward for "abstinence" as interest, or the cost of waiting, during which time capital could be accumulated.

Senior's description of interest as a return to abstinence was his most orig­inal contribution to economics, and it soon became assimilated into the main­stream of economic theory. In it he surpassed Smith, Malthus, and Ricardo, and his analysis of capital and interest stood as the most complete in British economics until the time of Jevons. A retrospective view of Senior's performance must therefore conclude that all his contributions, though essentially modifications of Ricardo's analysis, were extremely impor­tant modifications for the future development of economics.