There are only two goods – potatoes and apples produced by John and Mary, respectively. For simplicity let us assume that in the initial conditions John produces 120 kilos of potatoes per year (10 kilos per month) and Mary the same way produces 120 kilos of apples. John prefers apples to potatoes, while Mary prefers potatoes to apples. So, in the end of each month John gives Mary 10 kilos of potatoes in exchange for an equal amount of apples.
Suppose that in this economy John has an opportunity within a two-year period to increase production of potatoes in the second year to 160 kilos (~12,6 kilos per month) but to create the conditions for that he should reduce production of potatoes in the first year by 24 kilos (2 kilos per month). Assume that this is the only way for John to increase the production of potatoes and that he is not willing to reduce his consumption of apples produced by Mary.
In such conditions the only way for John to increase production of potatoes is to convince Mary not to decrease production of apples despite the fact that she will have to forego part of her consumption of potatoes. In return John would promise Mary that in the following year she would receive from him 32 more kilos of potatoes. John’s profit from this investment project will be 8 kilos of potatoes in the second year.
What will it mean if Mary agrees to the deal? It will mean that her rate of time preference or annual interest rate is less than ~33,3%, that is she prefers 32 kilos of potatoes in the second year to 24 kilos in the first year.
But what if her interest rate is, say, 40% and John, without consulting Mary, mistakenly assumes that it is less than 33,3%?
Then in the first month of the first year he produces 8 kilos of potatoes instead of 10 and starts his investment project. In the end of the month he meets Mary as usual. Mary puts forward her 10 kilos of apples and waits for John to put forward his potatoes. When he does, she notices that the amount of potatoes is lower than she had expected. She asks John about it and he tells her that he decided that she would agree to forego part of her consumption of apples on the aforementioned conditions. In response, Mary tells him that she will not agree to that and for his misconduct she will only give him 8 kilos of apples this month to ensure that he would produce 10 kilos of potatoes in the following month.
Thus, in order to maintain his consumption of apples at the desired level, John will have to abandon his investment project and because of his mistake the economy will lose the value of 2 kilos of potatoes for Mary and the positive difference between the value of 2 kilos of apples for John and Mary.
I believe that, despite being extremely primitive, this model captures the essence of malinvestment conceived by the Austrian theory of business cycle. In the real economy the presence of money and hence credit markets makes it easier for producers to make the right investment decisions. But this only holds in the situation where the amount of credit equals the amount of savings. If the amount of credit exceeds savings, investors may find themselves in the position similar to John’s.
