Crusoe investment

Interest rates are social phenomena in that they appear only when two or more people interact as lenders and borrowers. However, the concepts of saving and investment can be seen more clearly by examining the actions of an isolated individual.

Recall the plight of Robinson Crusoe, washed ashore on a tropical island with little more than his clothing. He feeds himself by fishing with a simple spear-like stick that he found on the beach. Using this spear he can catch five pounds of fish in about ten hours of fishing. But Crusoe can think of a better way of catching fish, and he decides to weave himself a fishing net.

It will take him an entire day to make the net. This means that he will not have his usual five pounds of fish to eat. Therefore, he must either go without eating that day or save up some fish beforehand. Whether he achieves this by working an extra hour per day for ten days, or by reducing his consumption by a pound per day for five days, he must forgo consuming this amount of fish production at some time in order to produce the net.

Crusoe’s reason for weaving the net is to catch more fish in the future. He can imagine a world in which he has a better standard of living: more fish for an hour’s work. He is willing to make the sacrifice of consuming less of his production now in order to be able to consume more in the future. Perhaps such a sacrifice, when seen in its long-term context, is not a sacrifice at all.     Nevertheless, some saving must occur to achieve the increase in productivity.

The day after the net has been completed, Crusoe finds he can catch 25 pounds of fish in ten hours. His daily production has increased significantly, and this allows him to more than meet his basic dietary needs. He can now use some of his time to work at satisfying other wants, such as making better clothing or picking coconuts or building a house. He might even build a boat that will take him out to better fishing grounds, where his productivity will be improved further.

Each of these new activities will require forgoing consumption of some amount of fish production. Using the time to build tools – productive goods such as the net and the boat – is called capital formation. These factors of production, such as tools, machines, buildings and vehicles, are called capital goods.

Source: This article is an extract from the book Real Money, published by the Free Market Foundation and may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.