Production Theory: Recent Episodes
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Production Theory includes nature of the firm, and allocation and pricing of the factors of production. Also theory of rent and capital and interest theory.
“Our civilization is inseparably linked with our methods of economic calculation. It would perish if we were to abandon this most precious intellectual tool of acting.”
Download lecture slides at Mises.org/MU23_PPT_28.
Recorded at the Mises Institute in Auburn, Alabama, on 27 July 2023.
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community."
Download the slides from this lecture at Mises.org/MU23_PPT_06.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2023.
While F.A. Hayek's famous 1945 essay effectively critiques the "perfect information" hypothesis, it is an inadequate explanation of the issue of economic calculation.
Original Article: "The Market Process Is Not a Knowledge Problem"
Jonathan Newman joins Bob to critique a recent Twitter argument where some were claiming that supercomputers solved the socialist calculation problem.
The Twitter thread on AI and Socialism: Mises.org/HAP394a
Bob on Socialism and calculation vs knowledge: Mises.org/HAP394b
Karras Lambert and Tate Fegley on economic calculation and AI: Mises.org/HAP394c
Part I: Economics, Chapter 2: Economic Theory
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Part I: Economics, Chapter 1: What Economics Is
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Part II: Market, Chapter 7: Economic Calculation
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Conclusion: Action and Interaction, How to Think about the Economy: A Primer.
Narrated by John Quattrucci.
How to Think about the Economy was written to accomplish something big: economic literacy. It is intentionally kept very short to be inviting rather than intimidating. You will gain a life-changing understanding of how the economy works in practically no time.
Narrated by John Quattrucci.
Download the complete audiobook (12 MP3 files) in one ZIP file here. This audiobook is also available on Soundcloud and via RSS.Purchase the Audiobook on Audible/Amazon, or paperback at the Mises Store.
Part II: Market, Chapter 5: Production and Entrepreneurship
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Part II: Market, Chapter 4: A Process, Not a Factory
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Part I: Economics, Chapter 3: How to Do Economics
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Part II: Market, Chapter 6: Value, Money, and Price
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Part III: Intervention, Chapter 8: Monetary Intervention
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
Part III: Intervention, Chapter 9: Regulatory Intervention
How to Think about the Economy: A Primer. Narrated by John Quattrucci.
It is easy to think of supply and demand curves as being key to economic analysis. In reality, they can't tell us much, and emphasizing them actually stands in the way of better understanding economic processes.
Original Article: "What Do Supply and Demand Curves Really Tell Us? Not Very Much"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community." Download the slides from this lecture at Mises.org/MU22_PPT_04.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
Download the slides from this lecture at Mises.org/MU21_PPT_22.
Recorded at the Mises Institute in Auburn, Alabama, on 21 July 2021.
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community." Download the slides from this lecture at Mises.org/MU21_PPT_05.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
I ended my article last week with a rash assertion. Marx says that capitalists exploit workers, and I countered that this claim depends on the false labor theory of value. It is vital to bear in mind that when Marx talks about exploitation, he has a technical sense of the concept in mind, rather than the popular sense, in which “exploitation” means unfair treatment. To claim that capitalists exploit workers in this sense need not rest on the labor theory of value.
The technical sense arises from a deep question that Marx asks: Why do capitalists earn profits? He does not mean here “profit” as Austrian economists use the term but rather what we would call “interest.” Marx’s question, then, is: Why does capital earn interest? The capitalist starts out with money, which he invests in a business. In the production process of the business, his money turns into commodities. These he sells for money, and he winds up with more money than he had at the start of the process. (This is the famous M—C—M’ formula, where M is money, C is commodities, and M’ exceeds M.)
To specify Marx’s question, what he wants to know is how it is possible, given that in equilibrium all commodities exchange at their labor values, that the capitalist ends up with an increase in money. To reiterate, Marx is talking about equilibrium. Sometimes, capitalists can take advantage of fluctuations in supply and demand to earn more than the going rate of return, and other capitalists earn less than this; but Marx’s question is why there is a rate of return on capital at all.
His answer is ingenious. He says that workers sell their labor power, that is, their ability to produce commodities once given access to the means of production, to the capitalists. The worker is putting himself at the disposal of the capitalist for a certain number of hours each day. Because each commodity sells at its labor value, and labor power is a commodity, a new question arises: What is the labor value of labor power? Marx’s answer is that it is the cost of labor, i.e., the costs of the goods the laborer needs for subsistence and, Marx adds, reproduction. This is in turn determined by the labor values of these goods. Suppose the cost of labor, understood in this sense, is eight hours per day, but the worker has contracted to work for the capitalist for ten hours per day. The extra two hours are “surplus value” and are the source of interest. In Marx’s account, workers are not paid below their value, as measured by the labor theory of value, but the gain to the capitalist comes from the workers’ extra hours; and this is Marx’s technical sense of “exploitation.”
As Wolff realizes, Marx’s account of profit is wrong. I won’t go into the details of Wolff’s mathematical argument for this, but he concludes, “I proved an extremely important theorem that shows that Marx was wrong to impute the exploitative capacity of capitalism to the labor/labor power distinction.” (Unfortunately, he later discovered that someone else had proved the same theorem two years before he did.)
Despite his proof, Wolff remains convinced that Marx was right. Capitalists do exploit workers and this is the most important fact required to understand capitalism. He thinks that where Marx failed, he has succeeded; he has a new proof of exploitation.
His proof is in essence the following. In the capitalist system, all the factors of production have a profit markup. If a capitalist earns below the going rate of return, he can cash out his investment and reinvest in something that pays better. But workers cannot do this. They own nothing besides their own bodies, and they cannot detach themselves from these. They cannot, then, cash out their bodies and invest them more productively elsewhere if they are earning below the profit markup for labor. They thus earn below what the equilibrium price of labor would be if they could make this switch, and this corresponds to the extra profits that capitalists make. In this way, workers are exploited.
Wolff explains his argument in this way:
Now, in a free market, a competitive market, a capitalist market—so all the classical Political Economists agreed—there is a single ruling rate of profit which is adjusted and regulated by the free choices that capitalists make to move their capital from sector to sector in pursuit of the largest return on their investment. If a capitalist who owns a factory that weaves woolen cloth observes that capitalists in the furniture business make a higher rate of return (and, let us recall, that in the classical school perfect information is assumed), then over time and with some adjustment that capitalist can cash in his investment in the woolen factory and shift it … to a furniture factory. To be sure, this is not a switch that can be made overnight for there is a problem with what is called “fixed capital,” but over time and more or less bumpily, the capital gets transferred to the new sphere of production. This has the double effect of increasing the amount of woolen cloth available in the market and decreasing the amount of furniture available for sale. Changes in the relative size of demand and supply alter the prices at which these goods sell which in turn reduces somewhat the rate of return in the cloth industry and increases it in the furniture industry. So by an unceasing series of such individual capitalist decisions and actions the profit rate is perpetually equilibrated. This is the familiar picture painted by Ricardo and his lesser contemporaries. The system of price equations representing the operations of a capitalist economy provides a mathematical model for this story of what goes on in the normal functioning of capitalism…. Ah, but the labor producers, unlike the furniture producers and the cloth producers, cannot shift their capital to a different line of production when they observe that it pays a higher rate of return, for their capital is nothing other than their bodies and the only way they can cash in their investment in their bodies is by… cashing it in, which is to say dying. This is nothing against capitalism, of course. Capitalism places no legal or other constraint on the choices of the workers. It is just an unfortunate metaphysical accident, perhaps laid at the door of Descartes if someone must be blamed, that the workers’ body and soul are inseparable this side of the grave…. Suppose we were to write a system of equations for an economy in which the workers genuinely are treated as free petty commodity producers of the commodity labor. And suppose we were to express mathematically this unfortunate constraint on the workers’ ability to move their capital into other lines of production, thus in a manner of speaking—and only in a manner of speaking—building the ironic treatment of capitalism as a free market system into the equations. Well, because of the unfreedom of those condemned to produce labor, the rate of return in that sector may not be equal to the rate of return in the other sectors and so it must be represented by a different variable…. Without troubling you overly with the mathematics, and, I might say, hardly surprisingly, it turns out that the total profit appropriated in the system by all of the capitalists exactly equals the profit forgone by the workers on their capital—their bodies—by the fact that they cannot shift that capital about in pursuit of a better rate of return and hence are forced to sell their output below what would otherwise be its equilibrium price.
I do not doubt the details of Wolff’s mathematics; his competence in such matters far exceeds my own. But he has not given us a sufficient reason to accept his analysis as a good account of either wages or interest. Marx’s account of interest fails, but at least he asks the right question: Why is there a rate of interest? Wolff does not ask this question but just postulates a profit markup for all factors; he then inquires why workers earn less than this markup. Austrian economics, by contrast, tries to account for the prices of all the factors of production. It is easy to assume what you should be trying to explain, but, as Bertrand Russell long ago said, “The method of ‘postulating’ what we want has many advantages; they are the same as the advantages of theft over honest toil.”
Many readers will be familiar with Robert Paul Wolff’s In Defense of Anarchism, a brilliant criticism of the state’s authority that arrives at conclusions similar to those of Lysander Spooner. Wolff is probably best known for his work on Kant, but he has published penetrating accounts of Marx and Rawls as well. He thinks that Marx offers an analysis of capitalism that is largely correct, and in a recent series of posts on his blog, The Philosopher’s Stone, he offers a characteristically incisive way of looking at Marx’s labor theory of value. I’ll try to show that, however ingenious it is, Wolff’s interpretation does not rescue Marx from absurdity.
Wolff lets us know his high opinion of Marx’s Das Kapital here:
I have devoted extended periods of time to the study and interpretation of the writings of two great thinkers: Immanuel Kant and Karl Marx. To the thought of each I devoted two books and a number of lengthy essays. Kant was my first love and my first great challenge. When I had come to terms with his thought, I was sure I would never encounter another thinker as difficult to master or correctly to interpret. However, when I plunged into Das Kapital three years after publishing my second book on the philosophy of Kant, I found myself confronted with a task even more demanding and multidimensional than that posed by the Critique and the Grundlegung [Groundwork of the Metaphysics of Morals].
As Wolff explains, Marx took over from Adam Smith and David Ricardo the notion that supply and demand aren’t fundamental in determining the price of commodities, i.e., goods produced in mass quantities and sold on the market. Changes in supply and demand will cause prices to fluctuate to restore equilibrium, but this equilibrium is determined by a “natural price” that underlies supply and demand and acts like a Newtonian gravitational force in drawing market prices to it. This natural price is the cost of labor: commodities will tend in equilibrium to exchange in proportion to the labor time needed to produce them. To the objection that capital goods are also costs of production, Ricardo replies that capital goods can be considered “stored-up” or frozen labor, so it remains true that labor costs determine price. There’s a complication involving rent that I won’t go into here. Rent according to this theory isn’t a cost of production; it is a payment capitalists make out of their profits to landlords.
As Wolff notes, there are severe problems with this theory:
In the simple case to which Marx [ha]s restricted himself in volume 1, commodities according to Ricardo exchange in proportion to the quantities of labor required directly or indirectly for their production, or what came to be called “embodied labor.” But if we think about that for a moment we realize there is a very elementary problem. Suppose that we are talking about the exchange of 10 yards of woolen cloth for a wooden chair. The labor required to produce the woolen cloth is quite different from the labor required to produce the chair. Making the woolen cloth involves shearing sheep, washing and drying wool, carding the wool, spinning it into thread, weaving the thread into cloth, and cutting the cloth into a piece 10 yards long. Making the chair involves sawing wood, turning it on a lathe, sanding it, nailing it or joining it with pegs, and so forth. Clearly if we are to compare the labor that produced the cloth with the labor that produced the chair we must abstract from all of these differences. So at the very least, we must be claiming that the wool and the chair exchange in proportion to the quantities of abstract labor required for their production…. But even this is not enough to capture what is mysterious about Ricardo’s seemingly transparently clear theory. For not all abstract labor counts when we are comparing boots and linen or wool and chairs. Suppose that a chair has been made by an apprentice carpenter who has not yet learned the trade. That young man … might spend 10 hours making a chair that a master carpenter could make in five. The buyers of chairs in the market would laugh at a carpenter who charged a higher price for chair because it had taken his apprentice longer to make. Only such labor as is “socially necessary” at any given stage in technological development counts when calculating the relative price of goods in the marketplace. Indeed, the problem is more complex even than I have suggested. Suppose that the carpenters making the chairs are averagely expert in their woodworking skills but find themselves under the direction of a novice manager who has not yet mastered the technique of combining the labor available to him in an averagely efficient manner. The time spent by the carpenters making the chairs may be devalued not because of any lack of skill on their part but because of problems elsewhere in the firm.
Thus, when Ricardo says that in the simple case (remember, we are still in volume 1[of Das Kapital] goods exchange in proportion to the quantities of labor directly and indirectly required for their production, he must be interpreted as actually meaning (although he himself failed to recognize this fact) that goods exchange in the market in proportion to the quantities of abstract socially necessary labor embodied in them.
You might think that this is sufficient to show that Marx is using the wrong theory. Wolff does not think so. He points out that the first few chapters of Das Kapital are written ironically, in a dense and difficult style. Marx is fully aware of the difficulties involved in “abstract labor,” but it is precisely the absurdity of capitalism that it compels capitalists and workers to look at value in this way:
Such talk is, Marx argues, thoroughgoingly mystified but, he insists, we must not commit the error of supposing that it is therefore mistaken. Quite to the contrary…. Marx writes “the categories of bourgeois economy consists of such like forms. They are forms of thought expressing with social validity the conditions and relations of a definite historically determined mode of production, viz., the production of commodities. The whole mystery of commodities, all the magic and necromancy that surrounds the products of labor as long as they take the form of commodities, vanishes therefore, so soon as we come to other forms of production.”
What does Marx mean when he says that this absurd form of thought has social validity? His meaning is profound and goes to the heart of his critique of capitalism. The form of thought whose absurdity he has just revealed has social validity both on the side of the capitalist and on the side of the worker. This mode of thought has social validity for the capitalist because only by conforming his thought and action to it can he function in a competitive marketplace and earn the going rate of return on his investment. If he makes the mistake of thinking of these commodities actually as useful objects made by the labor of real men and women and designed to satisfy human needs, he may become distracted by the reality of the factory or workplace and find himself lavishing more labor on a fabric than will be justified in the market by the price he can get for it…. On the side of the workers, the necessity that they stifle their natural desires, instincts, and creative efforts in their labor in order to work steadily, efficiently, and in a fashion that produces an adequate profit for their employers will of course have a severely destructive effect on their human being.
Though this is ingenious, it rests on a mistake. It isn’t the capitalist market that compels capitalists and workers to think absurdly in units of abstract labor. It is the false labor theory of value that does this. Without the assumption of a natural price that explains what is “really” going on beneath the veil of supply and demand, there is no mystification involved in capitalist production. As Murray Rothbard says, “[V]alues always fluctuate, and there is no invariable fixed base of value from which other value changes can be measured.” (Classical Economics, p. 91) In the Austrian theory of subjective value, there is no resort to this wrong assumption. Wolff at one place suggests that the notion of equilibrium price that modern economists use shows that natural price has not been abandoned, but this isn’t correct. The use of equilibrium concepts, such as Mises’s evenly rotating economy, doesn’t introduce anything other than subjective values in determining prices.
Marx, and Wolff following him, has projected the absurdities of the labor theory of value into the capitalist system of production and on that basis declares capitalism absurd. We should bypass this tangle and instead accept the clear analysis that Austrian theory provides. Austrian economics, to anticipate a rejoinder, does not rest on the unrealistic assumptions of neoclassical economics about which Wolff has elsewhere complained. He would no doubt respond that Austrian theory disguises the realities of capitalists’ exploitation of workers, but it is the false labor theory, not capitalism, that generates an “exploitation” that doesn’t exist.
Rothbard: "At the outset of every step forward on the road to a more plentiful existence is saving….Without saving and capital accumulation there could not be any striving toward nonmaterial ends."
Original Article: "The Upside of Lockdowns: More Saving"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Abstract: The concept of entrepreneurial opportunity has undergone a period of useful critique and refinement since Venkataraman (1997) and Shane and Venkataraman (2000) employed the term as one of the defining features of entrepreneurship studies. This paper presents a novel Austrian reinterpretation of this concept as an intersubjective phenomenon that emerges from the dual entrepreneurial process of discovery and judgment. Just as markets can be described as price discovery procedures for existing goods, services, and resources, entrepreneurship can be usefully described as a price discovery procedure for future goods, services, and resources. This view retains the essential elements of Kirzner’s (1973) approach while also refining the opportunity discovery concept within an evolutionary realist framework for understanding entrepreneurial motivation and action.
Gregory M. Dempster (gdempster@hsc.edu) is Elliott Professor of Economics and Business at Hampden-Sydney College.
INTRODUCTION Since Israel M. Kirzner’s (1973, 1979) groundbreaking work on entrepreneurial discovery over forty years ago, the concept of opportunity has been central to the academic literature on venture creation and innovation. Sankaran Venkataraman (1997) and Scott Shane and Venkataraman (2000) made opportunity a primary operational construct in their definition of the field of entrepreneurship studies. Though some views, such as those of Frank H. Knight (1921), Joseph A. Schumpeter (1934), and Buchanan and Vanberg (1991) deemphasize the concept in favor of other factors such as uncertainty, innovation, and creativity, the opportunity discovery view has remained a primary construct, often integrated with these other concepts as separate but interrelated aspects of venture creation. Indeed, there is general agreement in the field of entrepreneurship studies that scholars need to “explain the role of opportunities in the entrepreneurial process” and to “clarify the central role that opportunities play in a framework for entrepreneurship” (Eckhardt and Shane 2003, 333).
Recent scholarship, however, has displayed a great deal of ambiguity toward the use of the concept of opportunity, and some have questioned the coherence and usefulness of the term altogether. Distinctions between “Kirznerian” and “Schumpeterian” opportunity are made to distinguish equilibrating from dis-equilibrating entrepreneurial innovations (Shane 2003); “discovery” and “creation” have been proposed as alternate views of how opportunities come into existence (Alvarez and Barney 2007); and both epistemological and methodological objections to the concept itself have been suggested (Klein 2008; Foss and Klein 2012; McCaffrey 2014). The fact that many of these objections come from scholars working in the Austrian scholarly tradition of Kirzner suggests that they represent serious challenges to the viability of the opportunity discovery construct as a research tool in understanding the nature, causes, and consequences of entrepreneurial activity.
This paper seeks to better define the role of opportunity in entrepreneurial discovery. It focuses on entrepreneurship as a collaborative process of intersubjective knowledge generation and integration, and reconceptualizes the idea of entrepreneurial opportunity as neither a purely “preexisting” entity nor a creation of the entrepreneur, but the emergent result of the collaborative process of discovery and judgment. Instead of things in the mind of an entrepreneur, to be either recognized or created as independent constructs, opportunities in this view are defined as decision alternatives that emerge from a set of collaborative procedures for uncovering and integrating localized knowledge, widely dispersed among potential stakeholders, into coherent mean-ends frameworks from which interdependent paths of value creation may be identified and potentially exploited for mutual benefit among stakeholders.This conceptualization of entrepreneurial opportunity echoes that of Shepherd (2015, 491), who calls for “thinking of a potential opportunity in terms of a process of social interaction (between a community and the entrepreneur) rather than solely as an outcome of thinking (in the mind of the entrepreneur).” In other words, opportunities are endogenous to the process of intersubjective experimentation, selection, and retention that characterizes the market process in general.
This paper places opportunity back in the limelight as a central concept for understanding the causes and effects of entrepreneurship. We argue that this is important for at least three reasons. First, there is the issue of how context affects both motivation and decision analysis behind entrepreneurial actions. Koellinger (2008) argues that examining entrepreneurial behavior involves at least two fundamental questions: (1) What motivates entrepreneurs to choose among alternatives, and (2) where do these decision alternatives come from? Profit motives under uncertainty (i.e., judgment) can, at best, offer only a general answer to the first of these questions, because in complex settings involving nonalgorithmic uncertainty, the very possibilities for ex ante profit cannot be “prestated” (Koppl, Kauffman, Felin, and Longo 2015); characteristics of latent demand and supply are not operational apart from the process by which they are discovered or enacted, and computability limits the effectiveness of policies that presume otherwise (Koppl 2008). In other words, before an entrepreneur can exercise judgment, he or she must hold beliefs in the present about the prospects of profiting from judgment in the future, and both the generation and validation of those prospects in the present is a matter, we argue, of entrepreneurial discovery. Ludwig von Mises (1949 [1996]), who served as one of the primary inspirations for Kirzner’s view, suggested that this role of the entrepreneur as both organizer and evaluator is the “driving force” behind the market process; entrepreneurs both “speculate” on uncertain futures and “promote” specific ways of exploiting prospects for advantage from those speculations (250).
Second, there is the issue of differentials among entrepreneurial strategies (see Hitt, Ireland, and Hoskisson 2013). Entrepreneurial strategies are methods by which decision alternatives are evaluated, selected, and pursued. There is a crucial distinction between these strategies and the conditions that motivate or enable their use, because the strategies’ attributes are contingent on the uncertain unfolding of the market discovery process over time. Not all strategies are equally effective in all contexts; external conditions have much to say about what strategies are effective and under what circumstances. Beliefs about the effectiveness of strategies can be correct or incorrect, and the context of entrepreneurial action, or the opportunity conditions under which it operates, is what ultimately affirms (or not) the correctness of such beliefs. In other words, the existence of opportunity validates not only entrepreneurial beliefs about consumer preferences (ends), but also their beliefs about the best ways to meet those preferences (means).
Finally, there is the issue of differential welfare impacts of entrepreneurial action. Research since Baumol (1990) has confirmed that the entrepreneurial process will produce variability in social welfare outcomes based on the extent to which policies and institutions incentivize value-creating (productive) versus value-dissipating (unproductive) forms of entrepreneurship. More generally, the results of the entrepreneurial process are not confined to the results experienced by individual entrepreneurs; there is a social dimension to entrepreneurial outcomes determined by the character of the institutional capital structure within which they are generated. This social dimension is defined, in part, by the “nexus” (Shane 2003) between the motivations, beliefs, and skills of individual entrepreneurs and the contexts that incentivize and constrain the expression of those motivations, beliefs, and skills. In other words, negative social outcomes do not always come from incorrect beliefs or faulty strategies on the part of entrepreneurs, but often from the limited array of decision alternatives produced by poor institutional contexts.
Simply put, without a meaningful opportunity discovery construct, it is difficult to properly understand the impacts of context, contingency, and institutional capital on entrepreneurial outcomes. This paper represents an attempt to further develop such a meaningful concept, drawing on the work of Kirzner but also on the rich literature that has developed in response to its ambiguous construction and role. The remainder of the paper is organized as follows. First, the role of opportunity in the study of entrepreneurship is surveyed, beginning with Kirzner’s seminal view and proceeding to recent developments. Both Kirzner’s approach and the more recent extensions and modifications of the opportunity construct are critiqued, including those that suggest an outright abandonment of the term. Next, a theory of opportunity development is provided that addresses the major shortcomings of existing versions while retaining their important contextual role, noting similarities to other approaches. Finally, some implications are outlined of this reconceptualization of entrepreneurship as an emergent, collaborative procedure of opportunity discovery and judgment for both strategy research and policy.
THE ROLE OF OPPORTUNITY IN ENTREPRENEURSHIP STUDIES Although the systematic study of the entrepreneur goes at least as far back as Richard Cantillon (1755), Jean-Baptiste Say ([1821] 1880), and John Stuart Mill ([1848] 1871), it was the work of Knight (1921), Schumpeter (1934), and, especially, Kirzner (1973) that did the most to incorporate the theory of the entrepreneur into economic and social analysis. Likewise, although the term opportunity has a long history in both academic and popular works on entrepreneurship, the primary theoretical role it plays in entrepreneurship studies derives from the work of the Austrian school, again most directly from Kirzner (1973). One of the best-known expositions of this view is presented in Kirzner (1979, 62), where he outlines the essential aspects of what he calls “entrepreneurial discovery,” which he describes as the “driving force behind [the] systematic process” of market equilibration.
Kirzner’s entrepreneurial discovery view developed primarily out of the insights of Austrian scholars Mises and F. A. Hayek, who were in turn heavily influenced by the ideas of earlier scholars in the Austrian tradition. From Mises ([1949] 1996) comes the concept of entrepreneurship as a process of action under uncertainty, while Hayek (1945, 1948) contributes the concept of knowledge acquisition as a fundamental aspect of market interactions (Kirzner 1997, 67). As Kirzner explains, Hayek conceived of markets as processes whereby “market participants acquire better mutual information concerning the plans being made by fellow market participants,” while Mises contributed the recognition that “this process is driven by the daring, imaginative, speculative actions of entrepreneurs who see opportunities for pure profit in the conditions of disequilibrium” (Kirzner 1997, 68).
There are two important aspects of the preceding views that come to bear on an examination of the opportunity construct. First, from Hayek, opportunities arise as the result of acquiring “better” information about what market participants intend than was previously possessed, a process that Hayek later described as “discovery” (see, e.g., Hayek 1978). Second, from Mises, it is the entrepreneur that recognizes opportunities and engages in actions designed to exploit them. Kirzner (1997) refers to these aspects as the discovery role and the entrepreneurial role, respectively.Kirzner (1997) also adds a third aspect, the role of rivalry, as a necessary component of equilibrating market processes. Since this paper does not focus on the equilibrating role of the entrepreneur, we do not emphasize this admittedly important concept. Thus, discovery in the Austrian view does not refer to the recognition of opportunities per se, but to the general role of markets as a knowledge acquisition process, from which entrepreneurs learn what opportunities might exist and how to act in order to profit from them. To quote from Hayek (1948, 97), markets and competition exist “to teach us who will serve us well: which grocer or travel agency, which department store or hotel, which doctor or solicitor, we can expect to provide the most satisfactory solution for whatever particular personal problem we may have to face.”The author thanks an anonymous reviewer for highlighting this passage.
The Kirznerian entrepreneur is one who looks for “opportunities for pure entrepreneurial profit created by temporary absence of full adjustment between input and output markets” (1973, 69), whether that absence of adjustment is in the present or the future. Full adjustment of input and output markets requires the absence of surpluses and shortages, but also the lack of profit above the opportunity cost of all resources employed in the process. So, for a forward-looking entrepreneur, the ability to correctly foresee a profit situation requires that he, in some way, be able to discover something that is not reflected in the current pricing of resources and/or consumer goods and services. The entrepreneurial roles of recognition and risk taking require the discovery role of knowledge acquisition. Hayek (1945, 1948) adds the proposition that this knowledge is often of the localized, tacit, and intersubjective type that cannot be uncovered without actions (experiments) that submit various ideas to market tests. The picture of entrepreneurship that emerges is very similar to the creative trial-and-error processes that characterize “constructivist” conceptions of venture development, like those of Buchanan and Vanberg (1991) and Sarasvathy (2001). It also bears resemblance to the role of the financial market speculator in Mises ([1949] 1996).This similarity is examined further in the final section of the paper.
Unfortunately, Kirzner (1973, 1997) illustrates this process by employing a framework that assumes an actual, existing supply and demand for consumer goods and services, thus reducing the entrepreneurial function to one of discovering current market inefficiencies, essentially as an arbitrageur. An important aspect of this characterization, as pointed out by Peter G. Klein (2008), is the lack of investment and, thus, risk taking on the part of the entrepreneur. By contrast, Knight (1921) suggests that only when characteristics of future supply and demand are uncertain will an entrepreneurial investment in current resources be necessary, so that the entrepreneur acts as innovator, speculator, and resource allocator in markets for future goods and services, not merely an arbitrageur of divergent market expectations.
Though Klein acknowledges Kirzner’s purpose in using the arbitrageur as an illustration, stressing the equilibrating aspect of entrepreneurship in the market process, and that Kirzner himself acknowledged the speculative role of entrepreneurship in other works (see, e.g,, Kirzner, 1985, 56), the focus on arbitrage is nonetheless problematic.An anonymous reviewer points out, correctly, Kirzner’s later employment of a multiperiod view emphasizing the psychological component of investment under uncertainty. Chief among the issues is the idea that entrepreneurs are defined by the characteristic of “alertness” to opportunities, that is, that their primary function is to look for situations where yet unrecognized market inefficiencies already exist. Not only does such a function ignore the important role of uncertainty bearing that creating new goods and services entails, but it is also difficult to operationalize apart from the very actions (investments) that create those goods and services. Essentially, we can only see the ex post results of alertness, and that only when risky investments in assets turn out to have been correct.McCaffrey (2014) also questions the suitability of uncertain profit opportunities as a motivating factor for the characteristic of alertness. By contrast, it is problematic to ascribe unsuccessful investments to “lack of alertness” to an opportunity, as there is no direct evidence that an opportunity existed in the first place; nor can one merely substitute the idea of alertness to a “nonopportunity” to explain unsuccessful investments, because the very idea of alertness implies that something exists to be aware of.
Nonetheless, there is a considerable literature in entrepreneurship that derives its emphasis from this framework. Drawing from Kirzner, Shane and Venkataraman (2000, 200) identify opportunity as a key construct in the definition of what entrepreneurs do and what those who examine entrepreneurship study. They define entrepreneurial opportunities as “situations in which new goods, services, raw materials, and organizing methods can be introduced and sold at greater than their costs of production.” Importantly, this definition is noncommittal on the questions of both the nature and sources of entrepreneurial opportunities. The opportunity discovery approach has been employed to fruitfully explore knowledge transfer (Shane 2000), the nature of entrepreneurial searching (Hsieh, Nickerson, and Zenger 2007), venture development in transitional markets (Mainela and Puhakka 2009), the role of transactions costs and property rights (Foss and Foss 2008), the use of intellectual capital (Puhakka 2010), and entrepreneurial networks (Shu, Ren, and Zheng 2018), among numerous other applications.
Management scholars have spent considerable effort trying to better formalize the role of opportunity in the framework of entrepreneurship studies. For example, Sarasvathy, Dew, Velamuri, and Venkataraman (2003) distinguish between three views of entrepreneurial opportunity they identify as allocative, discovery, and creative views. An allocative view of opportunity implies a current misallocation of existing resources; thus, the emphasis is on recognition of discrepancies in current supply and demand, much as illustrated in Kirzner (1997). A discovery view implies that there is one important aspect of a potential market that is undeveloped—i.e., a (latent) demand without a supply or a (latent) supply without a demand. The emphasis in this view of entrepreneurial opportunity is on “discovering” where latent supply or demand exist, such as a service without a provider (latent demand) or a resource without a use (latent supply), and completing the market by implementing the missing piece. Finally, a creation view implies that there is neither a supply nor a demand for the good or service in question; in this case, the entrepreneur creates the opportunity by providing both a new good or service and a new set of means by which the good or service is created.
Sharon A. Alvarez, Jay B. Barney, and Susan L. Young (2010) employ a similar approach in their article on opportunity formation. They also use a threefold categorization scheme, focusing on three philosophical approaches to opportunity: realist, social constructionist, and evolutionary realist. Despite the different nomenclature, their views essentially correspond to those of Sarasvathy et al. (2003), with their realist view corresponding to the recognition view, the constructionist to the creation view, and the evolutionary realist to the discovery view of the latter. Confusingly, they refer to methods of “discovery” as applicable to the realist framework, although their description of realism corresponds closely to that of the allocative view in Sarasvathy, et al., (2003); likewise, they ascribe methods of “creation” to the evolutionary realist framework, although their description of this framework corresponds closely to that of discovery in the latter.
A rich literature has developed around constructivist views linked to the “creation” approach since Alvarez and Barney (2007) proposed the basic dichotomy between creation and discovery, including Alvarez and Barney (2010, 2013), Wood and McKinley (2010), Alvarez, Barney, and Anderson (2013), and Alvarez, Young, and Woolley (2015).Though Alvarez and Barney (2007) are generally credited with the discovery- creation dichotomy, earlier research had identified important aspects of the distinction. See, e.g., Buchanan and Vanberg (1991), Chandler, DeTienne, and Lyon (2003), and Baker and Nelson (2005). The emphasis in each of these extensions is on the idea of “enactment,” rather than discovery, of opportunities; as explained by Wood and McKinley (2018), the “causal influence of the entrepreneur on the opportunity is more strongly highlighted” than in the discovery view (8). The opportunity creation literature has expanded considerably to include the examination of niche construction (Luksha 2008), information technology startups (Ojala 2015), entrepreneurial affect (Goss and Smith 2018), the conditions of uncertainty underlying entrepreneurial actions (Mitchell et al. 2012), and social entrepreneurship (Gonzalez, Husted, and Aigner, 2017). Several studies have also attempted to bridge and/ or reconcile the opportunity discovery and opportunity creation approaches (see, e.g., Zahra 2008; Edelman and Yli-Renko 2010; Martin and Wilson, 2016; and Chetty, Karami, and Martin, 2018).
Although maintaining the importance of opportunity, however, the essence of the creation view still locates it solely in the mind of the entrepreneur. In doing so, this view fails to address the important problems of where entrepreneurial beliefs come from and why entrepreneurs perceive the decision alternatives that they do, particularly those alternatives that ultimately prove successful. The idea that successful entrepreneurship requires some knowledge of future conditions outside the mind of the entrepreneur seems to also require that there be entrepreneurial methods of “discovering” what those conditions are. Thus, at the heart of the dichotomy between creation and discovery are the questions of what ultimately makes entrepreneurial profit seeking successful, and whether it lies entirely within the entrepreneur’s imagination or at least in part in the recognition of external realities that give it credence.
Other extensions of the opportunity literature have attempted to better integrate it with more traditional views in psychology and evolutionary economics, such as the cognition-based approach of “opportunity recognition” (see, e.g., Baron 2004, 2006; Baron and Ensley 2006; and Ozgen and Baron 2007) and the idea of opportunities as “propensities” (Ramoglou and Tsang, 2016, 2017). Baron (2004, A1) proposes opportunity recognition as a form of pattern recognition, the “process through which individuals perceive emergent patterns among seemingly unrelated stimuli or events.” As such, opportunity recognition is a form of discovery informed by theories of human cognition and perception. Similarly, Ramoglou and Tsang (2016, 2017) propose that opportunities are real propensities for a future, emergent state of the world and that entrepreneurs sometimes recognize these propensities and act to bring them to fruition, much as one who recognizes the future plant within a seed must act to bring the plant into being. This evolutionary-realist view of opportunities as propensities is further examined below.
One way to examine the validity and completeness of alternate views of entrepreneurship is to ask how entrepreneurial behavior would be different under the different approaches. For example, consider the distinctions between discovery and creation as illustrated by Sarasvathy et al. (2003) and Alvarez, Barney, and Young (2010). Under the realist approach of Alvarez, Barney, and Young, analogous to Sarasvathy, Dew, Velamuri, and Venkataraman’s allocative view, the entrepreneur acts as the Kirznerian arbitrageur; entrepreneurs seek pure profit by addressing an existing market disequilibrium. Although such a view is plausible in many cases, it does not address the important Knightian roles of risk taking and investment under uncertainty, which characterize ventures to provide future goods and services. By contrast, under Alvarez, Barney, and Young’s constructionist approach, analogous to Sarasvathy et al.’s creation view, individuals develop both the opportunity and the market for it through their actions. They “do not recognize opportunities first and then act; rather, they act, wait for a response—usually from the market—and then they readjust and act again” (Sarasvathy et al. 2003, 30, emphasis mine). The implication is that it is entirely the actions of entrepreneurs that produce an opportunity—no latent market characteristics (demand or opportunity cost) exist independently that can be employed as motivation for actions or justification for beliefs.
However, the idea that entrepreneurs act without either motivation from or beliefs about latent external characteristics does not hold up to logical scrutiny, because it dodges the question of why entrepreneurs act at all. Although it is true that a yet undiscovered objective opportunity cannot serve as its own motivation for discovery, neither can purely subjective perceptions of an opportunity do so. The real question here is one of incentives—why do entrepreneurs believe that there are ex ante profit opportunities available? Do they not expect that, in some objective sense, their actions will result in an expected benefit above the opportunity cost of the action? What is the basis for a belief of this kind, and from where does the feedback that potentially affirms or alters the belief come? Hayek suggests that it comes in the form of information (i.e., revealed preferences) about the subjective perceptions of consumers and resource owners regarding the expected benefits and opportunity costs of future goods and services. In other words, it reflects underlying realities of (latent) supply and demand as revealed by consumers and resource owners. If this were not true, it would be difficult to understand how one could explain market feedback as a test of validity of the entrepreneur’s actions—and, by extension, the validity of the opportunity—because the concept of feedback requires some revelation about preferences not previously obtained by the learner, who is the entrepreneur.This emphasis on the role of the entrepreneur in “discovering” the preferences of the consumer is also explicit in Mises ([1949] 1996).
Taking a different approach, Klein (2008) and Nicolai J. Foss and Klein (2012) introduce the concept of judgment, derived from the work of Knight (1921). Judgment is defined as “decision making when the range of possible future outcomes, let alone the likelihood of individual outcomes, is generally unknown” (Klein 2008, 177). In other words, judgment refers to the choice among alternatives when both the full scope of alternatives and their probabilities are noncomputable. The entrepreneurial function, in this view, is to evaluate decision alternatives for bringing future goods and services into being and, if necessary, make risky investments in assets with the aim of profiting from those evaluations. This approach, although in a younger stage of development, has produced a significant literature of analysis and critique in both management and economics (see, e.g., Sarasvathy and Dew 2013; McCaffrey 2014, 2015; McMullen 2015; Foss and Klein 2015; Godley and Casson 2015; Hallberg 2015; and Foss, Klein, and Bjørnskov 2019).
However, while adequately addressing the evaluation and exploitation of potential opportunities for profit, judgment does not address the motivation for such judgments or the generation of decision alternatives any better than alertness (of objective circumstances) or creation (around purely subjective beliefs) do. The problem centers on an important flaw that is common among constructivist critiques of the opportunity concept: the idea that, since the actual existence of opportunity can never be revealed except where (successful) entrepreneurial action confirms its existence, opportunity itself must be entirely subjective, i.e., it exists only in the mind of the entrepreneur. Klein (2008) states this succinctly when he writes:
Expectations about the future are inherently subjective and, under conditions of uncertainty rather than risk, constitute judgments that are not themselves modelable….[o]pportunities for entrepreneurial gain [and] are, thus, inherently subjective—they do not exist until profits are realized. (180–81, emphasis mine)
Consistent with this line of reasoning, Foss and Klein (2012) propose the alternative judgment-based approach (JBA) focusing on beliefs, actions, and results. Employing this approach, they suggest that the notion of opportunity can only be understood as an ex post construct and that the ex ante correlate is entrepreneurial beliefs, which are translated into actions stemming
from 1) more or less articulated business plans ultimately based on knowledge and beliefs about current conditions and 2) estimates of future profits and losses that result from realizing the business plans. (Foss, Klein, and Bjørnskov 2019, 1204, emphasis mine)
The problem with this and similar characterizations of the subjective nature of opportunities is that they confuse the existence of latent preferences in the marketplace, preferences that can potentially be discovered by entrepreneurs who are motivated to find ways to profit from their own subjective beliefs about those preferences, and the revelation of those preferences, which occurs when entrepreneurs submit their ideas to the market tests that produce feedback about the correspondence of their beliefs to actual circumstances. Although it is true that entrepreneurial beliefs are purely subjective, the feedback entrepreneurs receive from market tests of their ideas is not; it is more correctly considered intersubjective (Sarasvathy and Venkataraman 2011; Venkataraman et al. 2012; Garud and Giullani 2013), because it contains information about the congruence (or lack thereof) between subjective beliefs on the part of the entrepreneur and subjective preferences expressed by market participants. Nicolai J. Foss, Peter G. Klein, and Christian Bjørnskov (2019) implicitly acknowledge the problem when they refer to plans that are “based on knowledge and beliefs about current conditions,” but fail to provide an explanation of how (or why) knowledge of current conditions shapes the motivations for and accuracy of those beliefs without methods of discovery.
Treating opportunities as purely subjective entities ignores the most important aspect of what Kirzner was trying to convey with his entrepreneurial arbitrageur, namely, the systematic search for and recognition of situations, whether temporally located in the present or in the future, where the characteristics of latent supply and demand (i.e., preferences) do not match objective price conditions. These situations are what we refer to as opportunities, and they are revealed when market tests show entrepreneurial beliefs about underlying preferences to be accurate and/or when they provide additional information necessary to adjust entrepreneurial actions to accurately reflect or influence those preferences.Lewin (2015) refers to these intersubjective characteristics of opportunity as shared understandings. Discovery is the process that reveals this information to the entrepreneur.
Another approach, mentioned above, that has recently flourished is the idea of opportunities as propensities (Ramoglou and Tsang 2016, 2017). This approach conceives of opportunities as objective constructs of latent demand or supply but outside the mind or consciousness of the entrepreneur, who “actualizes” them through attempts to match their beliefs about the profitability of future goods and services to data provided via market tests. Opportunities, in this view, are not directly observable but “can be evidenced through their effects,” as Stratos Ramoglou and Eric W. K. Tsang (2016, 412) explain. Their view comes closer to the opportunity discovery view proposed here in allowing for a realist construct for opportunity; in contrast to the constructionist views, they reject opportunity as only existing in the mind of the entrepreneur. However, Ramoglou and Tsang’s actualization approach also rejects a purely empiricist view of opportunity, which they refer to as discovery. Nonetheless, one can take this as a starting point for a reexamination of exactly what discovery and opportunity contribute to the emerging conversation on entrepreneurship.
The two lines of research examined above not only propose to represent the “middle ground” between the discovery and creation approaches described earlier, but also place themselves as correctives or reconstructions of the Kirznerian approach based in Mises and Hayek. Thus, further refinements in the Austrian view of entrepreneurship must take account of their critiques and incorporate their positive developments. We argue here that these critiques, although useful, have nonetheless erred in failing to distinguish between two aspects of subjective judgment that are important to understanding the motivations for and results of entrepreneurial action: the beliefs and aspirations of the entrepreneur and the preferences of the consumers whose wants they intend to fulfill with their business plans. For example, Foss, Klein, and Bjørnskov (2019, 1198) state: “We think that what is often meant when scholars (and practitioners) use the opportunity construct is that entrepreneurs hold certain beliefs concerning what they think they can do with their resources….But, it doesn’t seem natural to call such beliefs, plans or projects ‘opportunities.’” Likewise, Ramoglou and Tsang (2016, 416) reject the “inapt” term discovery as “linguistic malpractice” because it lures us into “inferring that opportunities must exist as actualized entities that can be somehow observed.”
The opportunity discovery approach does not deny that both beliefs and preferences are subjective phenomena—in fact, no “Austrian” view could reasonably do so. The question is not whether they are individually subjective, however, but whether the conditions under which they happen to dovetail are subjective. In other words, does the fact that entrepreneurial outcomes are based, in part, on how well entrepreneurs understand or anticipate actual future conditions mean anything for understanding their beliefs, actions, results? Discovery means that when successful entrepreneurs explore “business plans” and “actualize” those plans into profits there has been recognition of something meaningful about the real world. Therefore, can we not meaningfully describe what they have recognized as a phenomenon (an opportunity) that, in part, framed those plans and shaped the actions by which they succeeded?
Foss, Klein, and Bjørnskov’s (2019) JBA framework concedes that entrepreneurial business plans are ultimately based on knowledge and beliefs about current conditions, but it is unclear from where that knowledge (and the corresponding beliefs) about conditions comes from. As pointed out by Ramoglou and Tsang, “[d]espite the subjectivity of goals, the conditions of their satisfaction lie in the objective conditions of the world” (2016, 417). Using a commonsense definition of opportunity as a set of circumstances that make something (like a goal) possible, or “a favorable juncture of circumstances,”Merriam-Webster, s.v. “opportunity (n.),” accessed June 1, 2020, https://www. merriam-webster.com/dictionary/opportunity. one might argue that correct knowledge about favorable conditions comes from discovery of at least some of those conditions; to argue otherwise would seem to leave “luck” as the only explanation for successful (i.e., profitable) entrepreneurship. Indeed, examinations of the actual processes employed by expert entrepreneurs suggests that they spend a considerable amount of time and effort both uncovering and manipulating the conditions of opportunity via means of effectual reasoning (Sarasvathy 2001).
DISENTANGLING BELIEFS, ACTIONS, AND RESULTS: ENTREPRENEURSHIP AS PRICE DISCOVERY The term discovery is as apt a word as any to describe the process by which entrepreneurs seek to verify the existence of opportunities and fits with the commonsense notion of opportunity as something that exists, in part, due to knowledge of external realities. Along these lines, Jeffrey S. McMullen and Dean A. Shepherd (2006) make a useful distinction between two types of opportunities, third-person and first-person. A third-person opportunity refers to a “potential opportunity for someone in the marketplace” (ibid., 137); entrepreneurs identify these potential opportunities by being attentive, or exhibiting what Kirzner (1973, 1997) refers to as alertness. Third-person opportunities are reflections of both the preferences of the entrepreneur and those of potential stakeholders; they are the basis for actions that may create something more concrete, a first-person opportunity. First-person opportunities can only exist in correspondence with actions on the part of entrepreneurs; they do not, in fact, exist independently of those actions. Tests of validity against “objective reality” (Alvarez, Barney, and Young 2010, 30), therefore, amount to tests of whether first-person (actual) opportunities envisioned by entrepreneurs reflect an underlying reality expressed in their beliefs about third-person (potential) opportunities; equivalently, they are tests of whether preferences revealed by entrepreneurial actions correspond to entrepreneurial beliefs about the existence of those preferences.
Disentangling opportunities into their exogenous, third-person and endogenous, first-person components goes a long way in clarifying the role of opportunity in motivating entrepreneurial action. Third-person opportunities may exist independently of entrepreneurial actions; they can be missed or misperceived; they can be well exploited, imperfectly exploited, or go unexploited; they represent the commonsense notion of opportunity as a set of conditions favorable to action that is value enhancing (i.e., produces benefits in excess of opportunity cost) for some set of stakeholders. They can serve as motivation (incentives) for engaging in actions intended to reveal characteristics of latent supply and demand for goods and services that are not yet in existence. However, first-person opportunities are not revealed independently of entrepreneurial actions; they are contingent upon those actions. They exist only in the sense that actions show them to be valid when entrepreneurs submit their initial and subsequent perceptions of benefit and opportunity cost to market tests. This conforms to the notion of opportunities as conditions of value creation revealed via correct judgments of future preferences.
The third-person/first-person distinction, however, does not go far enough in many ways. It does not address the generation of decision alternatives, nor the tendency (or lack thereof) for those alternatives to match actual preferences. This discovery of intersubjective agreement between entrepreneurial beliefs and consumer preferences, and the subsequent replacement of less correct prices with more correct prices for both resources and goods, is the sine qua non of the Austrian approach to entrepreneurship and is what distinguishes the role of entrepreneurship in the Austrian tradition from its passive role in neoclassical economics and its uncertainty-enhancing role in post-Keynesian approaches (see, e.g., Dempster 1999). The discovery approach of Mises, Hayek, and Kirzner thus conceives of entrepreneurship as an essential error correction procedure within the market process.
Entrepreneurship researchers in management, even some of whom adhere to a constructivist view of entrepreneurship, have recognized the problem with thinking of opportunity in a purely subjective sense. Per Davidsson (2015), though skeptical of the usefulness of the opportunity construct, concedes that opportunity exists in recognizing that subjective perceptions of market disequilibrium (an objective phenomenon) motivate entrepreneurial actions and provide an explanation for their success. Matthew S. Wood and William McKinley (2018), in presenting a case for retaining the opportunity construct as an umbrella concept in entrepreneurship research, argue that the construct is necessary to help researchers distinguish means from ends, to account for feedback from market tests (preference revelation), to avoid ambiguity (between beliefs, judgments, and actions), and to link entrepreneurship to practice, where the notion of opportunities—both successfully exploited and missed—is part of the generally accepted norms of language in entrepreneurship. This discussion supports these conclusions and provides an additional rationale for retaining the opportunity construct, namely, that it correctly describes the situation of congruence between the judgment of decision alternatives and the characteristics of subjective preferences that determine the correctness of those judgments. In this view, opportunities are neither merely “out there,” existing independently of entrepreneurial beliefs and actions, nor are they purely subjective creations in the mind of the entrepreneur. Instead, they refer to conditions under which preference revelation indicates disequilibrium between actual prices of resources and goods and their intersubjective (shared) values.
In this article the concept of discovery is refined as the processing of information into knowledge (Foss, Klein, and Bjørnskov 2019, 1204) that allows entrepreneurs to replace less correct prices with more correct ones based on the revelation of unsatisfied preferences for new goods and services in new markets. In other words, discovery and opportunity coevolve as mutually reinforcing components of the entrepreneurial process. There can be no recognition of opportunity without successful discovery, just as there can be no revelation of opportunity without successful judgment. In this sense, the idea of discovery as the result of alertness to preexisting (objective) opportunities is merely being replaced with a more plausible idea of discovery as a corollary to the emergence of (intersubjective) opportunities. Unlike the former, this view allows not only for the possibility that opportunities are real things, with real properties that correspond to actual states of the world, but also for the possibility that discovery fails to identify an opportunity, either because the characteristics of the opportunity were different from what the entrepreneurs imagined (a missed opportunity) or because there was never an opportunity in the first place (a nonopportunity).On the concept of nonopportunity, see, e.g., Ramoglou and Tsang (2016, 420–21).
The preceding discussion, therefore, highlights four important aspects of opportunity discovery for the study of entrepreneurship: (1) motivations for entrepreneurial actions, (2) generation of decision alternatives, (3) convergence of subjective beliefs and subjective preferences, and (4) welfare impacts of variability in entrepreneurial strategies. We address these aspects by employing a simple model of the entrepreneurial process. The model abstracts from admittedly important elements in the process. Nonetheless, it provides a useful framework for understanding the important differences between subjective and intersubjective phenomena, and the corresponding differences between discovery and judgment that are important for delimiting the role of the opportunity construct. Figure 1 below illustrates the model.
Figure 1. The Entrepreneurial Discovery Process
The entrepreneurial process begins with the subjective phenomena that make up the material for value judgments: the subjective preferences of individuals in the marketplace with respect to benefit and cost, and the beliefs of individuals that might profit from an understanding of those preferences, i.e., potential entrepreneurs. These entrepreneurial beliefs consist of evaluations of what others’ preferences are, what kinds of ventures and strategies might be profitably employed to satisfy those preferences, and what benefits and costs might be earned and incurred as the result of actions to implement such ventures and strategies. Importantly, these beliefs may vary widely in their accuracy concerning any of these things; potential entrepreneurs begin with only an imperfect understanding of preferences, strategies, and consequences. Nonetheless, if entrepreneurial beliefs suggest a value-creating allocation of future resources that differs from the current allocation that might earn an economic profit, the potential entrepreneur may be motivated to engage in a Hayekian discovery procedure, whereby they gather information to validate, modify, or falsify their own beliefs.
It is here that the conceptualization presented in this article differs from the standard Kirznerian view of opportunity discovery. At this point, the most that can be said of the potential entrepreneur is that they possess beliefs and motivation. However, an effectual (Sarasvathy 2001) process of discovery can reveal possibilities of convergence between entrepreneurial beliefs and the subjective preferences of individuals that represent decision alternatives. Among these decision alternatives may be opportunities for profitable actions. The process itself is collaborative, requiring that the entrepreneur interact with the market environment (and the individuals in it), identify and recruit important stakeholders, and learn from both direct and indirect experience to discover whether and how intersubjective convergence of personal beliefs and the realities of preferences might be achieved. If such an intersubjective convergence takes place—itself an uncertain proposition—an opportunity can be said to exist. Thus, opportunities arise as possibilities for profitable action among decision alternatives. Table 1 below illustrates this result.
Table 1. Outcomes of the Discovery Process
As indicated in the table, there are basically four possible outcomes of the entrepreneurial discovery process. One possibility is that the entrepreneur discovers that consumer preferences with respect to the area of investigation are in line with the opportunity costs of resources. In other words, there is no “third-person” opportunity to explore. This is what would most correctly be termed a nonopportunity; it refers to the situation where gains from entrepreneurial action are not expected under correct assumptions about the reality of the external environment, including both actual and latent preferences. A second possibility is that the entrepreneur believes an opportunity exists when it, in fact, does not. This would be an example of mistaken judgment on the part of the entrepreneur. A third possibility is that an opportunity for realignment of preferences with prices is possible but that discovery fails to reveal this to the entrepreneur. This is, quite simply, a missed opportunity. Finally, there is the case where entrepreneurial discovery correctly notices and diagnoses a possibility for realignment; this is where intersubjective convergence of entrepreneurial beliefs and consumer preferences results in a valid opportunity for action. Although this does not guarantee a successful venture—entrepreneurial judgment may still fail to implement the appropriate strategies for successful exploitation—it is nonetheless a precondition for successful judgment. No amount of expert judgment can overcome a lack of intersubjective convergence between consumer preferences and entrepreneurial beliefs.Put differently, if judgment is the ability to “accurately assess, estimate, or infer others’ preferences” (McMullen 2015, 654), then discovery of intersubjective convergence (i.e., opportunity) is a necessary prerequisite for a correct judgment that results in a profitable investment; otherwise, correct judgment will result in no investment action at all.
In this view, there is no reason to assume that either (a) opportunity (convergence) always results from the discovery process or (b) entrepreneurs engaging in discovery always recognize and/or exploit the opportunities that emerge. Opportunities are uncertain; they can fail to emerge, they can emerge and be missed, or they can emerge, be recognized, and still fail to be taken advantage of with the correct entrepreneurial judgments and investments. Thus, Foss and Klein’s (2012) judgment-based approach is not entirely at odds with the view expressed here. Rather, it is more correct to say that the process by which an opportunity is discovered is operationally distinct from the process by which judgments are made. Correct (successful) judgment requires correct (successful) discovery, but discovery itself does not ensure correct judgment. Foss and Klein are correct to emphasize a previously underexplored aspect of the entrepreneurial process but are incorrect in suggesting that discovery is unimportant. The framework presented here incorporates elements of both and may thus be expressed as a discovery-judgment view (DJV). This view of opportunity discovery fits well within the parameters of evolutionary reasoning as well as with notions of pattern recognition emphasized by Baron (2004, 2006). Most importantly, it makes a useful distinction between the information-gathering (discovery) and decision-making (judgment) elements of the entrepreneurial process.
APPLICATIONS OF THE DISCOVERY-JUDGMENT VIEW TO ENTREPRENEURIAL STRATEGY AND POLICY Our view suggests that the motivation for entrepreneurial actions is the possibility of intersubjective convergence between beliefs and preferences in a future goods space. Thus, it indicates a distinction between the conditions of opportunity and the strategies for recognizing and exploiting them. This is at the heart of Mises’s ([1949] 1996, 214) distinction between the capitalist-entrepreneur—the uncertainty-bearing aspect of entrepreneurship emphasized in Knight (1921) and in the JBA framework—and the entrepreneur promoter, who speculates on behalf of the capitalists. This entrepreneur not only speculates about future conditions that may bring about profits, as a pure capitalist might, but also formulates specific plans (strategies) to adjust production to the expected future conditions. Entrepreneurs are more than just risk takers; they are the actors who imagine, explore, and validate decision alternatives regarding future resource allocations.
Strictly speaking, economics does not suggest that consumers want goods and services, per se; what they desire—and are willing to sacrifice for—are the “features” of goods and services. Features are what make up consumer preferences, not goods and services, because it is the advancement of subjective ends like happiness, health, comfort, prestige, contentment, joy, status, power, etc. that individuals are trying to satisfy when they sacrifice resources to obtain goods and services (see, e.g., Gorman 1959, 1980; Lancaster 1966, 1971; and Becker 1965, 1981, 2007). Therefore, the “discovery” aspects of entrepreneurship does not mean discovery of individuals’ demand for iPhones or ride sharing services, but the discovery of preferences that suggest something like an iPhone or a ride sharing service might be demanded at a price above opportunity cost. In other words, discovery does not require that a fully formed idea of a product or service be in the mind of either the entrepreneur or the consumer, only that the entrepreneur be able to gather and process information about consumer preferences and relate it to their own ideas about the use of resources and their opportunity costs. It does not require a demand for any particular thing.In fact, this must be precisely what Ramoglou and Tsang mean by “propensities,” because they are the “seeds” from which a fully formed demand must eventually emerge. Before introducing products like iPhones or ride sharing services into the marketplace, entrepreneurs examine evidence of consumer preference for features of these goods (like the convenience of ride sharing, internet connectivity, or any of the other characteristics that make them desirable), what consumers might be willing to sacrifice for them, and the opportunity costs of including them in the bundle of features that define the good or service. This is what we mean by discovery.
A useful analogy is that of entrepreneurial strategy as an options-producing (or options-writing) process. In finance theory, option writers obligate themselves to future courses of action without the certainty of knowing that those courses of action will turn out to be profitable; they provide options for others to submit as tests of those expectations. The writer obligates himself or herself to a course of action that depends on the subsequent decision of the purchaser of the option to exercise it or not. If conditions turn out to be favorable for exercise, the option writer stands as the counterparty (buyer for the option to sell, seller for the option to buy) to the option holder; if not, the option expires unexercised along with the obligation of the writer. Option writers seek to benefit from future market conditions by receiving more in profit from the sale of options than they incur in costs of obligations.One of the most well-known models of options pricing, the Black-Scholes option pricing model, estimates this value (premium) as a function of five simple features: the price of exercise, the spot price of the underlying asset(s), the expected volatility of the underlying asset price(s), time until exercise, and the risk-free rate of return. One can define entrepreneurial strategy as the options-writing process applied to the creation of new paths of future resource allocation, i.e., the writing of real, as opposed to financial, options. It is, to paraphrase Jean-Baptiste Say, the application of knowledge to a potentially useful purpose (Hebert and Link 1982, 31), and the process that produces this knowledge and its application is the work of entrepreneurial discovery, both within and without existing firms.
The options-writing perspective has implications for our understanding of entrepreneurial strategy. First, the entrepreneurial function can be thought of as encompassing two very different roles, often fulfilled by different actors. The writers of real options comprise the actors who engage in a systematic process designed to explore third-person potential opportunities and examine the first-person characteristics of those opportunities by submitting them to market tests. These are Mises’s ([1949] 1996) entrepreneur promoters; they are what we traditionally think of as the Schumpeterian entrepreneur who searches for new means-ends frameworks, or a new “production function” (Schumpeter 1934). The entrepreneur promoter must also be able to “engineer agreement among all interested parties, such as the inventor of the process, the partner, the capitalist, the supplier of parts and services, the distributor, etc.” (Hirschman 1958, 17).This description suggests a strong affinity with the stakeholder approach of Parmar et al. (2010) and others.
Mises ([1949] 1996) also refers, however, to the risk-taking and judgmental aspects of entrepreneurship fulfilled by those who choose from among various options to bring first-person ventures into existence via funding and expertise. These capitalist-entrepreneurs are the ones who are responsible for making the crucial decisions that direct resources toward specific ventures—and, by extension, not toward others. This aspect of the entrepreneurial process refers to the outcome of trial-and-error market tests intended to evaluate third-person opportunities for first-person significance, as well as the associated asset-specific investments necessary to materialize the chosen options. David A. Harper (1996, 34) refers to this part of the process as the “internal architecture of a business enterprise [that] affects the acceptance and rejection of entrepreneurial hypotheses and enterprising activity.” Just as financial options purchasers give actual existence to an options contract by agreeing to include it their portfolios, capitalist-entrepreneurs attempt to actualize opportunities by expending resources (financial, intellectual, and social capital) to bring them to fruition.This underscores the importance of a well-functioning financial system directing resources and expertise to the most valuable ventures (Dempster 2015).
Notice that in the analogy of the options process to the entrepreneurial process, the entrepreneur promoter takes the role of the options writer, while the capitalist-entrepreneur takes the role of the option purchaser. Mises ([1949] 1996, 215) realized that these two roles are often entangled because we use one term, entrepreneur, to express both aspects of the entrepreneurial process. Therefore, the tension between Schumpeterian innovation and Kirznerian price discovery is the result of linguistic confusion over what aspect of the entrepreneurial process is being emphasized. This paper has argued that the tension between creation and discovery is, in part, the result of this same confusion. The very term entrepreneur is an umbrella concept that describes several functions of innovation, promotion, and risk taking (Hebert and Link 1982) that evolve within the same process.
Further, it is not necessary that the entrepreneurial roles implied by the options analogy refer to distinct parties. Entrepreneur promoters, unlike financial option writers, typically devise and arrange contracts that allow them to direct resources contingently toward the developing ends and to share in the upside potential of the future resource allocation paths they identify.An exception would be those who search for opportunities with the intent of selling them to others. Likewise, unlike financial option holders, capitalist-entrepreneurs often take an active role in the development of the market tests that identify potential opportunities. This view of the dual nature of entrepreneurial strategy—the direction of attention and decision alternative generation by entrepreneur promoters, and the direction of resources and risk taking by capitalist-entrepreneurs—allows us to build a conceptual bridge between the subjective, speculative nature of entrepreneurial search and the objective, concrete nature of entrepreneurial action. It is, thus, a description of Sarasvathy and Venkataraman’s (2011, 125–27) notion of intersubjectivity as the concept that links the identification of market problems with their solutions via a coherent, directed process of knowledge integration and informational synthesis.
The view presented in this article also provides a more stable framework for exploring and understanding the public policy implications of variability in the institutional contexts of entrepreneurial action. Baumol (1990) and subsequent work (see, e.g., Acemoglu, Johnson, and Robinson 2001; Boettke and Coyne 2009; Sobel, Clark, and Lee 2007; Sobel 2008; and Dempster and Isaacs 2017) emphasize the importance of institutions for determining the social welfare consequences of entrepreneurial action. In short, institutions incentivize differences in entrepreneurial strategies that may be either welfare enhancing or welfare reducing from a societal standpoint. Entrepreneurs choose strategies for exploiting perceived opportunities based on their estimates of private benefit and cost, which may or may not reflect social benefit-cost ratios. Thus, it is possible that entrepreneurial discovery could result in decision alternatives that anticipate private net benefits while also resulting in net social welfare losses. Simple examples include perceived opportunities exploited via corruption, political reallocation of resources, or the establishment of monopolistic barriers to entry. In maintaining the central position of opportunity in the analysis of entrepreneurial action, the view presented here provides a framework for examining variability in the social welfare impacts of alternative decision strategies that other approaches which have jettisoned the theory of opportunity discovery will tend to obscure.
CONCLUSIONS The concept of entrepreneurial opportunity has undergone a period of useful critique and refinement since Venkataraman (1997) and Shane and Venkataraman (2000) first employed the term as one of the defining features of entrepreneurship studies. This article has incorporated much of the research in this area over the past two decades to formulate a novel Austrian reinterpretation of this concept as an intersubjective phenomenon that emerges from the entrepreneurial process of discovery and judgment. This view recognizes the inherent problems with the traditional Kirznerian portrayal of discovery as a matter of alertness or attentiveness to preexisting conditions and instead conceives of entrepreneurship as a price discovery procedure for the emergence of future goods, services, and resources within an evolutionary realist framework. In this framework, entrepreneurial motivations and actions are reflections of the expectation of actual, but yet-to-be-revealed, conditions here described as opportunities, and the process by which these expectations are formed and validated is described as discovery. Discovery is, thus, distinct from judgment, as it describes the process that allows judgment to be exercised, i.e., it is an antecedent to judgment. This view retains the importance of the anticipation of intersubjective agreement between entrepreneurial beliefs and consumer preferences as the sine qua non of the Austrian view of entrepreneurship while jettisoning problematic descriptions of opportunity discovery as the result of superior attentiveness to the preexisting conditions of supply and demand.
Abstract: Entrepreneur-promoters, or the pioneers of economic improvement, provide an essential market function which economics cannot do without. Yet Ludwig von Mises maintains that this function lies beyond what can be defined with praxeological rigor. This paper attempts to find a praxeological subcategory of entrepreneurship that conforms with Mises’s indeterminate references to the entrepreneur-promoter in Human Action. Rather than relying on the evenly rotating economy, which is commonly used for analyzing entrepreneurship, the imaginary construction of a specialization deadlock is employed, adapted from Per Bylund’s Problem of Production. This construction allows for the derivation of a praxeological subcategory of entrepreneurship, distinct from the general function of uncertainty bearing, which suggests a theoretical explanation for what constitutes the driving force of the market process.
JEL Classification: L11, L26, O12 Per L. Bylund (per.bylund@okstate.edu) is assistant professor of entrepreneurship and Records-Johnston Professor of Free Enterprise in the School of Entrepreneurship in the Spears School of Business at Oklahoma State University. He is also a fellow of the Mises Institute and an associate fellow of the Ratio Institute in Stockholm.
The author has benefited from thoughtful comments on previous versions of this paper by Porter Burkett, Fernando D’Andrea, Sinclair Davidson, Hunter Hastings, and Mark Packard. He has also benefited from feedback from two anonymous reviewers. All remaining errors are the author’s.
Austrian economics has found a resurgence through the increased attention to entrepreneurship in policy and research (Klein and Bylund 2014). This should not be surprising. Although mainstream economic theory has long been uninterested in the topic (Baumol 1968; Hébert and Link 1988), entrepreneurship is core to the Austrian understanding of the market as a process (Kirzner 1992, 1997). Indeed, the school’s founder himself discussed entrepreneurship in his groundbreaking magnum opus (see Menger [1871] 2007, 160–61). But it was not until much later that Austrians developed a theory of the entrepreneur, with Israel M. Kirzner’s theory (1973, 1979, 2009) being the most widely known. Kirzner (1973, 84–87) builds explicitly on Ludwig von Mises’s ([1949] 1998, 254, 255) praxeological definition of the entrepreneurial function (contra Menger) as “acting man exclusively seen from the aspect of the uncertainty inherent in every action,” that is, “in regard to the changes occurring in the data of the market.” Mises also famously observed that entrepreneurship, due to its uncertainty-bearing and therefore speculative nature, is the “driving force of the whole market system” (Mises [1949] 1998, 249). It is Mises’s definition of entrepreneurship and its limitations that is of interest to us here.
Mises substantiates the conception of the entrepreneur as bearer of uncertainty using the imaginary construction of the evenly rotating economy (ERE), a fictional economy “characterized by the elimination of change in the data and of the time element” (Mises [1949] 1998, 247). The ERE thus encompasses all the elements of the real economy, including production, exchange, market prices, and so on, but without the uncertainty of change. Consequently, Mises ([1949] 1998, 247) notes, “The system [ERE] is in perpetual flux, but it remains always at the same spot. It revolves evenly round a fixed center, it rotates evenly.” In this unchanging world of the ERE, therefore, there is no uncertainty and, consequently, “there is no room left for entrepreneurial activity” (Mises [1949] 1998, 247).
What is curious is that Mises at the same time affords the entrepreneur-promoter,I will henceforth, following Mises, refer to this function simply as “promoter.” a subcategory of entrepreneurship that “cannot be defined with praxeological rigor” (Mises [1949] 1998, 256), a premier role for understanding the market process. In fact, the promoter embodies, as it were, the incessant change in the market: “One enters the ranks of the promoters by aggressively pushing forward and thus submitting to the trial to which the market subjects [everybody]” (Mises [1949] 1998, 309). The market process, in other words, progresses primarily through the actions of promoters, who push forward and thereby challenge the status quo. For this reason, “economics cannot do without the promoter concept” (Mises [1949] 1998, 256). However, Mises maintains, the promoter nevertheless lies beyond what economic theory can explain.
This article will show, first, that the importance of the promoter is that Mises saw in this role the actual driving force of the market: the cause of the progression of the market process and the economy’s development. Rather than entrepreneurship in general, the uncertainty-bearing aspect of any action, it is the promoter’s speculative undertaking of novel production processes and new ways of doing business that create the specific future market conditions under which all types of entrepreneurs can earn profits (or suffer losses).
Second, an economic (praxeological) definition of this category that largely conforms with Mises’s indeterminate references to the promoter in Human Action ([1949] 1998) will be suggested. To distinguish promoters from nonpromoters, the imaginary construction of the specialization deadlock adapted from Per Bylund (2016) will be used. It has previously been used to determine the economic function of the firm as a means for implementing novel production structures beyond the extent of the market (Bylund 2011, 2015a, 2015b, 2016) but can be applied more broadly. The specialization deadlock can be understood generally as an adaptation of Mises’s ERE where the assumptions have been significantly relaxed. Thereby, and due to the model’s focus on the evolution of the market’s production structure, it is a useful means for distinguishing between and explaining the driving force of production. In other words, the specialization deadlock can be applied to distinguish between categories of entrepreneurship, i.e., the types of productive progress taking place side by side in the market process, and it can identify their respective causes. Specifically, it is argued that the role of the promoter as pioneer of economic improvement can be defined praxeologically, by way of Bylund’s (2016) model, as that entrepreneurial function which breaks the specialization deadlock and thus acts in pricelessness.
In what follows, it will first be substantiated that Mises saw in the promoter specifically, and not entrepreneurship more broadly, the driving force of the market. The ERE will then be used as a contrast to explain the workings of the specialization deadlock and how their respective assumptions differ. Thereafter, an economic definition of the promoter will be presented and then used to shed light on Mises’s varied treatment of the market’s driving force in Human Action. Finally, the praxeological definition of the promoter will be related to the entrepreneurship theories of Kirzner (1973) and Joseph A. Schumpeter ([1911] 1934).
Throughout this discussion, both Mises’s nontheoretical notion and the praxeological category derived here will be referred to as “promoter.” All references to apparent actors (entrepreneurs, promoters, etc.) are to their economic functions unless stated otherwise.
THE PROMOTER AS DRIVING FORCE Mises holds that uncertainty “means acting man in regard to the changes occurring in the data of the market” (Mises [1949] 1998, 255). These data do not comprise only consumers’ preferences, which do change unpredictably, but their preferences relative to the totality of the goods offerings by entrepreneurs (the structure of supply). The entrepreneur, therefore, bears uncertainty by speculating about the unknown future market conditions: the entire situation in which the entrepreneur’s good will be offered for sale. As the market data for this future situation do not yet exist and behaviors of both producers and consumers are unpredictable, there is (and can be) no reliable knowledge in the present on which to base entrepreneurial decisions.
Uncertainty is different from imperfect knowledge, which is a problem that can be overcome at a cost. For example, a producer’s lack of technological know-how can be remedied before or during production and is ultimately a calculated tradeoff between the cost of acquiring information and that of an estimated risk of problems in production. Although economic actors are affected by both imperfect knowledge and uncertainty, and it may often be difficult to distinguish between them in reality, the concepts are theoretically distinct and require separate analyses (Townsend et al. 2018). It is specifically due to the function of uncertainty bearing that “the entrepreneur earns profit or suffers loss” (Mises [1949] 1998, 255):
the specific entrepreneurial profits and losses are not produced by the quantity of physical output. They depend on the adjustment of output to the most urgent wants of the consumers. What produces them is the extent to which the entrepreneur has succeeded or failed in anticipating the future—necessarily uncertain—state of the market. (Mises [1949] 1998, 290)
Entrepreneurs, who as uncertainty bearers are always speculators, are responsible for all adjustments of production in the economy. But such adjustments can be of different magnitudes, and Mises distinguishes between the “great adjustments,” for which mainly the promoter is responsible, and the “many small adjustments [that] may seem trifling and of little bearing upon [production],” for which he is not:
Adjustment of production to the best possible supplying of the consumers with the goods they are asking for most urgently does not merely consist in determining the general plan for the utilization of resources. There is, of course, no doubt that this is the main function of the promoter and speculator. But besides the great adjustments, many small adjustments are necessary too. Each of them may seem trifling and of little bearing upon the total result. But the cumulative effect of shortcomings in many of these minor matters can be such as to frustrate entirely the success of a correct solution of the great problems. At any rate, it is certain that every failure to handle the smaller problems results in a squandering of scarce factors of production and consequently in impairing the best possible satisfaction of the consumers. (Mises [1949] 1998, 300)
Having earlier noted that the promoter cannot be defined praxeologically, Mises ([1949] 1998, 300–07) focuses on distinguishing entrepreneurship, which can be defined, from nonentrepreneurial functions that also can. The latter, he argues, do not bear the uncertainty of the undertaking, but act on behalf of the entrepreneur. So “[t]he entrepreneur hires the technicians, i.e., people who have the ability and the skill to perform definite kinds and quantities of work” (Mises [1949] 1998, 300). The entrepreneur also typically appoints “[a] manager [who] is a junior partner of the entrepreneur, as it were, no matter what the contractual and financial terms of his employment are” (Mises [1949] 1998, 301).
Of interest to us here, however, is the distinction Mises makes between “regular” (nonpromoter) entrepreneurs and promoters. Mises is uncharacteristically imprecise, but this should be expected: having already asserted that promoters cannot be theoretically distinguished from nonpromoters, there is no basis for precision and no means to address the boundary conditions of the subcategories. We should not expect Mises (or anybody else) to use very precise language with respect to an undefined concept, because to do so is impossible. Mises is nevertheless clear that the “main function” of the promoter, which gets to his specific role, is to bring about “[a]djustment of production to the best possible supplying of the consumers with the goods they are asking for most urgently” and that it “does not merely consist in determining the general plan for the utilization of resources” (Mises [1949] 1998, 300; emphasis added). Indeed, as Joseph T. Salerno (2008, 195) summarizes, it is the promoter entrepreneur’s role to have “the will and ability to assume leadership in the social division of labor by pushing or promoting oneself into a position of organizing and directing the factors of production.” What characterizes the nonpromoter entrepreneurs, then, is that they are uncertainty bearers who are not making those great adjustments and thus not assuming such leadership—they instead focus on the “many small adjustments,” which, at least individually, appear to have little effect on the organizing of market production overall. Nonpromoters also, although only in aggregate, “[determine] the general plan for the utilization of resources” in the economy.
This suggests that the nonpromoter entrepreneur has a primarily allocative role with respect to productive factors, the shifting of productive efforts from one line of production to another so that output better meets consumers wants. The promoter, in contrast, adjusts production beyond simply “determining the general plan for the utilization of resources” by instead “assum[ing] leadership in the social division of labor.” Consequently, the promoter causes change to the structure of production. Following this reasoning, then, it can be posited that nonpromoters typically bear the uncertainty of the common, but not pioneering or disruptive, business enterprise. To use a common dichotomy in the entrepreneurship literature, nonpromoters would be more akin to imitator entrepreneurs, who may start new businesses but ones without structural implications, than they would be to disruptive innovators, who revolutionize production. Although nonpromoters provide a valuable (if not essential) function, their role is predominantly allocative, and they make adjustments within the existing structure of production rather than change it. They thus earn the profits of running the business, and also suffer the losses, and respond to changes in demand. Their actions cause continuous adjustments to the market’s overall allocation of productive resources between lines of production.
Although this is illustrative of the main dividing line, it does little to provide a scientific definition of the role of the nonpromoter entrepreneur—those entrepreneurs who are not promoters and thus do not go beyond the “many small adjustments” and thereby do not determine the “general plan” of production. Nonpromoter entrepreneurs do, however, determine resource utilization, and this suggests that their function is primarily allocative (rather than disruptive). Promoters, in contrast, are “especially eager to profit from adjusting production to the expected changes in conditions, those who have more initiative, more venturesomeness, and a quicker eye than the crowd, the pushing and promoting pioneers of economic improvement” (Mises [1949] 1998, 255). The promoter is different from the nonpromoter in degree but not in kind:
The mentality of the promoters, speculators, and entrepreneurs is not different from that of their fellow men. They are merely superior to the masses in mental power and energy. They are the leaders on the way toward material progress. They are the first to understand that there is a discrepancy between what is done and what could be done. They guess what the consumers would like to have and are intent upon providing them with these things. (Mises [1949] 1998, 333)
As they focus on “guess[ing] what the consumers would like to have” (but are not offered) and adjusting production toward that end, promoters’ impact on the economy is much greater than nonpromoters’. By being responsible for the major shifts in production, as opposed to the allocation and utilization of resources, the promoters exercise greater influence on the direction in which the market’s overall production apparatus progresses (Bylund 2015b, 2016). Consequently, promoters, as the “pushing and promoting pioneers” and “leaders on the way toward material progress,” epitomize the driving force of structural change in the market. Mises agrees:
The driving force of the market, the element tending toward unceasing innovation and improvement, is provided by the restlessness of the promoter and his eagerness to make profits as large as possible. (Mises [1949] 1998, 256)
And similarly:
The driving force of the market process is provided neither by the consumers nor by the owners of the means of production—land, capital goods, and labor—but by the promoting and speculating entrepreneurs. (Mises [1949] 1998, 325)
The promoter is the real driving force of the economy, the disruptor of the status quo who leads the way toward greater productivity and value creation by “guess[ing] what the consumers would like to have” and “pushing and promoting” the structure of production in this direction.
Considering the importance of this role in the unfolding of the market process, it is important to theoretically be able to distinguish the promoters from those entrepreneurs who do not constitute this “driving force.” Yet as has been seen, Mises finds no basis for a theoretically rigorous distinction. The difference between promoters and nonpromoters, per Mises, exists only in the relative magnitudes: promoters’ attempted and achieved adjustments to production are “great” (not “small” or “trifling”) and they are “leaders on the way toward material progress” (as opposed to followers or imitators). Based on this observation, Mises properly concludes that the distinction lies beyond what can be determined with praxeological rigor.
However, as shall be seen, this is an unwarranted conclusion that follows from a misapplication of the imaginary construction used. Mises’s conclusion, I argue, is based on specific limitations of the ERE, not of praxeology per se. In fact, the ERE’s assumptions are appropriate for distinguishing the function of entrepreneurship from other functions, but it thereby disallows distinguishing different types within this function.
FROM THE EVENLY ROTATING ECONOMY TO THE SPECIALIZATION DEADLOCK Mises astutely notes that “[t]he use of imaginary constructions to which nothing corresponds in reality is an indispensable tool of thinking” (Mises [1949] 1998, 202). These constructions, including the ERE, are indispensable because they allow for rational analysis of complex processes, delineation of causal relationships, and examination of interactions that may not exist independently and cannot be observed in complex real-world situations. Their power for developing our understanding of and interpreting the economy is practically irrefutable.
However, as Mises also notes, “one of the most important problems of science is to avoid the fallacies which ill-considered employment of such constructions can entail” (Mises [1949] 1998, 202–03). The misapplication of imaginary constructions can cause “serious blunders.”
Using the ERE to distinguish between types of entrepreneurship would be such a serious blunder, because the ERE is formulated to eliminate uncertainty, by excluding change, and thereby separate uncertainty bearing from other functions in the market. As Mises ([1949] 1998, 249) summarized it, “In order to grasp the function of entrepreneurship and the meaning of profit and loss, we construct a system from which they are absent.” The ERE is indeed appropriate for this particular end, but this also makes it unsuitable for the purpose of distinguishing between types of uncertainty bearing. It relies on assumptions that all but exclude those adjustments to the production structure that are the main function of the promoter, and thus it cannot assist in distinguishing promoters from nonpromoters.Mises cannot be blamed for making such an error (because he did not), but he appears to have overlooked the possibility of creating and employing other imaginary constructions to analyze entrepreneurship subcategories.
The Evenly Rotating Economy
The ERE creates a fictional economy in which all causes of change in the market data have been theoretically removed. As these data are constants rather than variables there is no uncertainty about the future (it will be just like the present), which means that there are also no opportunities for entrepreneurs: adjustments to the production apparatus or resource allocations could not better satisfy consumers than the status quo. The economy that emerges is thus necessarily entrepreneurless. Mises explains:
In the frame of this imaginary construction no change occurs; there prevails an unvarying course of all affairs. In the evenly rotating economy consequently nothing is altered in the allocation of goods for the satisfaction of wants in nearer and in remoter periods of the future. No one plans any change because—according to our assumptions—the prevailing allocation best serves him and because he does not believe that any possible rearrangement could improve his condition. No one wants to increase his consumption in a nearer period of the future at the expense of his consumption in a more distant period or vice versa because the existing mode of allocation pleases him better than any other thinkable and feasible mode. (Mises [1949] 1998, 482)
Murray N. Rothbard elaborates on the difference between the ERE and the real economy and adds specificity to what the ERE entails and its rationale:
the real world of action is one of continual change. Individual value scales, technological ideas, and the quantities of means available are always changing. These changes continually impel the economy in various directions. Value scales change, and consumer demand shifts from one good to another. Technological ideas change, and factors are used in different ways. Both types of change have differing effects on prices. Time preferences change, with certain effects on interest and capital formation. The crucial point is this: before the effects of any one change are completely worked out, other changes intervene. What we must consider, however, by the use of reasoning, is what would happen if no changes intervened. In other words, what would occur if value scales, technological ideas, and the given resources remained constant? (Rothbard [1962, 1970] 2004, 321)
The ERE, per Rothbard, holds four types of changes constant: consumers’ value scales, technological ideas used in production, available supply of resources, and individuals’ time preferences. If we were to theoretically fix those four variables in the present economy, an evenly rotating economy would emerge after a period of transition. During this transition stage, actors (as both producers and consumers) find their maximizing behavior through value-seeking trial and error. As the data of the market do not change, the actions that maximize each actor’s satisfaction remain constant and are thus attainable. As actors try to find their max, this process eventually brings about a state of affairs in which each individual will no longer choose to adjust their behavior but will repeat those actions that they have learned maximize their satisfaction. This final stage is not without production, consumption, and so on but is unaffected by the aforementioned types of changes so there is no uncertainty—the economy is “evenly rotating.”
The specific assumptions of this imaginary construction allow the theorist to analyze the impact of individual variables, jumbled and indistinguishable in the constant flux of the empirical world, by introducing specific changes and then reasoning through the implications. For example, by theoretically changing the rate of time preference in the ERE, the theorist can logically reason through how actors’ behaviors change and can therefore analyze the effect on the time structure of production of a change in time preference alone. Similarly, one can change or relax other ERE assumptions and thereby analyze the impact of specific changes in value scales, technological ideas, etc.
The limitation of the ERE’s usefulness is evident from its assumptions: the ERE can be used to analyze specific changes and responses to them, because all other changes have been theoretically eliminated. Although each of the changes assumed constant can be relaxed, the ERE can only be used to analyze uncertainty bearing per se with respect to those particular variables (value scales, technology, etc.). But entrepreneurship cannot be decomposed using the ERE, as the former is defined as those speculative undertakings “exclusively seen from the aspect of the uncertainty inherent in every action” and thus “in regard to the changes occurring in the data of the market” (Mises [1949] 1998, 254, 255). Outcome magnitudes, such as Mises’s distinction between great and small adjustments, or types of actions, such as the distinction between directing production and allocating resources, remain out of reach when using the ERE. But this does not mean that all imaginary constructions must fail at this task. This article argues that the specialization deadlock is suitable for determining the function of the promoter.
The Specialization Deadlock
Bylund (2016) formulates a praxeological explanation for the economic function of the business firm. In order to do so, he adopts Mises’s ([1949] 1998, 238–39) imaginary construction of the pure market economy, unhampered by political restrictions but without any form of organizations or coordinated production structures that can be interpreted as firms. The assumption underlying this model is that coordination can only take place through the price mechanism, which is commonly recognized as the alternative to intrafirm organization (cf. Coase 1937). Then, applying the Misesian fact that “[s]ociety is concerted action, cooperation” that arises due to the fact “that work performed under the division of labor is more productive than isolated work and that man’s reason is capable of recognizing this truth” (Mises [1949] 1998, 143, 144), Bylund analyzes the dynamics of productive adjustments (in other words, entrepreneurship) in the price-coordinated market. The aim is to analytically uncover the processes by which an unhampered economy adopts, improves, and implements more intensive specialization under the division of labor. In other words, to answer the question of economic development: how a market progresses through ever more intensive specializing to achieve greater productivity and thereby attains higher standards of living.
Bylund (2016) finds that this decentralized, price-coordinated market hits a development ceilingThis ceiling is contingent on population density, as discussed by Durkheim ([1892] 1933), and is thus a moving target. Yet it constitutes an effective conclusion, or at any rate a dramatic slowdown, of the market’s progression. beyond which autonomous actors are unable to adopt more intensive specialization. To progress beyond this limitation, and thus achieve greater specialization intensity, requires advanced splitting of production tasks—typically the introduction of new production processes to replace existing tasks—and thus coordination beyond what the price mechanism can provide (Bylund 2011, 2015a). Any such action would take place in pricelessness, beyond the realm of economic calculation through market prices, because there is no existing market for novelty. This type of entrepreneurial undertaking goes well beyond the simple arbitrage of, e.g., Kirzner’s (1973) entrepreneur, which requires no additional coordination, and it is also beyond the firm as theorized by, e.g., Ronald H. Coase (1937), which is practically a mirror image of market production (Bylund 2015c, forthcoming). To establish a new production process requires imagination, financing, and coordination as well as leadership (Witt 1998), and it can often also include experimentation and development of new capital.
Compared to the ERE, Bylund’s imaginary construction, called the specialization deadlockFor details, see Bylund (2016, 60–65). (referring to the ceiling), allows change in all four types of market data that the ERE holds constant. Uncertainty is therefore present in the specialization deadlock construction, and consequently it includes entrepreneurship. However, the focus on specialization introduces a new distinction that decomposes technological ideas (which guide and limit the scope of production undertakings) into those that (1) can be implemented through decentralized means (through price mechanism coordination) and those that (2) require centralized (nonprice) coordination of the implementation process in order to bring about the imagined production structure.
The former type includes specialization by the individual actor or that can be attained through coordination with others using simple exchange or market contracts. These are the types of divisions of labor that Adam Smith famously discusses in The Wealth of Nations. To Smith, “the division of labour is limited by the extent of the market” (Smith [1776] 1976, bk. 1, chap. 3). This “extent” can be understood as the degree to which “individuals [are] sufficiently in contact to be able to act and react upon one another…and the active commerce resulting from it” (Durkheim [1892] 1933, 257; cf. Land 1970). This limitation allows for a sphere of dynamic actions, including uncertainty-bearing entrepreneurship in response to changing market data, within the limitation of the specialization deadlock. These specializations that do not require centralized coordination can also build on previous specialization efforts incrementally, thereby pushing the extent of the market outwards.
Importantly, however, this incremental progression would not generate the pin factory that Smith uses to exemplify the productive powers of specialization under the division of labor. The incremental progression of the division of labor would not facilitate specializations far beyond what has already been implemented in the market, since this would require the form of coordination excluded from the specialization deadlock. In other words, while the incremental intensification of specialization could eventually generate a highly specialized process, similar to the one taking place within Smith’s pin factory, it would do so without need for the centralized organizing of the factory and also without being substantially different from specializations already supported in the market.
This incremental progression within the specialization deadlock can, however, be upset by the implementation of novel technological ideas (including new types of organization) that require centralized coordination to be feasible. In other words, to establish for the first time a highly specialized production process, akin to what Smith observes in the pin factory, is to go beyond and thus break out of the specialization deadlock. This would require centralized coordination and up-front financing: the creation of a factory. From the point of view of the market’s existing production structure, then, there is a categorical difference between changes in the form of adjustments that are compatible with the existing division of labor and therefore take place within the extent of the market, coordinated through the price mechanism and simple contracting, and those attempted changes that fall outside the market’s extent, challenge the status quo, and will, if successful, bring about disruptions to it. Rothbard helps illustrate this difference:
While a continuing and advancing division of labor is needed for a developed economy and society, the extent of such development at any given time limits the degree of specialization that any given economy can have….Economic and social development is therefore a mutually reinforcing process: the development of the market permits a wider division of labor, which in turn enables a further extension of the market. (Rothbard 1991, 26)
Per the assumptions of Bylund’s imaginary construction, this “mutually reinforcing process” is limited to such division of labor as does not require coordination of factors beyond what can be achieved through the price mechanism and simple contracting. In other words, the opportunities for adopting more intensively specialized production in the decentralized market process are subject to (and thus limited by) the specialization deadlock—the specialization intensity beyond which decentralized economic actors cannot go without effecting incompatibility with the existing production structure. This provides insight into what types of entrepreneurial undertakings are excluded from the specialization deadlock model: those implementations that cannot be coordinated through market prices. They would, assuming that they take place, be located beyond the deadlock and therefore break it.
We can conceive of two types of distinct changes that entrepreneurs can effect in the structure of production that go beyond and so break the specialization deadlock and thus require coordinated action. First, the production of a new type of consumers’ good that cannot be assembled through simple means from standard components already available in the market. The production process would introduce novelty in both the consumer’s good, which has not previously been offered for sale and for which demand is therefore unknown (no value has been realized), and in its production. Second is the introduction of an innovation in the form of novel organizing of existing production stages through the splitting of tasks (Bylund 2011, 2015a), new combinations of factors (Schumpeter [1911] 1934), or creation of new and adapted capital structures (Lachmann [1956] 1978). Both types of changes depend on the utilization of novel technology, broadly conceived, whose implementation institutes a change in the production apparatus in some significant way. In other words, these types of changes constitute “great adjustments” of production by the entrepreneur who, in undertaking their implementation, “assume[s] leadership in the social division of labor by pushing or promoting oneself into a position of organizing and directing the factors of production” (Salerno 2008, 195).
The latter case will be elaborated here to illustrate the specialization deadlock, which is also the focus of Bylund’s (2016) discussion. Assuming an existing roundabout production process in which a good is produced through several conceptually separate stages, each with their own specializations, novelty would be introduced in new ways of organizing and therefore replacing (at least) one stage. In other words, an entrepreneur conceives of a new and potentially more productive way of producing such that an existing stage is replaced by several more intensively specialized tasks (a new subprocess). So the new way of producing must be compatible with the remainder of the production process—unless this new process is in the highest- or lowest-order stages, the new process must procure inputs in the open market from producers at prior stages and also sell the produced outputs to producers in subsequent stages. In other words, for an innovation to be successfully implemented, it must achieve three things. First, it must be adapted or positioned to use inputs that are already available for purchase in the market. Second, it must similarly produce outputs that the subsequent production stage is equipped to use in its production. These are both required in order for the innovative production process to be compatible with the existing production structure. Third and final, the novel production process must be organized and coordinated such that it constitutes a complete chain of productive tasks that produce compatible outputs from existing inputs. Also, for this undertaking to be successful, the new process must be more valuable overall than the mode of production already existing in the market that it (competes with and) attempts to replace.
Bylund (2015a) illustrates this with a theoretical existing production process that consists of only three stages (tasks) from start (only original factors) to finish (consumer’s good), t1–t2–t3. The entrepreneur envisions a means to improve production by changing the process. Specifically, the entrepreneur’s imagined solution consists of replacing the existing stage t2 with three separate and much more highly specialized (and therefore expected to be more productive) tasks in a subprocess: t21–t22–t23. Thus:
The [envisioned] efficient process comprises t1–[t21–t22–t23]–t3 where the intermediate tasks t21–t22–t23 are more highly specialized (sj>>Sm) and therefore jointly more productive than the market-traded task t2. The input for [t21–t22–t23] remains the output of t1, and the process’s output is the input of t3—both are traded (or tradable) in the market, and so the new and more specialized process is compatible with the market and complete in replacing task t2. In fact, in order to successfully compete with and supplant t2 by exploiting the productive capability of [t21–t22–t23], the mutually specialized subprocess must be compatible with the existing productive structure (i.e., t1 and t3) or, alternatively, rely on substitute inputs that do not require new production structures (they should already be available in the market). Incompatibility with either t1 or t3 suggests failure by disconnecting the encapsulated subprocess from the market. (brackets in original)
This thought experiment provides several important insights, but it is sufficient for our purposes to note that this type of novel production process requires more than the coordination offered by the price mechanism (Bylund 2016, 67–85). Indeed, as the new tasks and structure [t21–t22–t23] are new, there can be no existing market prices for their contributions. These tasks are also not marketable, since they have not previously been observed. This suggests not only that the entrepreneur will need to provide coordination to accomplish the envisioned structure but also that up-front financing will be needed in order to attract factors from their current market positions. Factors will command prices higher than the prevailing market wage to become part of the new and untried (and thus more vulnerable) position (Bylund 2016, 107–20; cf. Bylund and Bylund, forthcoming). This undertaking is speculative, uncertainty-bearing entrepreneurship, but it is significantly different from the types of uncertainty bearing through arbitrage and production that can take place within the extent of the market. It is of a specific kind because it (per our assumption) utilizes specialization beyond the intensity that the economy is currently able to support—beyond what can be coordinated through existing market prices. In other words, this entrepreneurship must have an internal coordinative component in addition to the coordinative implications of resource allocation for the market. It is also blind to the relative economic efficiency of the parts of the (sub)process that it implements because there are (and can be) no market prices. In other words, when this new structure is implemented, it becomes an “island of specialization,” or what Bylund (2016) argues is properly (and praxeologically) a firm. We do not need to take that full step to the firm here, however, but need only recognize the specialization deadlock and that although it is an obstacle, it is not insurmountable. Indeed, as has been shown, markets can and do overcome the deadlock, specifically through innovative coordinated entrepreneurial undertakings that establish new and more intensive divisions of labor.
DETERMINING THE ROLE OF THE PROMOTER The discussion in the previous section suggests a framework for analyzing the economic nature of what Mises ([1949] 1998, 300) refers to as “great adjustments” of production as compared to “small adjustments.” It is also clearly relevant to Salerno’s (2008, 195) view of the promoter as having “the will and ability to assume leadership in the social division of labor by pushing or promoting oneself into a position of organizing and directing the factors of production.” Seen through the lens of the specialization deadlock, rather than the ERE, we can distinguish between entrepreneurship as uncertainty bearing within the limits of the market’s existing specialization intensity (that is, within the present extent of the market and without challenge to the specialization deadlock) and uncertainty bearing (through coordinated production undertakings) beyond the market’s existing specialization intensity (that is, outside the extent of the existing market and thus taking place despite and in direct conflict with the specialization deadlock).
These are not arbitrary classifications but are distinct by being either compliant with or directly challenging the specialization deadlock, which is an implication of the interdependence of factors that arises under the division of labor. Importantly, they are also not adjacent from a specialization point of view. There are two reasons for this. First, as Bylund (2011, 2015a, 2016) emphasizes, the “splitting” of a task into many, thereby replacing a standard task with a process, is not an incremental but a discrete change—there are no feasible solutions in between. Also, even if in-between solutions were possible, new production that utilizes specialization intensity just beyond what is compatible with the existing production structure would be unlikely to provide sufficient efficiency gains to cover the costs of implementing and bearing the uncertainty of such production. Thus, these are discrete types of entrepreneurial undertakings, because between the innovative, deadlock-defying “great adjustments” and the market-compatible “small adjustments” exists an “infeasibility zone” where no production undertakings will or can take place:
This ‘zone’ arises due to the fact that all productive innovations that are impossible to realise through market means suffer from unknowability and that their internal strict interdependence suggests incompleteness even from failure in one of their parts. (Bylund 2016, 100)
In other words, the costs of implementing novel production beyond the specialization deadlock are significantly higher than production within the extent of the market. For such an undertaking to make economic sense, the entrepreneur must rely on significant gains from specialization to cover those costs. Unless the new division of labor takes a significant leap forward as compared to the within-market intensity of specialization, the costs exceed the gains and the undertaking would thus generate a loss to the entrepreneur.
In sum, there are two distinct categories of entrepreneurial action. Entrepreneurial action in the first category consists of implementing innovative production structures through advanced task splitting (division of labor) and specializing beyond the specialization deadlock by some magnitude. The other category consists of the efficiency-improving adjustments that take place within the specialization deadlock.
Nonpromoter Entrepreneurs
The entrepreneurial actions taking place within the specialization deadlock, and thus within the existing extent of the market, are, relatively speaking, small and, in Mises’s words, “may seem trifling and of little bearing upon the total result.” They include the allocations of resources between production processes for arbitrage gain as well as so-called imitative entrepreneurship, including where the entrepreneur introduces to an industry ideas and technologies already implemented elsewhere. But these actions, which individually are of little magnitude from the perspective of the economic system, are still highly important for the market process as “the cumulative effect of shortcomings in many of these minor matters can be such as to frustrate entirely the success of a correct solution of the great problems” (Mises [1949] 1998, 300). Although the individual nonpromoter entrepreneur does not exercise much influence, the aggregate effect of such actions, including the weeding out of less productive entrepreneurs, is essential.
Entrepreneurs of this type respond to and attempt to second-guess changes in market conditions so as to position their ventures in the best possible way. They allocate factors between and organize production within the structure of production. They also competitively bid for resources in the open market, which effectuate changes to market prices that facilitate improved economic calculation. As a result, their efforts bring about continuous minor changes to the production structure through shifting allocations of resources in response to expected or foreseeable changes in the market data and through incrementally adopting more intensive specializations. But these adjustments are limited in economic scope, as they do not attempt to innovatively disrupt the existing structure of production—these adjustments happen within the extent of the market and are compatible with production in the status quo. Nevertheless, they serve a very important function in the market economy though their constant adjustments and attempted responses to changes (Hayek 1945).
This entrepreneur, acting within the confines of the specialization deadlock, is primarily a responsive agent who is alert to and thus discovers opportunities revealed within the present extent of the market (cf., Kirzner 1973). Whether these opportunities are due to changes in the market data, such as changing consumer preferences or shocks to production, nonpromoter entrepreneurs profit from swiftly adjusting their efforts to the change or exploiting a previously undiscovered misallocation of resources. It is thus, from the point of view of the new market data and whether the data are themselves new or simply new to the actor (or perhaps all actors), accurate to refer to such actions as corrections of errors made by previous entrepreneurs (Kirzner 1978). They could also be characterized as discoveries, since they are in fact already existing, as it were, within the fabric of the market but have, for whatever reason, remained unnoticed and unexploited (Shane and Venkataraman, 2000; Shane, 2003). These adjustments would consequently always, when successful, be equilibrating, since the discovery and correction of an error (or inefficiency) cannot be anything else (Kirzner 1973, 1978).
Yet given the discussion above, the limited impact of this type of entrepreneur on the market process and the structure of production is obvious. Corrections of errors, continuous adjustments of existing production processes, and the (re)allocation toward more valuable production in response to new (or expected new) data are just that: responsive. This is not to say the nonpromoter entrepreneur is passive, only that the opportunity for profit, existing in the form of a discovered disequilibrium (an “error”), emerges before the action to exploit it. The impact of the alertness on which this type of entrepreneur acts is limited by what opportunities he discovers, but the opportunities themselves are not actively created (cf. Alvarez and Barney 2007). From the perspective of this entrepreneur, disruptions are of exogenous origin (Shane 2003); nonpromoter entrepreneurs only respond to them as they discover them.
Promoters
The promoter’s role as producer of “great adjustments” to the market’s production, as a leader in the social division of labor, is distinct from that of the nonpromoter—and significant. Promoters are the entrepreneurs who, through attempting to coordinate and organize disruptive production processes, establish production significantly beyond the limit of the market’s existing specialization intensity and thus are positioned (and intended) to break free from the specialization deadlock. Rather than responding to the discovered opportunities within the market’s extent, already existing in its fabric, they imagine new ways of structuring and organizing production. This may take the form of a new type of consumer’s good or a new type of production, as noted above, but common to their efforts is an active pursuit of what does not yet exist. Their imagined production also cannot be obvious or limitedly innovative, since such novelty would either be reachable through within-system specializing, and therefore would be in the realm of the nonpromoter, or would fall within the unfeasibility zone and so would be economically unfeasible. Typically, producing a new good or replacing an existing production stage with a new, more roundabout process would entail task splitting and, consequently, would not be an incremental change. As a result, entrepreneurs attempting this must break new ground and, where successful, bring about changes in the data on which other entrepreneurs (primarily nonpromoters) base their decisions. Their actions, and the economic impact thereof, thus go well beyond what nonpromoter entrepreneurs undertake. The promoter’s entrepreneurial undertaking is different and constitutes much more than being “more adept than others at anticipating and adjusting to change” (Salerno 1993, 123).
Although their actions may indirectly affect consumers’ value scales (by offering new goods), their time preferences (by, for example, improving the standard of living), and the supply of resources (through refined production techniques), they comprise the development and implementation of novel technology—recipes for production (Rothbard [1962, 1970] 2004, 11). To be positioned beyond the specialization deadlock, and thus outside the extent of the market, these ideas must be novel and original and thus, to again refer to Bylund (2016), utilize more intensive specialization. But note that the “entrepreneur’s technological ability does not affect the specific entrepreneurial profit or loss” (Mises [1949] 1998, 288; emphasis added). It is not the technological production recipe that makes the promoter, but that the implemented ideas are novel from an economic perspective (they must better satisfy consumers), which means that the entrepreneur cannot rely on the price mechanism for coordination. He can only to a limited extent apply existing knowledge of what is economically feasible—there is only imagination and judgment to guide his uncertainty bearing.
To use Schumpeter’s (1947) well-known phrase, these entrepreneurs cause “creative destruction” to market production by challenging and, where successful, undermining and undoing the status quo.Interestingly, Schumpeter (1961, 107) also noted that that “[t]he promoter may indeed be…the purest type of the entrepreneur genus. He is then the entrepreneur who confines himself most strictly to the characteristic entrepreneurial function, the carrying out of new combinations.” From a Misesian perspective, promoters disrupt the existing market’s production structure by envisioning and implementing novel production beyond the extent of the market, thereby undermining and ultimately dissolving the specialization deadlock. Our analysis categorizes as promoter entrepreneurship specifically such novelty as is not incrementally pushing the boundary of but defies the specialization deadlock and thus must be implemented in the realm of pricelessness. This type of undertaking cannot be accomplished, as Bylund (2016) argues, without up-front financing of the endeavor—the successful implementation of new production depends on productive completeness through coordination, compatibility with the surrounding production structure, and sufficient use of intensive specialization to produce gains in excess of cost. In this sense, to borrow a phrase from Rothbard (1974, 903), “the entrepreneur and the capitalist are one and the same”—there can be no promoter without a capitalist investment in novel production.
The unique role of the promoter, then, is not to perfect existing production, which is rather the role of nonpromoter entrepreneurs. Instead, promoters challenge the status quo by replacing production processes, stages, or tasks with novel production structures that are imagined more in line with the wants that consumers are eager to satisfy. Specifically, promoters imagine and implement production processes that are more intensively specialized than is realizable through the price mechanism and market contracting. The application of the specialization deadlock here makes clear that this promoter role can be defined praxeologically as that which revolutionizes the structure of production by bringing about more roundabout production processes.
As the new process implemented by the promoter is untried, its economic efficiency relies solely on the entrepreneur’s judgment. Therefore, it is likely to be quite ineffective, both technologically and economically speaking. As is the case with first-generation devices, any success is a proof of concept and reason to further refine the ideas and their implementation. Consequently, the first attempt can be largely misaligned with the imagined consumer wants but still profitable. The bar that the promoter needs to initially meet is not impeccable implementation, but better satisfaction of consumers than existing production. The promoter’s undertaking is successful if more value is facilitated through his endeavor than previously in the market, through either producing a better (more highly valued) good or reducing the cost of production (or both). “The only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of the consumers” (Mises [1949] 1998, 288). It does not matter if the production technology can still be (greatly) improved, the offering better positioned, or the business model tweaked. It is possible, if not likely, that the promoter’s novel contribution is not initially maximized or efficient, and thus encompasses many and potentially significant “errors” (inefficiencies, both technological and economic) that can be corrected over time by the original promoter or competing entrant entrepreneurs.
This depiction of the promoter is fully compatible with Mises’s view:
The driving force of the market, the element tending toward unceasing innovation and improvement, is provided by the restlessness of the promoter and his eagerness to make profits as large as possible. (Mises [1949] 1998, 256)
The promoter is responsible for this “unceasing innovation” that, in Mises’s words, “[adjusts] production to the best possible supplying of the consumers with the goods they are asking for most urgently” that “does not merely consist in determining the general plan for the utilization of resources” (Mises [1949] 1998, 300; emphasis added). Rather than resource allocative, the role is innovative and disruptive to the structure of production. Thus, rather than improving the effectiveness of the economic system by correcting existing errors, the promoter brings about improvements by revolutionizing the overall structure of production and changing the market data for nonpromoter entrepreneurs, who to earn a profit must respond to this change.
It has been shown, then, that by using the specialization deadlock, an imaginary construction complementary to the ERE, it is not only possible to praxeologically offer a definition for the promoter, but also to distinguish this actor from nonpromoter entrepreneurs.
CONCLUDING DISCUSSION The discussion above offers a theoretically sound definition of the promoter as producer of great adjustments of production that distinguishes promoters from nonpromoter entrepreneurs. Although Mises asserted that this is not possible, that the promoter “cannot be defined with praxeological rigor” (Mises [1949] 1998, 256), his conclusion rests on an analysis of entrepreneurship using the ERE. This imaginary construction, however, is inappropriate for distinguishing between types of entrepreneurs, because it excludes all change and, consequently, does not allow for distinction between types (or magnitudes) of change. To alleviate this shortcoming, the specialization deadlock and the theory of how decentralized market production can(not) adopt innovative divisions of labor were instead applied to show that there is a real and theoretically determinable difference between promoters and nonpromoters: the former introduce novel production beyond the current extent of the market and thereby provide direction for the overall structure of production.
What remains is to briefly address what the praxeological determination of the promoter role means in terms of the “driving force of the whole market system.” First, the market process following the promoter’s realized profits will be addressed, and then the way in which Mises’s varying uses of the “driving force” come together in the promoter as he is here defined will be shown.
Subsuming the Promoter
The viability of the promoter’s project is temporary. Where successful and earning above regular returns, it will set market processes in motion that undermine and eventually will dissipate the economic profits by attracting other entrepreneurs. These entrepreneurs are eager to share in the profits and thus attempt similar production structures by emulating the promoter’s new solution. While emulating the promoter,The exact role of the follower entrepreneurs is beyond the scope of this paper’s discussion. However, it appears their actions constitute a type of arbitrage that goes beyond and is different from regular within-market resource allocation between production processes. Their actions constitute arbitrage between two alternative production structures rather than different production processes: the promoter’s newly created structure of production and the existent market. This role should be further analyzed in future research. they also make adjustments to and so aim to improve on the promoter’s original recipe and contribution to consumer welfare by incorporating their own knowledge and expertise. This is partly due to not being able to fully reproduce the promoter’s production structure, which, because its parts are not subject to market exchange, could to some extent be hidden. Part of the reason is also that the followers may have different conceptions of what constitutes the actual economic value of the novel production and use their idiosyncratic expertise to further improve on the original attempt. These emulators would therefore need to rely on their own judgment rather than reproduce the original exactly. Although the promoter has provided direction and proof of concept, the emulators are still not acting within a fully formed market but must imitate the promoter’s complete project. And to capture the promoter’s profits, they must overtake the pioneer in terms of value creation and produce a better offer for customers.
Through these followers’ investments in similar structures of production, they augment the impact of the promoter’s own actions by further shifting resources in the promoter’s indicated direction. As they compete for the same (types of) resources, the follower entrepreneurs, “eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor” (Mises [1949] 1998, 332). Because of the promoter’s realized profits, the followers can bid higher than within-market actors for the needed resources and thereby bid up their market prices. They may also attempt to bid for the promoter’s, and each other’s, resources and thereby generate market prices for the novel factor specializations. As market prices are determined, the promoter’s “island of specialization” eventually disintegrates and the entrepreneurs can replace previously unique “internal” functions with market services (cf. Rothbard [1962, 1970] 2004, 609–16). As a result, the extent of the market is expanded, and the specialization deadlock shifts outward so that the promoter’s original contribution is subsumed within what is now the market. By means of the promoter’s imagined and implemented production structure, and through the actions of those entrepreneurs eager to capture the his new profits, the market has overcome the previous specialization deadlock.
As we can see, then, the promoter is the instigator of increased specialization intensity in the market, and thus what brings about ever-deeper divisions of labor through leaps forward—not incremental improvements. Promoters are in this sense leaders “in the social division of labor by…directing the factors of production” (Salerno 2008, 195). They do this by establishing “islands of specialization” (Bylund 2016), or intensively specialized production structures that must be implemented beyond the extent of the existing market. These pioneers are thus necessary for and constitute the vanguard of progress in the market process, and promoters are therefore core to understanding the driving force of the market.
Mises on the “Driving Force”
Mises is often quoted as saying that entrepreneurship is the “driving force” of the market, by which he specifically meant the promoter, as has been shown here. Using the theoretical definition of this role as developed here, further support for this conclusion is found.
Reading Human Action, however, it becomes clear that Mises uses that same phrase in several different ways. It is not immediately obvious that he was referring to one and the same driving force. In light of the foregoing discussion and the definition developed above, his references to the “driving force” come together and thus Mises, rather than being inconsistent, appears to really have been referring to important nuances of the very same thing.
In this section three specific uses of the “driving force” are examined and reinterpreted using the definition elaborated in this article.
- “Profit-seeking speculation is the driving force of the market as it is the driving force of production” (Mises [1949] 1998, 325–26).
Mises here notes not simply that profit seeking is the driving force or that speculation is, but that profit-seeking speculation is. Both profit seeking, in the sense of economic and not merely accounting profits, and speculation in the market process are virtually synonymous with uncertainty bearing. Thus, there is reason to believe that Mises may have been making a deeper point, a suspicion that is further augmented by the reference to production. The distinction made in this article between entrepreneurship within the extent of the market (nonpromoter) and entrepreneurship that breaks free from it (promoter) reveals that there is a significant difference in their speculative undertakings. The former speculates, as does any actor, about future market conditions but only attempts to respond to what is expected. The profit sought is that attainable through discovering opportunities that already exist as “errors” because the economy is not fully equilibrated. Nonpromoters’ role is primarily to effect allocation of resources toward those production processes that are expected to become most profitable, not to change production processes.
In contrast, the latter speculates about bringing about a new future by creating new production structures beyond the specialization deadlock and, as a result, disrupting the status quo. Profits are for the promoter not due to corrections or arbitrage opportunities within the normal progression of the market that are attainable through exchange, but are new profits that do not derive from, and may not even be related to, the status quo. In contrast, the followers of the promoter do not speculate about the economic feasibility of the undertaking in the sense that promoters do, because the promoter has already broken the new ground and shown that it is profitable.
The nonpromoters’ profits should be relatively temporary, since competitors can rather easily acquire similar (or identical) means to copy the what the profiting entrepreneur did. But for the latter, the promoter’s profitable undertaking is not easily, and perhaps not even entirely, reproducible, which suggests the original profits may last comparatively longer. Also, improvements to the original innovation can potentially extend profitability by keeping ahead of competitors and/or lowering production cost. It is also possible that follower entreprenuers can sufficiently improve on the original innovation to outcompete the promoter and create renewed (and extended) profitability.
It is possible that Mises had a similar distinction in mind and therefore pointed out profit’s role as driving force of the market through its being a driving force of production. This is indeed the implication of our analysis here. Although allocating resources between existing production processes (those that can be established within the extent of the market and, thus, the limitations of the production structure) will shift relative quantities of output, these are adjustments of production in degree, not kind. This is also the case for those entrepreneurs following and attempting to emulate the successful promoter, although their actions adjust the structure of production from the status quo to the novelty created by the promoter. These are all different from the promoters, who break new ground by establishing novel production processes and, as a result, extend the division of labor.
- “[The free enterprise system’s] driving force is the profit-motive the instrumentality of which forces the businessman constantly to provide the consumers with more, better, and cheaper amenities” (Mises [1949] 1998, 611)
This is similar to the quotation above but, in contrast, appears to downplay the distinction between promoters and nonpromoters somewhat and instead elevates the businessman as an important actor in the market process. However, this may be a contextual interpretation.
In a market without promoters, the market is purely “driven” by entrepreneurs’ responses to discovered price discrepancies and expected changes. There is little novelty in production and the market lacks the means to disrupt the structure of production—it lacks the means to move beyond the specialization deadlock (i.e., the extent of the market) other than through minor, incremental changes. Although improvements are possible building on previous incremental improvements, this is a slow and steady process unable to take the leaps forward provided by promoters (cf. Bylund 2015b). Advanced task splitting and the establishment of new processes that are more than a recombination of already existing tasks are beyond the market’s reach without promoters.
But added promoters, who are potentially always present in the free enterprise system, the adjustments carried out by nonpromoting entrepreneurs must always take into account also imagined disruptions by promoters. Empirically, therefore, in markets where there are promoters, all entrepreneurs must adjust their production to the imagined future market conditions that must include also potential disruptions by promoters. In other words, in a market that does not preclude promoters the task for nonpromoters will be much more difficult, because market data can undergo dramatic, promotor-caused change. It may not be sufficient to discover the arbitrage opportunity of a price discrepancy if that discrepancy can be made an irrelevant error (and thus unprofitable) by a promoter’s disruptive innovation.
This suggests that in the empirical market, which is always subject to potential disruption, there may be less difference between within-market nonpromoters and those entrepreneurs who emulate promoters. Both would need to position themselves and their businesses with respect to existent “errors,” whether those errors exist as price discrepancies between market-priced actions or between market-based and promoter-innovated production. As the former are dissipated by the emergence of the latter, there may be no time-extensive simple arbitrage entrepreneurship in the empirical market.
Also, in this situation, where the market can potentially be disrupted, an entrepreneur who is not herself seeking to disrupt the market may still do so. Consider an entrepreneur who aims to adjust his production to what he imagines will be the true future market conditions using resources already available in the market. He assumes or must at least account for potential disruptions in his calculations. As a result, his nonincremental positioning, in effect an attempt to exploit an expected price discrepancy emerging from expected (but not yet occurred) disruption, could itself cause a disruption (if the expected disruption does not happen but the positioning turns out profitable) to which other entrepreneurs will then have to adapt.
This suggests that there may be less difference empirically between the actions of promoters and nonpromoters than the distinction determined theoretically suggests. In fact, the potential for disruption should increase the difficulty of “regular,” nonpromoter entrepreneurship, thereby potentially increasing the burden of uncertainty that they bear.
- “Profits are the driving force of the market economy” (Mises [1949] 1998, 805)
Similar to the second quote above, it is new economic profits that bring about the change in direction for the market economy. Although resource allocation is undertaken for profit, and changes in consumer preferences can shift profitability across production processes, such profit seeking will only redistribute productive effort. Nonpromoters equilibrate the production structure by earning profits from correction of errors, thus responding to what is.
In contrast, promoters break new ground and attempt to create new profits by disrupting production of existing goods or creating new ones. As discussed above, those new profits created by the promoter then attract follower entrepreneurs who attempt to capture part of the profits by emulating the promoter. The island of specialization that is established beyond the specialization deadlock thereby expands to eventually become subsumed under the general market as entrepreneurial bidding determines market prices for the new factors and processes. While the promoter is the entrepreneur instigating the process by earning above regular profits, the follower entrepreneurs also earn such profits but act to undermine them by bidding up the prices of factors. The followers’ profits, however, do not constitute the driving force but are the result of successfully following the promoter. They are also indicative of the end of such profits, since the followers through their actions undermine the promoter’s profitability and allow for the remainder of the market to “catch up” with the innovation and subsume the new specialization intensity. The new profits are then extinguished such that there is no remaining economic surplus available from the original innovation. What remains at that point are profits available through correcting the errors made by entrepreneurs in the market-based production processes, which should be attainable primarily through arbitrage. Such arbitrage profits do not, however, “drive” the market in any direction other than making comparatively incremental progress toward less costly production (i.e., with fewer/lesser errors).
Finally, it should be noted that it is only the successful promoter that revolutionizes the market. A promoter’s failed undertaking does not cause substantial or lasting change to the market. Thus, as Mises notes, it is the profits earned by the promoter that, through profit-seeking follower entrepreneurs, take the market in that particular direction. Promoters suffering losses do not change the course of the market, but can only indicate to potential follower entrepreneurs that the route they chose was not, at least in the way they attempted it, feasible.
The Promoter and Austrian Entrepreneurship Theory
Finally, it behooves us to briefly comment on the nature of the promoter as the driving force of the market economy from the perspective of contemporary entrepreneurship theory. Austrian entrepreneurship theory has over the past decades been dominated by Israel Kirzner’s entrepreneurship as alertness (Kirzner 1973, 1979, 1997). Kirzner borrows from and elaborates on Mises’s conception of “pure entrepreneurship” (Mises [1949] 1998, 254); his entrepreneur is primarily an agent responding to and discovering opportunities in the form of errors (inefficiencies) remaining after previous entrepreneurship (Kirzner 1978). This entrepreneur neither owns capital nor can suffer losses but is defined by alertness—the ability to discover opportunities for arbitrage gains. Thus, entrepreneurship is purely equilibrating.
Although Kirzner’s alert entrepreneur has been subject to criticism, both in the past (Rothbard 1974; High 1982) and more recently (Foss and Klein 2010; Bylund, forthcoming), there are important similarities between his entrepreneur and Mises’s nonpromoter. For example, both are nondisruptive and responsive to change; they strive for improved adaptation through adjustments and reallocations, and they deal primarily with discovering and correcting already existing errors (opportunities) within the market. This is different from the promoter’s attempted disruptions. As Salerno (1993, 123) notes, “For Mises, the promoter concept goes beyond the category of the pure entrepreneur derived from the action axiom.” In contrast, “Kirzner’s analysis of the market process has no use for the concept of the dynamic promoter-entrepreneur who is perpetually forecasting and appraising the future in quest of anticipated profit opportunities” (Salerno 1993, 127).
The promoter’s placing of new production beyond the extent of the market, and thus outside of the specialization deadlock, is the market’s “driving force.” Entrepreneurial discovery of arbitrage opportunities can only bring the market closer to realizing what is already possible given the present structure of the economy. In other words, these opportunities are profitable corrections to the allocation of resources, a result of previous entrepreneurs’ inefficient solutions.
In contrast, the actions of promoters should undermine the alert entrepreneur’s attempted equilibratory actions by actively causing change to the market data by disrupting production, introducing new goods, etc. They create, when successful, new profits through novel production that is impossible to undertake within the present market’s production structure. In this sense, it seems that Mises’s promoter, as compared to the “pure entrepreneur” and the nonpromoter, may have more in common with both Schumpeter’s ([1911] 1934) innovator as instigator of “creative destruction” and Lachmann’s ([1956] 1978) reformer of the capital structure (see e.g., Horwitz 2019) than with Kirzner’s alert entrepreneur.
Joe Biden thinks a centrally planned supply chain for healthcare supplies is necessary, because "We can no longer leave this to the private sector." There are many reasons why this is so very wrong.
Original Article: "Biden’s Covid "Supply Commander" Is Bad Medicine".
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Abstract: Some Austrian economists have argued that the disutility of labor is a necessary auxiliary empirical assumption to complement otherwise a priori economic theory in order for it to apply to the real world. Without this assumption, it is claimed that individuals will supply the full quantity of labor of which they are physically capable. We argue that the disutility of labor assumption is unnecessary to derive this conclusion, which can instead be derived through standard marginal analysis. Leisure (the state of not engaging in labor) is a necessary complementary good for consuming other goods. As such, leisure’s status as a consumer good is a priori true, not an empirical assumption. Furthermore, the concept of disutility of labor is not only unnecessary but also leads to confusion due to its being used in two different ways, and therefore ought to be discarded.
JEL Classification: D01, J01, J20, J22 Tate Fegley (tfegley@gmu.edu) is a postdoctoral associate at the Center for Governance and Markets at the University of Pittsburgh. Karl-Friedrich Israel (israel@wifa.uni-leipzig.de) is senior researcher at the Institute for Economic Policy at Leipzig University, Germany. The authors would like to thank Ash Navabi, Kristoffer Mousten Hansen, Łukasz Dominiak, and an anonymous referee for their helpful comments.
- INTRODUCTION Prominent economists in the Austrian tradition, including Ludwig von Mises and Murray Rothbard, consider the empirical assumption that labor involves disutility to be necessary to supplement the otherwise a priori analysis of praxeology in order to develop a theory that is relevant to our world. Without such an assumption, Mises argues, individuals would supply as much labor as they are physically capable of providing:
In a world in which labor is economized only on account of its being available in a quantity insufficient to attain all ends for which it can be used as a means, the supply of labor available would be equal to the whole quantity of labor which all men together are able to expend. In such a world everybody would be eager to work until he had completely exhausted his momentary capacity to work. The time which is not required for recreation and restoration of the capacity to work, used up by previous working, would be entirely devoted to work. (1998, 131) However, in our world, as Mises would argue, labor is usually also economized on account of its involving disutility, and therefore individuals will cease to engage in labor even if they are physically capable of providing more. In contrast to Mises’s fundamental concept of action, the assumption of disutility of labor is not a necessary prerequisite of praxeological analysis. He explains:
The disutility of labor is not of a categorial and aprioristic character. We can without contradiction think of a world in which labor does not cause uneasiness, and we can depict the state of affairs prevailing in such a world. But the real world is conditioned by the disutility of labor. Only theorems based on the assumption that labor is a source of uneasiness are applicable for the comprehension of what is going on in this world. (Mises 1998, 65) Similarly, Rothbard (1957, 316) states that praxeology contains one fundamental, a priori axiom—the action axiom—and a few subsidiary empirical postulates, including the assumption that leisure is a consumer good.Interestingly, Rothbard (1957, 316) states that this assumption is unnecessary “for an analysis of Crusoe economics, of barter, and of a monetary economy.” This could be interpreted as being equivalent to the assumption that labor carries disutility. If leisure were not a consumer good, then labor would not involve disutility, and individuals would not consider forgone leisure a cost. In such a world, they would provide as much labor as physically possible. But is that really true?
We argue that the empirical assumption that labor involves disutility is not necessary in order to derive the implication that individuals will not choose to supply as much labor as they are physically able, but that such an implication can be derived through standard marginal analysis. Moreover, we will argue that equating the existence of opportunity costs to disutility is inconsistent. In addition to the benefit of making economic theory more parsimonious, we believe our paper clarifies this otherwise confusing concept.
- DISUTILITY OF LABOR DEFINED Before defining disutility of labor, it is helpful to define what labor is. According to Mises, labor is “the employment of the physiological functions and manifestations of human life as a means” (1998, 131), whereas leisure is the absence of labor. Alternatively, we could define leisure as the employment of the physiological functions and manifestations of human life as an end. This means that leisure is not only the act of “doing nothing,” but the use of one’s body for consumption, rather than production. This distinction involves a subjective element. The same physical activity could be labor or leisure depending on whether it directly serves the ends of the individual engaged in the activity, or does so only indirectly. To be clear, labor as such is a means. The physical activity undertaken cannot be solely an independent end itself, otherwise it would be considered leisure.
The disutility of labor is the forgone utility of forgone leisure. Leisure, as any other consumer good, is subject to the law of diminishing marginal utility: if only one unit of leisure is available, it is used to satisfy the highest ranked end. If two units of leisure are available the next most highly ranked end will be satisfied as well, and so on. The disutility of labor is the inverse of this process: one unit of time spent laboring will come at the cost of the lowest ranked end that would have been served by time in leisure, the second unit of labor will come at the cost of the second lowest ranked end, and so forth. Thus, labor is subject to increasing marginal disutility (Mises 1998, 132). Mises (1998, 132) writes, “We must conclude that the first unit of leisure satisfies a desire more urgently felt than the second one, the second one a more urgent desire than the third one, and so on. Reversing this proposition, we get the statement that the disutility of labor felt by the worker increases in a greater proportion than the amount of labor expended.” In other words, the disutility of labor is its opportunity cost in terms of leisure forgone.
It would be simple enough to stop here in terms of defining the disutility of labor, as the given definition is sufficient to accomplish the task of explaining what purely a priori reasoning is accused of being insufficient to explain, i.e., why individuals ever cease to engage in labor. However, there is plenty of confusion surrounding the concept of disutility of labor that must be addressed. Much of this confusion is the result of incorporating psychological elements into the disutility of labor, such that it is these psychological elements that become its defining feature. Indeed, Greaves (1974, 34–35), in his glossary for Human Action, defines the disutility of labor as “the discomfort, uneasiness, inconvenience or pain inherent in human effort. Because of this quality men regard labor as a burden and prefer leisure to toil or labor.”
It is not difficult to see why Greaves would define the disutility of labor in such a way, as Mises himself writes,
The expenditure of labor is deemed painful. Not to work is considered a state of affairs more satisfactory than working. Leisure is, other things being equal, preferred to travail. People work only when they value the return of labor higher than the decrease in satisfaction brought about by the curtailment of leisure. To work involves disutility. (1998, 131–32) There are a number of passages in Human Action and Socialism in which the way Mises refers to the disutility of labor makes it seem as though it is a psychological phenomenon, an obstacle to be “overcome,” rather than merely the opportunity cost of engaging in labor. For example, Mises (1998, 584–85) lists a number of reasons why someone might choose to forgo the enjoyment of leisure, such as strength of mind and body, to serve God, and to avoid greater mischief, and states that, in these cases, “the disutility of labor in itself—and not its product—satisfies.”
Besides being utterly confusing, as Mises’ statement ultimately suggests that “disutility” can generate something like “utility,” i.e. that it can satisfy wants, it would imply that the disutility of labor is not the utility of leisure forgone, but the pain, discomfort, or unpleasantness of engaging in labor. Although Mises (1998, 585–89) attempts to distinguish the disutility of labor from the psychological phenomena of the “joy” and “tedium” of labor, in so doing he identifies the disutility of labor with unpleasantness, rather than strictly the opportunity cost of forgone leisure. One of the sources from which the joy of labor springs is that, after having completed a task, a worker “enjoys the feeling of having successfully overcome all the toil and trouble involved. He is happy in being rid of something difficult, unpleasant, and painful, in being relieved for a certain time of the disutility of labor” (Mises, 1998, 586). Mises (1981) also writes of labor directly satisfying the human need of “stirring,” which is “a physical and mental need.” But it only does this to a certain point, beyond which labor becomes toil. The only graph Mises (1981, 145) ever uses in his texts is to illustrate the relationship between the time spent in labor and its direct satisfaction or dissatisfaction.
Likewise, Rothbard (2009) includes the disagreeable conditions under which labor is performed as part of what constitutes the disutility of labor:
In some cases, labor itself may be positively disagreeable, not only because of the leisure forgone, but also because of specific conditions attached to the particular labor that the actor finds disagreeable. In these cases, the marginal disutility of labor includes both the disutility due to these conditions and the disutility due to leisure forgone. Thus, these two conceptions of the disutility of labor—(Conception 1) as the forgone utility of leisure and (Conception 2) the unpleasantness, discomfort, or pain involved in laboring—need not be considered mutually exclusive, and the latter can be classified as a subset of the former. That is, if part of the utility derived from leisure is the avoidance of the unpleasantness of labor, then that would be utility forgone when one engages in labor.
- WHY THE DISUTILITY OF LABOR ASSUMPTION IS UNNECESSARY Conception 2 of the disutility of labor, even though considered by Greaves to be the essence of the concept, is superfluous in terms of doing the work that Mises and Rothbard want the empirical assumption to accomplish. That is, even if labor carried with it no unpleasantness, pain, or discomfort, it would still involve the forgone utility of forgone leisure. Furthermore, Conception 2 also seems to be the “empirical” part of the “empirical assumption” of disutility of labor that we can imagine being different. Contrary to what Mises and Rothbard argue, we cannot without contradiction conceive of a world in which Conception 1 is false, i.e., a world in which engaging in labor has no opportunity cost. Hence, it is not really an additional assumption that supplements otherwise a priori praxeological theory, but rather an aspect of it that is already implied in the concept or axiom of action. Any specific course of action, be it classified as labor or leisure, has opportunity costs, as the choice of one action presupposes alternatives that must be forgone.
What ought to be apparent by this point in our discussion is the awkwardness of the phrase “disutility of labor,” if what is meant by it is the opportunity cost of labor and if one of the purposes of the assumption is to explain why individuals do not engage in all of the labor they are physically capable of performing. It is unclear what is unique about labor in this regard. If, as Rothbard (1957, 316) states, the proposition that leisure is a good is so generally true as to be self-evident, why do we not resort to an assumption about the “disutility of leisure” to explain why individuals ever start to labor in the first place? Indeed, why not assume that every action involves “disutility” to explain why people ever stop doing anything?
The reason is that we already have concepts to explain these things: diminishing marginal utility and opportunity cost. The fact that people do not devote themselves fully to labor can also be explained through these concepts. There are diminishing marginal returns to labor: the first unit of time allocated to labor will be to satisfy the highest ranked end, the next unit to the second most highly ranked end, et cetera. Using one’s body for labor incurs an opportunity cost—one’s body cannot be used to serve other ends one may have. Thus, as individuals engage in further labor, the utility derived from the fruits of their labor diminishes, while the marginal utility of ends forgone remains the same. Eventually, the marginal utility of another unit of labor will be less than the marginal utility of a unit of leisure, and one will cease to labor.
But is that not the work that the assumption that “leisure is a consumer good” is doing, that is, assuming that labor has an opportunity cost? We argue that such an assumption is superfluous, and it is already implied in the definition of labor. Recall that labor is “the employment of the physiological functions and manifestations of human life as a means.” Thus, people labor so that they can consume. This raises the question, though neither Mises nor Rothbard address it specifically, of what, if any, the relationship between leisure and consumption is. Rothbard (2009, 46) states, “Leisure is the amount of time not spent in labor, and play may be considered as one of the forms that leisure may take in yielding satisfaction.” This implies that there is a mutual exclusivity between labor and at least some types of consumption . Only if it is the case that there is no necessary relationship and one can engage in all types of consumption he or she desires without ceasing to labor, could it be possible at all that individuals would supply all the labor of which they are physically capable of providing. Only under such conditions would there be no opportunity cost, in terms of forgone consumption, to engaging in labor. But the action axiom implies that the use of the human body is scarce and one must prioritize among ends. In order to use one’s body to enjoy consumer goods, leisure—the employment of the physiological functions and manifestations of human life as an end—is a complementary good. This is why we conclude that a world in which leisure is not a consumer good is inconceivable, unless it is a world in which no consumption takes place, but this raises the question of why anyone would choose to engage in labor in the first place, since the ultimate purpose of labor is consumption.
The reason why people engage in labor is so that they can consume and if they are to consume, they must refrain from labor. Thus, eventually ceasing from labor is already implied in the concept of labor itself, that is, when labor is understood as a means to attain ends, notably some form of consumption. The end is thus not the labor itself, but rather the enjoyment of its ultimate attainment, which precludes labor. If it were the case that individuals never stopped engaging in labor, then the physical acts they are performing can no longer be considered labor (which is a means), but ought to be considered ends in themselves.
Even if it were considered as an end in itself, labor would obviously have utility or value. And yet, it still would have opportunity costs. Hence, even if it were an end in itself, we would at some point stop laboring. The extra assumption of disutility is not required. Nor is it required for labor as a means. In fact, even simply by virtue of being a means labor should be regarded as having utility instead of disutility. Just like any other means it derives its value from that of the ends it serves to attain.
A world in which labor carried with it no unpleasantness, pain, or discomfort is conceivable without contradiction. But it should be clear why such a world would not be one in which individuals supply all of the labor they are physically capable of performing. Labor would still involve the opportunity cost of various types of consumption forgone. But likewise, any specific type of consumption carries with it the opportunity cost of another type of consumption. Would anybody therefore argue that there is disutility of consumption?
- CONCLUSION We have attempted to clarify the meaning of the phrase “disutility of labor” and to highlight the confusions its use has caused. It is most often identified with unpleasantness in performing labor (Conception 2), which may affect the supply of labor in various occupations and therefore the respective height of monetary wages, but such a conception is irrelevant in regards to whether individuals will ever cease to labor. If all that is meant by it is that labor has an opportunity cost (Conception 1)—that the use of one’s body for labor comes at the cost of not using one’s body for consumption—then there is nothing exceptional about human effort compared to any other scarce resource that has alternative uses. Just as for any consumer good or productive factor, there is no need to resort to a concept of “disutility” in order to explain why people stop consuming a good or employing a factor before they have exhausted their full stock. Rather, they consume units of a good and employ productive factors as long as the expected marginal benefits are greater than the marginal costs. The use of their bodies for labor and leisure is subject to the same reasoning.
This has implications for the applied analysis of consumer behavior. An unstated assumption of the idea that people would engage in labor as much as they are physically capable if they did not directly value leisure is that the process of consuming takes place more or less instantaneously. However, just as production takes place over time, so does consumption, and just as the time involved in a production process is relevant to its value, the time needed to consume various goods is relevant to consumers’ valuation of those goods. Labor supply may be more sensitive to changes in the quality of time-intensive consumer goods than it is to changes in labor productivity or how unpleasant work is. See Becker (1965) for a discussion of the allocation of time between earnings-generating and other activities. Appreciating the role time plays in consumer decision-making may lead to a more informed analysis of a variety of observed phenomena, from changes in workforce participation to changes in fertility rates.
Bob offers his commentary on the movies “The Hunt” and “The Purge”—both produced by Blumhouse Productions—and focuses on whether The Purge storyline offers a challenge to Rothbard’s depiction of anarcho-capitalism.
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An individual’s demand is constrained by his production of goods. The more goods an individual produces, the more of other goods he can secure for himself.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Original Article: "If We Want to Increase Demand in the Market, We Must First Increase Production".
To succeed, entrepreneurs must demonstrate superior foresight and judgment, and practice continuous dynamic improvement in their assembly and reassembly of assets to serve the consumer.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "How Murray Rothbard's Theory of Entrepreneur-Driven Progress Can Be Applied to Modern Businesses".
The economic nationalist faces a dilemma. Foreign aid handouts and economic protectionism are not only wholly compatible in theory, but the effects of foreign aid perfectly complement economic nationalists’ goals.
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Original Article: "Foreign Aid Is Protectionism".
Without a monopolist central bank, market forces would restrain the issuance of bank notes. But once central banks monopolize money creation, wealth is systematically transferred to the central bank and the privileged few who are favored by the state.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Why Savings Are So Critical to Improving the Standard of Living".
AOC and Paul Krugman are wrong: we can't just pay people money to stay home and expect "stuff" to materialize around us. This show explains why—as we cover Rothbard's Man, Economy, and State Chapter 5, "Production: The Structure," with our great friend Dr. Shawn Ritenour from Grove City College.
Don't miss a great discussion of that critical missing link in mainstream economics—capital theory—and its corollaries, from the temporal and uncertain nature of production to cost fallacies. This show also features plenty of examples from today's economy and a short but dynamic exposition of the evenly rotating economy by Dr. Ritenour.
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Man, Economy, and State: Mises.org/MES
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Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
The heart of economic growth is the expansion of real savings. Monetary pumping only destroys wealth and savings.
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Original Article: "Savings Are Critical to a Prosperous Economy".
The real problem with inflation, properly understood is that it is essentially a wealth transfer away from the most productive parts of the economy. This causes bubbles and economic fragility.
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Original Article: "Defining "Inflation" Correctly"
Some claim "the rich" will be fine—or even better off—after the COVID panic destroys the economy for most of us. But there's a problem: the wealthy depend heavily on an economy fueled by the production and consumption of all workers and entrepreneurs.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "We’re All in This Together. But Not in the Way You Think."
Thanks to past interventions, the economy is now rife with malinvestments and prices that don't reflect real demand. The solution is to allow deflation and other types of painful readjustment. Otherwise true growth will elude us.
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Original Article: "How Government Intervention Triggers Depressions"
Abstract: Since Samuelson’s (1966) reswitching example in the 1960s, it became clear that the Average Production Period (APP) is not necessarily a decreasing function of the interest rate. Recently, Fillieule (2007) and Hülsmann (2010) have shown that Samuelson’s example is not a mere curiosity. They showed that in a reasonable production structure model, the length of production increases with the interest rate instead of decreasing. However, their model did not present “reswitching” behavior. In this paper a generic model of the structure of production, in which both Fillieule’s and Hülsmann’s models are specific cases, is presented. It shows that the APP has a nonmonotonic dependence on the interest rate, which resembles a “reswitching” behavior: it increases for low-interest rates up to a maximum value, and then decreases back to almost the initial value. The decrease occurs within a relatively narrow range of interest rates, which may explain why it was missed in the literature.
business cycle — interest rate — structure of production — austrian economics — reswitchingJEL Classification: B53, E43, L11, L16, D24, B25, L23
Er’el Granot (erel@ariel.ac.il) is a professor at the Department of Electrical and Electronics Engineering, Ariel University, Israel.
INTRODUCTION Recently, there has been a revival in the interest in the reswitching debate. The debate is part of the Cambridge capital debate, which took place during the 1960s and 1970s (Harcourt 1972, 1976; Cohen and Harcourt 2003). While the capital debate did not end with a clear conclusion, Samuelson (1966) used a nice pedagogical example to illustrate the problem, in what was considered to be one of the main pillars of economics. One of the conclusions of Böhm-Bawerk’s intratemporal studies was that the players’ time preference determines the pure rate of interest (PRI), and therefore when the PRI decreases the entrepreneur seeks more productive roundabout production processes (Böhm-Bawerk 1959). Consequently, it seems that the natural conclusion is that when the PRI decreases, the structure of production lengthens.
This conclusion affected not only the neo-classical school but significantly influenced the Austrian school of thought. Hayek (1933, 1935) developed Jevons’s structure of production and Böhm-Bawerk’s analysis in his business cycle studies. Rothbard (2008) developed Hayek’s treatment by integrating the interest rate in the structure of production. The general structure appears in more modern writings.See, e.g., Skousen (1990), de Soto (2006).
The reswitching debate did not have a considerable impact on the Austrian school, probably because it was not regarded initially as more than a mere curiosity. Moreover, it is true (see Murphy [2003]) that the validity of reswitching does not fundamentally contradict Böhm-Bawerk’s claim that the entrepreneurs’ time-preferences is directly related to their willingness to lengthen or to shorten the production process. In fact, the reswitching effect does not contradict any fundamental praxeological law. However, does it affect the structure of production?
Fillieule (2007) constructed a simple model for the structure of production. In his model the structure of production consists of infinite stages of production, i.e., the structure of production begins at the dawn of humanity. Moreover, it was taken that in every stage the ratio between the amount of money invested in original factors of production (labor and land) and the amount of money invested in capital goods is a given constant ratio.
Under these fundamental propositions, the structure of production has an exponential shape. That is, the structure of production decays exponentially the higher one goes in the production’s stages, since the ratio between the amounts of investment in adjacent stages is fixed. An example of such a production structure is illustrated in Fig. 1.
Figure 1.
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Due to the fixed ratio between adjacent stages of production, the calculation is relatively simple and straightforward. In this case, the Average Production Period (APP) was found to be (Fillieule 2007)
(1)
where λ is the APP, I stands for total investment, C is the amount of consumption and r is the interest rate per stage of production.
It should be noted that in the literature the stages are usually numbered by positive numbers, however, to be consistent with the fact that stage 0 is the final stage, I chose to present them as negative numbers. This notation is also consistent with the terminology: “1st stage of production”, “2nd stage of production” etc. 1st cannot correspond to 9, but it may correspond to -9.
Hülsmann (2011) took a similar approach, but with several differences, which have to be stressed. In Hülsmann’s production structure model, there is a finite number of production stages. Furthermore, it is assumed that capitalists pay for original factors of productions (land and labor) only at the beginning of the production process. In the intermediate production stages, capitalists pay only for capital goods plus interest. Furthermore, his research focuses on a low interest rate, in which case the structure of production has a trapezoidal shape (as in Hayek’s model). An example of such a production structure is presented in Fig. 2 (again, one can see that I use negative numbers to represent the stages of production because production takes place in the present).
To simplify the discussion, Hülsmann (2011) did not present a formula, and instead, numerical results were presented. However, straightforward derivation reveals that in the low interest regime (the most relevant one, and the one which creates the trapezoidal shape), the dependence of the number of production stages (N) on the interest rate (r) is (see Eq. 6 in Appendix A)
(2)
Figure 2.
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A more accurate derivation, which is valid for 0 < r < C/I, shows that (these expressions do not appear in the original paper, but are derived in Appendix A as Eqs. A5 and A6).
(3)
Both the numerator and denominator of Eq. 3 increase with the interest rate, however, since in the numerator r is multiplied by a larger numberIC 1 then the number of stages is an increasing function of the interest rate. Moreover, as r increases and tends toward CI from below, then the number of stages diverges, i.e., N—> ∞.
Therefore, we recognize that in both models the length of production (LOP) increases with the interest rate, which, as was emphasized by Hülsmann, is in clear contrast to the Austrian understanding of the structure of production.
Machaj (2015, 2017) tried to solve the inconsistency between these results and the Austrian literature by emphasizing the importance of the Intertemporal Labor Intensity (ILI) in the production’s structure. According to this terminology, ILI indicates the amount of money being spent on original factors of production in the earlier stages of production relative to the later stages.
High ILI corresponds to the case where most wage payments, i.e. labor investment, are concentrated in the early stages of the production process. Low ILI corresponds to the opposite case, where most wages are paid in the last stages of production. Machaj does not quantify the relation between the ILI and the correlation between the LOP and the interest rate; however, it seems that he relates low ILI with negative correlation and high ILI with a positive one. This tool helps him to explain the positive correlation between the LOP and the interest rate in Hülsmann’s and Fillieule’s model, since, according to him, in both models the ILI is high (see Machaj [2017, 78]).
Clearly, the ILI has an important impact on the structure of production. However, how can it explain the inconsistency between the Austrian literature and the results of Hülsmann and Fillieule? After all, contrary to Machaj’s claim, the ILI is completely different in the two models.
In Hülsmann’s case, the ILI is clearly high (since labor is invested only in the first stage of production). However, in Fillieule’s model, most of the labor investment is concentrated in the last stages of production (after all, there are infinitely many stages, but the labor investment increases exponentially), and therefore the ILI is definitely low, regardless of the interest rate.
Nevertheless, both models present a positive correlation between the LOP and the interest rate (provided the ratio between investment and consumption is fixed).
Therefore, knowing the ILI is insufficient to determine whether the LOP increases or decreases as a function of the interest rate.
Moreover, the ILI is not a well-defined quantity. If ILI is a measure of the average period of labor investment, then it is almost identical to the Böhm-Bawerkian definition of the APP. Then it is clear that the APP is low whenever the ILI is low and vice versa. Therefore, the ILI does not add information to the question about whether the APP will increase or not; the ILI is the solution to this question. But, as we will see below, the situation is even more complicated than that.
Hülsmann emphasized that it is not surprising that in both models the same positive tendency appears, i.e., LOP increases with interest rate, because, according to him, they basically followed the same methodology. However, a close inspection reveals major differences.
Nevertheless, despite the differences between the two models, they are, basically, two specific cases in a more generic one.
CONSTRUCTING THE GENERIC MODEL The generic model, is the case where there is a finite number of production stages N (like Hülsmann’s, Hayek’s and Rothbard’s models), but in every production stage the investment consists of capital investment, whose fraction is (1-a), investment in original factors (OF), whose fraction is a (as in Fillieule’s model) and interest fraction r (it should be noted that only when the time period of a single stage is one year does r stand for the annual interest rate). Mathematically, it means that the amount of money capitalists spend in the -nth stage is I-n and the consumption at the final stage (stage zero) is equal to c, i.e.,
(4)
In the first production stage of high-level goods, the investment is equal to
(5)
In general, the expenditure on OF of production at the nth stage of production is
(6)
that is, in the intermediate states only a fraction a out of the entire investment is dedicated to OF, while in the first production stage all investment is directed to it.
Therefore, the investment in capital products at the -nth stage of production is
(7)
(note that we adopted Fillieule’s notations except for the stages’ numeration).
Consequently, the relation between the investments in adjacent stages is (for 2 ≤ n ≤ N)
(8)
The structure of production of this generic model is presented in Fig. 3.
Figure 3.
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This is a generic model: Hülsmann’s model is a specific case, which can be derived by taking the limit of zero expenditure on original factors, i.e. a —> 0, while keeping the number of production stages finite, i.e., N < ∞. Fillieule’s model can be reconstructed by keeping a constant percentage of the expenses on original factors, i.e., a > 0, but taking an infinite number of stages, i.e. N —> ∞. In both models, the interest rate is taken to be non-zero, i.e., r > 0. It should be noted in passing, that the generic model encompasses a third kind of structure, which is reminiscent of Hayek’s (1935) model of the structure of production in that it does not take the interest payments into account, i.e., r = 0. However, it is not the same kind of structure because Hayek’s structure is linear, while the generic model is exponential.
Now, since the LOP in both models (Eqs. 1 and 2) is independent of a we find a problem. Nevertheless, before we explain the problem, we must emphasize again the point that r in our model (as in Fillieule’s and Hülsmann’s) is not the annual interest rate, but rather the interest rate paid in a single production stage. Therefore, if one chooses very short production stages (in the possible range), r can be arbitrarily small regardless of the interest rate (note that the ratio I/C is independent of the length of the stages). In this limit, Fillieule’s result reveals only a negligible dependence on the interest rate.
In fact, if one follows Fillieule’s derivation with a single difference: omitting the interest rate at the last stage of production, the prefactor (1+r) vanishes, i.e., λ = I/C. Therefore, the dependence on the interest rate (1+r) is a result of the last stage and has nothing to do with the entire (infinitely long) structure of production.
If the number of production stages is finite, then it is clear that in the limit of low interest rate rN << 1 Hülsmann’s model is retrieved, because then Hülsmann’s trapezoid shape appears. However, in the limit of high-interest rate rN >> 1, Fillieule’s model is retrieved, since in these cases the amount of investment in the early stages (n > 1/r ) is minuscule, and therefore for any practical purposes N can go to infinity without affecting the distribution of investment.
Consequently, the parameter which determines in which domains we are is the product Nr. If Nr >> 1 then the model enters Fillieule regime (the production structure is approximately exponential), while when Nr << 1 the model enters Hülsmann’s domain (the production structure is approximately trapezoidal). Clearly, however, our model is richer than the two independent regimes.
Now, we can turn to and explain the problem:
When the interest rate is low, then the APP can be approximated by Eq. 2, i.e. , however, since I/C > 1 then . However, , as was explained above, should be valid for higher interest rates, when the number of stages diverges. Therefore, for any given interest rate, Hülsmann’s model APP is higher than Fillieule’s, which means that eventually, the APP must decrease. Below we will present this behavior in detail.
The inevitable conclusion is that the two formulae do not present the same reality, and not even the same tendency. In fact, these results show that for low interest rates, the LOP increases with the interest rate, while for high interest rates the LOP must decrease. The mathematical proof for this will be presented below.
There is no monotonic dependence on the interest rate. Therefore, not only do these models contradict the Austrian and neo-classical literature, but a reswitching >musteventually occur. Reswitching is, then, not an anomaly or a mere curiosity, but it is the norm (provided the ratio between consumption and investment is fixed).
It should be stressed, however, that this “reswitching” is not equivalent to Samuelson’s original one. This is because the reswitching does not occur between two different production methods, but rather a reswitching occurs in the sense that for low interest rates the production structure is short; when the interest rate increases the structure of production lengthens. However, it shrinks again when the interest rate keeps increasing.
One of the reasons that this unexpected conduct was overlooked is that there are inconsistencies in the definitions of the LOP.
In what follows, we will solve this model analytically, and present the reswitching result. However, before we do that, we have to clear up the confusion regarding the definition of the LOP.
Jevons, Hayek, Rothbard, and Hülsmann identified the LOP with the number of production stages. When the number of stages is low, i.e., when N(α+r) << 1, the number of stages is indeed a very good estimation to the LOP. However, when the number of stages increases, the amount of money invested in the early stages of production, i.e., where higher-level goods are produced, is small in comparison to the aggregate investment. Therefore, the contribution of these stages to the LOP is negligible. Clearly, when the number of stages is infinite, i.e., when the production process begins at the dawn of humanity (as in Fillieule’s model), it is clear that the number of stages is an inadequate evaluation of the LOP.
It should be stressed that taking the production stages to infinity is not merely an academic exercise. In fact, as was stressed by Machaj (2017), any modern production process begins with capital goods. It is almost impossible to reconstruct a production process that does not require capital goods in its initial production stage. Therefore, an infinite number of stages does not seem to be the exception, but rather seems to be the norm, and should not be disregarded.
Ironically, it seems that Böhm-Bawerk has realized this problem, and used the average period of production, which is defined as the “average time interval occurring between each expenditure of originary productive forces and the final completion of the ultimate consumption good.” Therefore, instead of using the ambiguous term LOP, we would use the more clearly defined term “average period of production” (APP). This term can easily be implemented in all three models by
(9)
where Ln is the amount of money invested in labor during the nth stage of production, while
(10)
is the aggregate investment in original factors (labor and land).
Hereinafter we will adopt Fillieule’s assumption that in the intermediate stages all the investment on OF consists of labor’s salaries. This is a reasonable assumption because it is very rare that the industries utilize unprocessed OF, i.e. non-capital goods, during intermediate stages of production. Moreover, it is not a restrictive assumption, and the model can easily be generalized.
CALCULATION OF THE APP From Eqs. 5 and 8, the investment in the nth stage can easily be calculated:
(11)
for n ≥ 1, where, for simplicity, the following notation was used
(12) .
Then, aggregate saving is (see Appendix A)
(14)
Similarly, the aggregate income of owners of OF is
(15)
where
(16) ,
are the incomes of owners of OF in the -nth stage, which is a manifestation of the fact that in the Nth production stage all money is invested in OF, while in the intermediate stages only part (a) of the money is invested in them.
Similarly, the aggregate income of owners of capital goods is equal to
(17) .
Using Eq. 9 the APP is (see Appendix A)
(18)
which can be solved as
(19)
The dependence of the APP on the interest rate is via the auxiliary parameter q.
According to Eq. 19 when the parameters a and N are fixed then λ (the APP) decreases when the interest rate r increases. However, when the interest rate varies, so does the aggregate investment I (according to Eq. 14).
In order to keep the aggregate investment fixed, the number of stages of production N must increase accordingly. Therefore, in order to keep the ratio between consumption and investment fixed, one can substitute the number of stages N from Eq. 14 into Eq. 19, i.e., to substitute
(20)
in the expression for λ, (note that Eq. 3 is a specific case when a=0). But before we do it, it is useful to adopt the following definition of the critical interest rate
(21) .
Using this terminology, the number of production stages, i.e., Eq. 20, can be written
(22) .
which clearly diverges when r —> rc.
By substituting Eqs. 12, 21, and 22 in Eq. 19 the APP can finally be written as (see Appendix B for elaboration)
(23)
When a —> 0 then λ —> N, i.e., the APP converges to the number of stages. In fact, as long asr << rc and a << r then λ ≅ N (see Eq. B2 in Appendix B), i.e., in this case, the number of production stages is indeed a good approximation of the APP. This is the interest rate regime, which was investigated by Hülsmann.
However, as the interest rate approaches the critical interest rate, i.e., r ≅ rc, then the number of stages N diverges, while the APP, i.e. λ, does not (see Fig. 4). In fact, the APP finally decreases and converges to (note that all the terms (rc-r) in Eq. 23 vanish)
(24)
which is exactly Fillieule’s (2007) result for r ≅ rc .
In context of the generic model, which is presented in this paper, we see that Hülsmann and Fillieule investigated different regimes of the interest rate. Hülsmann’s model agrees with the generic model at the low interest rate regime, while Fillieule’s model agrees with the generic model only around r ≅ rc, where the number of stages diverges.
As can be seen from Fig. 4, there is an interest rate level r, below which the APP increases, and above which the APP decreases. This is the point where APP receives its maximum value λmax = λ(r) (see Fig. 4).
Figure 4.
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In Fig. 5, the APP as a function of a and r is presented in a contour plot. As can be seen, for any given 0 < a < C/I there is an interest rate, which is lower than the critical one, in which the APP receives its maximum value, and above which it decreases to almost the initial value.
Figure 5.
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This maximum effect is especially noticeable when the fraction of OF’s investment is very low, i.e., a << 1 (For details, see Appendix C).
This “reswitching” phenomenon occurs due to the following reasons. In the low interest rate regime, any increase in the interest rate forces the APP to expand in order to compensate for the reduction in the high-level stages of investment. However, this process cannot last for long, since when the interest rate increases beyond a certain level (r*), the reduction in the low stages’ investment reduces the APP beyond the increase caused by the additional stages. Thus, in this regime, the APP decreases. Beyond the critical interest rate (rc) the reduction in the low stages’ investment cannot be compensated by the negligible investment in the high stages of production.
It should be emphasized that when r < rc the interest rate can increase while both I/C and a are fixed, because the number of stages can increase. However, beyond rc, since the number of stages is already infinite, it is impossible to raise the interest rate without affecting either a or I/C. In this regime, if the ratio I/C is fixed, then λ = (I/C)(1+r) (Eq. 1), in which case the APP mildly increases with the interest rate (see the dashed curve in Fig. 6). However, if a is fixed, then APP obeys the equation λ = (1+r)/(r+a) (see Fillieule [2007]), in which case the APP decreases with the interest rate (see the solid curve in Fig. 6).
Figure 6.
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A further important and original result is, that the APP does not have a simple monotonic decreasing dependence on the ratio between consumption and investment (as wrongly predicted in the literature, see, for example, Chapter 8 in Murphy [2006]). If the fraction a and the interest rate r are fixed, the APP initially increases with the ratio (C/I), and only after receiving its maximum value, it begins to decrease (as N does); see Fig. 7.
Figure 7.
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In countries like the United States where C/I ≈ 0.5 (see Skousen [1991, 45]) the difference between rc ≡ C/I a, and r (the interest rate with the longest APP) is very small (see Fig. 8 where r was calculated numerically).
Figure 8.
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This fact can explain why this “reswitching” was missed in the literature, and how it became common knowledge that the APP must decrease when the interest rate increases.
SUMMARY AND CONCLUSION A generic model of the structure of production was presented and studied. Hülsmann’s and Fillieule’s models are two limiting cases of the generic model. The low interest regime of the generic model can be approximated by Hülsmann’s model, while the high interest regime of the generic model can be approximated by Fillieule’s model.
Thus, the generic model leads to a result that is different both from the older Austrian literature and from the recent one.
Therefore, this model predicts that when the interest rate increases, the APP does not decrease as the neo-classical models (and the old Austrian literature) predict. Moreover, the APP does not increase as the new Austrian models predict.
In fact, the main prediction is that when the ratio between consumption and investment is fixed, the APP increases for low interest rates, but beyond a certain value, it decreases.
This conduct resembles a “reswitching” behavior when the APP is low for both low and high interest rates, but it grows for intermediate interest rate levels.
However, this conduct can occur only if the ratio between consumption and investment (C/I) and a are both fixed, which is possible to maintain only within a narrow range of interest rate values. Whenever the interest rate exceeds this range, at least one of these parameters, either (C/I) or a, must vary as well. If the former (C/I) is fixed, then the recent Austrian prediction holds, but when the latter (a) is fixed, then the older Austrian prediction is valid.
Central banks have decided that one of their main missions is to prevent deflation. But this only ends up causing the malinvestments that lead to economic busts.This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Let's Hope Deflation Is Headed Our Way"
Prices and purchasing power are determined by how individual consumers value goods and services. The "velocity of money" won't help us understand prices or the money supply.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Money Velocity and Prices"
Although the money supply has greatly increased, accompanying growth in production has it possible to keep the current system of immense debt increase going for a long time.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Decades of Productivity Gains Have Made Our Debt Bomb Manageable (For Now)"
Dr. Mark Thornton, our in-house Cantillon expert, joins the Human Action Podcast to discuss the contributions of this important proto-Austrian thinker. Cantillon may well have written the first true economic treatise, one which lays out a comprehensive theory of production, money, interest, value, method, and trade—almost 150 years before Menger's Principles. And along with the other French physiocrats, Cantillon gave us the concept of lassez-faire that later influenced Adam's Smith's invisible hand. If you want to understand economics today, and the precursors to the Austrian school, you need to know Cantillon and his work.
Cantillon's An Essay on Economic Theory, edited by Mark Thornton. Free PDF available.
A biography of Cantillon by Mark Thornton.
"More on Cantillon as A Proto-Austrian" by Guido Hülsmann.
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The Problem of Production: A New Theory of the FirmPer BylundLondon: Routledge, 2016, 194 pp.
Mateusz Machaj (mateusz.machaj@uwr.edu.pl) is research fellow at the Faculty of Social and Economic Studies at Jan Evangelista Purkyne University in Usti nad Labem, Poland; and assistant professor at the Institute of Economic Sciences, University of Wroclaw.
Quarterly Journal of Austrian Economics 21, no. 4 (Winter 2018) full issue, click here.
Literature on the theory of the firm is literally flooded with a repetitive question: “Why do firms exist?” It has become such a monotonous query that while addressing it, it is increasingly difficult not to fall into either of the two traps: make trivial points, or worse, make trivial points disguised in difficult and sophisticated terminology. Fortunately, Per Bylund’s book does not fall into either of those, and offers an original contribution to the theory of the firm. Moreover, I believe that he does not fully recognize how shattering his point is. After reading The Problem of Production: A New Theory of the Firm, one no longer is inclined to ask the question about firm’s existence. A more proper question should be “Why do markets exist?” Bylund has made a compelling Austrian argument that makes the firm’s appearance even more fundamental than the market. Firms precede markets.
To summarize a central thesis: what is the firm? The firm is the outside-of-the-market creation of a novel production function, since its internal organizing of factors is distinct from and unsupported by the existing market structure. In other words, firms exist because they are the only possible rational channels of introducing innovations to society. At a particular point in time, the extent of a market only supports some types of production and closes into “specialization deadlock” (Bylund, 2016, p. 4). Many hypothetical and heterogeneous investment projects require sinking specific and complementary factors of production into risky areas. The markets for intermediate goods created and used up in those projects do not exist. Therefore, the only way for those projects to be materialized is to organize a specific human entity around it: the firm (Bylund, 2016, p. 103).
Through such reasoning, Bylund is accurately seeing the firm as a mechanism to unlock “specialization deadlock.” I would call it, then, an unlocking theory of the firm—a theory of an entity which unlocks the door to projects that were not introduced into the market and were not tested by it each step of the way. By placing an emphasis on the dynamic unlocking part of organizing, Bylund avoids many of problems present in previous theories—either focusing too much on the legal aspects (Grossman and Hart, 1986), or the supposed hierarchy (Williamson, 1967), or explaining the firm’s existence by reference to particular economic costs (Coase, 1937). So far, the most important Austrian contributions to the theory of the firm were made in significant articles in Klein and Foss (2012), where authors are building bridges by finding enlightening and eloquently Austrian themes in competing theories. Bylund’s book structure takes a more sweeping approach and builds his theory from scratch on Austrian foundations.
One difficult aspect of Bylund’s thesis is a lack of more practical examples that could help to narrate his points and efficiently navigate the story (which overall has a very good arrangement). Rough considerations about factors 11, 12, and 13 may make it hard to follow the reasoning. I may try to join in with something more concrete to exemplify his explanation of why firms emerge as sort of “out of the market” phenomena.
Take the case of car manufacturers, who decide to implement an already existing new feature, say, to sell cars that already have child seats integrated with a final product. The current extent of the market has already everything “priced in.” There is a price for a final car and the components necessary to construct it. There is a price for a child seat that can be bought separately (and inserted by the customer). Prices for child seat components are already there. There are many competing car companies and even more child seat producers. Both industries are so developed that it is easily knowable how current market circumstances view both products: a car with a child seat in it and a car without it. The only uncertain thing that remains to be discovered is what the customers prefer.I am presenting the argument here, although I do not fully agree with it (see below). The current (empirical) state of the market is that people prefer to generally buy those products separately. In any case, there is no extra benefit of choosing either way of production. There is no significant role for the firm, as the choice of production is somewhat forced onto the producers by the market and at already existing prices.
Things are different, however, once we consider the processes of production which are not covered in the existing extent of the market. Let us move back couple of decades into the times of internal combustion engine cars using exclusively either diesel or gasoline. Now, some producer develops an entirely new idea: a hybrid car that has two sources of power, a traditional internal combustion engine, and a battery, which can enhance performance, or perhaps fully substitute the engine at times. The novel idea of a hybrid car is not in place yet. At the same time, it requires significant changes in existing ways of production. A completely new version of the battery has to be produced to fit the car and its components, the drive has to be adjusted in order to accept energy from two sources, the gears must be modified, and new types of brakes are to be integrated with a regenerative braking mechanism that will charge the battery. All of those changes are central to innovation that is not supported by the extent of the market.
Many of the used materials in the process are purchased in the market, but the project is done by an innovative firm—and it can only be done so. Hence the clear reason we have firms in the market: because they are agents of innovative change. The materials used in production of a hybrid car are purchased in the market, but the integration of all the components is done in the “island of specialization,” the firm implementing a particular entrepreneurial vision of building a hybrid car with all of the necessary components. The project itself is realized by imaginative thinking and if it succeeds, that particular firm becomes an organized entrepreneurial imagination (Bylund, 2016, pp. 82, 109). The market process develops further and the firm is absorbed by the market (Bylund, 2016, p. 113). As hybrid cars come into greater demand, other companies follow suit, while at the same time a market for components develops. Now, specialization is becoming much deeper, new companies are formed to work on each of the parts of the car and the hybrid mechanism. New firms producing batteries are flourishing, and the same can be said about units producing specific types of braking and drive systems. Now a company interested in supplying hybrid cars may gather the relevant information from the market: many producers of both the final product, and many competitive suppliers of the components—something that earlier had not existed. The firm has been “absorbed by” the market.
Perhaps another clear example could be provided with smartphones that use very rare chemical elements which decades ago were considered mostly waste (Abraham, 2015). The initial idea to create touchscreen smartphones was imaginary as the market for those elements was radically undeveloped and specialization for smartphone components production was in the distant future. The companies going into the business had to make a decision about combining the components in ways that previously were not tried and tested. Once the product became successful, markets for intermediate products and subcomponents emerged—and so did competition which brought on further improvements in quality and pricing.
In such a way, the firm is seen as an agent of change in the market. Bylund offers a strong argument about the existence of firms by combining essential features of the Austrian School: methodological individualism, disequilibrium, uncertainty and heterogeneity of capital (Bylund, 2016, pp. 17, 22, 26, 38). All of those characteristics are integrally tied to the idea of the firm. What makes Bylund’s point so persuasive and captivating is that he does not start from equilibrium at all. His theory is rooted in methodological individualism; he does not try (like Coase, for example) to explain human behavior by relating it to some external parameter, such as costs of using the market mechanism (Bylund, 2016, p. 86). Rather the firm is a creative implementation of the entrepreneurial ideal, an end and the final cause in itself: an organizational project motivated by a visionary wave of the future.
Bylund also explicitly starts from disequilibrium, as it creates necessary conditions for the firm’s emergence due to limits of existing methods of production. Capital heterogeneity and uncertainty are also in the center of his argument as they place limits on entrepreneurial risk taking (Bylund, 2016, p. 58). Any investment process is susceptible to sudden uncertain change, therefore starting a project “outside” of the current market means creation of more specialized production connected with more specific intermediate capital goods. Remember: those are goods which are complementary to the uncertain project, and the market for those goods does not exist yet. That further increases the uncertainty factor as the innovative choice may result in tremendous sunk costs (Lachmann, 1948, p. 204). Here it is worth noting how important the social and legal conditions are: an entrepreneur acting in a firm needs to persuade the investors and other stakeholder to realize the project, and to continue it during hard times.
The author has made a striking contribution, but I do not think he goes far enough in his considerations, and perhaps is not fully aware of the advancement he has made. His primary interest was to explain why firms emerge. The answer lies in the innovative actions of entrepreneurs. Yet as Bylund is well aware, the longevity of the firms is much greater than the implementation of innovation, when he states:
A possible explanation for why firms survive past what our framework seems to explain is that we have not considered strategies adopted by individual firms to extend their lifespan and extract value from their positioning outside the extent of the decentralised market. It should be in the interest of the individual firm to raise barriers to entry into the created production space such that a first-mover advantage is created and profitable production can be prolonged. Such strategies to deter new entrants or make entry economically unfeasible can range from organisational measures to encapsulate fully or make the production process opaque, to gaining control of the supply of necessary resources or sources of input (Bylund, 2016, p. 195)
Therefore “there is room for explaining how and why firms can survive past their initial function as an ‘island of specialisation’”—and the story has to be bigger than monopolization and rent-seeking. Well, perhaps the problem may exist from a Schumpeterian perspective, but not a Misesian one. Maybe we should understand innovation more broadly—not just as significant discrete alterations in methods of production, but also as continuous minor adjustments and even doing passively repetitive routines. With that addition in mind, Bylund’s unlocking theory of the firm is actually not only about innovative changes and Schumpeterian breakthroughs (as he seems to suggest). The logic of his Austrian argument goes further. After reading the whole book one just cannot help but to reflect: so that actually explains not why firms exist, but why the market exists. The firm is a fundamental unit of the market, with the latter being a derivative. Economics is founded on human action, not market action. Firms are market creators—without them the markets could not exist. But firms are also market followers. That is the unavoidable logic of Bylund’s Austrian consommé consisting of methodological individualism, disequilibrium, uncertainty and capital heterogeneity. Firms are always working with their production functions: they always implement them, they always change them, but they also routinely repeat them. Doing things as they were done yesterday, or perhaps slightly adjusting them, is still a firm’s choice. A market is never doing anything. A market is a result of firms’ actions attempting to coordinate production and prices of various products (Mathews, 1998, p. 43; Demsetz, 1993, p. 162). Bylund (2016, pp. 86–90, 121, 122, 132) many times strongly defends that perspective.
Therefore, in order to explain the occurrence of firms we do not need to envision radical changes in production functions, although imagining them is the easiest way to grasp the firm’s importance for socio-economic evolution. Besides, quite often entrepreneurial breakthroughs are done by more firms than just one, and frequently in skewing existing markets. Perhaps a historical case could illustrate the point. At the edge of the industrial revolution, clock production was dominated by experienced craftsmen, who produced high-end watches suitable for preferences of rich customers. Everything changed with Georges Frederic Roskopf, who had an ambitious plan to produce a “worker’s watch”; a functioning time indicator cheap enough so that any person could afford it.
Roskopf’s project—ridiculed by many—eventually succeeded due to significant changes: usage of the cheapest metals, leaning of the production (smaller number of parts and economic factor usage), and two important parts, the so called pin-pallet escapement and porte-échappement. All those things were not entirely new, and were produced previously. Roskopf’s breakthrough was fitting the idea into the pocket watch to massively produce a cheap final product (Buffat, 1914, pp. 9–10). He tried to cooperate with many people in the business, but it required them to alter existing habits to accept orders for creating necessary components. While experiencing various forms of resistance he was inclined to create the watch on his own, but eventually decided to cooperate with other factories and existing suppliers (ibid., pp. 11–12, 14–18).
The “worker’s watch” proves that Bylund is entirely on spot with treating the firm as a praxeological concept, since it is organized around a specific entrepreneurial idea. At the same time, it does not have to bring creative destruction to the current extent of the market. The firms are driving agents of markets that more or less evolve—and they are also at center of markets that are very sluggish in evolving. Most of the firms are going bankrupt, especially the most innovative ones. They go out of business because other firms survive and make better judgments. Just as a firm may be an entity of innovation, it also may be an entity of conservation and keeping of the existing routines. Knowing when and where to rebel against the status quo is key to entrepreneurial success. Sometimes repetition is key, sometimes mutation is, and firms are the only agents to test out various business strategies for flourishing and survival. Keeping production functions stable is also a deliberate choice.
Bylund, perhaps unintentionally, puts (correctly) an argument on its head. For many years classical economists and later Marxists argued that profits are a derivative of economic process with wages being fundamental variables. The reality is that profits are logically and economically prior to the wage fund. Bylund is offering a similar revolution in the theory of the firm. For decades the literature has been tangled in a limiting Coasian narration: firms develop as derivatives in the market—as islands of planning and hierarchical power. Bylund proposes the other route: markets are developed as derivatives of imaginative entrepreneurs, creating those organizations called “firms.” By changing the perspective in such way, we are offered another deadly blow to the neoclassical framework.
The author has constructed a beautifully crafted Austrian argument, but at times it leans slightly too much towards Schumpeter (Bylund, 2016, pp. 83–84, 100, 109, 131, 136).Schumpeter’s original point is of course in Schumpeter ([1913] 1934). I cannot see that as an important shortcoming, however, since his point can easily be extended to be in full compliance with Mises’s notion of an entrepreneur: the firm is an agent of any economic choice, since repetition is also an entrepreneurial choice shaping the market. Perhaps we could paraphrase Rothbard’s response (2004, p. 494) to Schumpeter and argue that firm is an adjuster, not just narrowly interpreted innovator.That can coincide with Rothbard’s line about “decision-making function, or the ownership function” for which the owner receives income (Rothbard, 2004, p. 602)—income that is outside of interest income. That would also fully comply with Klein and Foss’s framework of seeing the firm as the “organized entrepreneurial judgment” in the environment of heterogeneous capital resources.
To conclude, I believe Bylund did offer a new theory of the firm: unlocking theory. I am not the one to make a strong judgment on the topic, but cannot wonder if we are seeing a genuine contribution to the subject that should be seriously considered by experts in the field.
ABSTRACT: In his recent book, Money, Interest and the Structure of Production (Machaj, 2017), Mateusz Machaj advances two significant criticisms of Mises’s theory of time preference and his pure time preference theory of interest (PTPT). First, he claims that time preference only exists under certain unrealistic conditions, and second, that the PTPT, as presented by Mises, is unable to provide a coherent explanation for the spread between the prices of inputs and output that characterizes production processes in a monetary economy. In this paper I present a brief defense of Mises’s conception of time preference and of his PTPT from both of these criticisms. I argue that, contrary to Machaj’s claims, the existence of time preference does not require any unrealistic assumptions and also provide an analysis of how the PTPT can provide a satisfactory explanation of the monetary surplus that permeates the production structure.
KEYWORDS: time preference, interest, production, Austrian economics JEL CLASSIFICATION: B53, E14, E23, E43 G.P. Manish (gmanish@troy.edu) is associate professor of economics at Troy University. Quarterly Journal of Austrian Economics 21, no. 2 (Summer 2018) full issue, click here. I. INTRODUCTION Mateusz Machaj’s Money, Interest and the Structure of Production (Machaj, 2017) is a welcome addition to the recent groundswell of works on Austrian macroeconomics. In this book Machaj covers a broad range of topics, some of them theoretical, such as the theory of interest, the inter-temporal structure of production, and the relationship between the rate of interest and the length of the production structure, along with others that are more policy-oriented, including an analysis of the cogency and practical relevance of popular macroeconomic concepts such as potential output and full employment, and the implications of the non-neutrality of money for monetary policy. The entire range of topics is covered in a manner that is intellectually courageous, provocative and thought provoking.
In part I of the book, which comprises two chapters on the theory of interest (Machaj, 2017, pp. 3–36) and on the inter-temporal structure of production (Machaj, 2017, pp. 37–86), Machaj advances a number of criticisms of traditional Austrian macroeconomics. In the first chapter, in addition to presenting an original theory of interest, Machaj focuses his critical ire on the theory of time preference as presented by Böhm-Bawerk (Böhm-Bawerk, 1930, pp. 237–281) and Mises (1998 [1949], pp. 476–487), and on the pure time preference theory of interest (PTPT) as advanced by the latter (Mises, 1998 [1949], pp. 521–534).It should be noted that Machaj is not alone in doing so. Prominent recent critics of the theory of time preference and of the PTPT also include Lewin (1997), Hülsmann (2002) and Gunning (2005). And in the second chapter, he presents a detailed and highly critical analysis of a proposition that has long been of great importance to the Austrian of economic growth and business cycles: the inverse relationship between the rate of interest and the length of the structure of production.In doing so Machaj builds on the critical analysis of this proposition advanced by Fillieule (2007) and Hülsmann (2008; 2010).
In this paper I present a brief defense of Mises’s theory of time preference and the PTPT from the criticisms advanced by Machaj. In doing so, I do not explicitly address his criticisms of the relationship between the rate of interest and the length of the structure of production.See Newman (2014) for a recent defense of the traditional Austrian position of this subject. Nevertheless, I do so implicitly, since the PTPT, especially as advanced in its most refined form by Mises, is critical to understanding the nature of this relationship. In fact, it is the PTPT that provides the microeconomic, price theoretic foundation to the traditional Austrian position that these two variables share a negative relationship.This, for example, is the position advanced by Hayek (2008 [1931]), Mises (1998), Rothbard (2009) and Garrison (2001). Thus, it is no surprise that Machaj, having rejected the PTPT, is also highly critical of the traditional Austrian position on the relationship between the rate of interest and the length of the structure of production.
II. MISES AND THE PURE TIME PREFERENCE THEORY OF INTEREST: THE TWO IMPORTANT CRITICISMS OF MACHAJ There are two main charges that Machaj levels against Mises’s pure time preference theory of interest (PTPT). First, he claims that the theory of time preference, including the one advanced by Mises, can only be worked out under certain unrealistic and unrealizable conditions. “With typical time preference theory,” Machaj notes, “one has to assume very sophisticated and quite unrealistic clauses about the other things being held equal […]” (Machaj, 2017, p. 27). Along with the assumption that “people compare two identical goods that are non-perishable and do not change,” he argues that the theory also makes two patently unrealistic assumptions: first, that “the circumstances surrounding them [the people: GPM] also stay the same, except for the passage of time,” and second, that there is “full certainty and predictability of future states of affairs” (Machaj, 2017, p. 27).To support these claims, Machaj, immediately after the passage cited here, provides a reference to a paper by Peter Lewin (Lewin, 1997). In order to avoid any potential misunderstandings, I would like to clarify that the criticisms offered in this paper only address the claims made by Machaj and not those made by Lewin in the paper that is referenced.
Two important implications follow from the unrealistic assumption of perfect certainty. First, time preference can only explain the rate of originary interest, or the rate of interest as it appears within the confines of the evenly rotating economy (ERE), where there is a uniform rate of return in every production process. And since the imaginary construct of the ERE is built on the assumption of perfect certainty and predictability of the future,For a detailed explanation of the assumptions underlying this imaginary construct see Mises (1998 [1949], pp. 247–251) and Rothbard (2009, pp. 320–329). it follows that the theory of time preference can only explain the rate of return that appears within the production structure under these artificial conditions, and is unable to explain the price spread between input and output that permeates the production structure in the real world characterized by uncertainty.
Second, adherents of the PTPT cannot explain how the rate of originary interest comes to be what it is. As Machaj notes, if the theorist is confined to explaining interest only in the ERE and has no explanation of the interest rate that appears within the production structure in the dynamic and uncertain world of reality, there is no way for him (or her) to provide any coherent and meaningful explanation of why the rate of originary interest is what it is. In such a scenario, the theorist is forced to acknowledge that the rate of interest within the ERE “is equalized not by the mechanisms of the model but merely by the assumptions of the model: everything is the same because everything is the same” (Machaj, 2017, p. 25).Mises advances a similar criticism of economists who focus purely on an analysis of the ERE, thereby assuming uncertainty away from their analysis. See Mises (1998 [1949], pp. 352–354).
Now, this first charge that Machaj levels against the PTPT, while restricting its scope to the imaginary world of the ERE, at least assumes, albeit implicitly, that the theory can actually explain the rate of originary interest that characterizes such an economy. The second and stronger charge that Machaj levels against the PTPT, however, denies even this possibility. The PTPT, he claims, cannot even explain the rate of originary interest. And why is it unable to do this? Because the concept of time preference simply cannot explain why there should be a monetary surplus that characterizes any production process, even in the ERE.
While Machaj accepts that time preference is indeed “an element of a pure theory of action,” he argues that there is “a gap” between accepting this proposition and “making it a prerequisite for physical monetary surplus” (Machaj, 2017, p. 25). In fact, as he goes on to note, “there is no clear bridge between a preference for sooner rather than later and a physical surplus of money in interest payments” (Machaj, 2017, p. 26). Thus, consider a production process where a capitalist-entrepreneur pays out 100 units of money today to hire various factors of production. An acceptance that his actions are guided by the concept of time preference does not in any way imply that he will sell his output tomorrow for a sum that is greater than 100 units, thereby earning some positive rate of return. Instead, “the transaction could well be 100 units of money today in exchange for 100 units tomorrow, such that monetary interest is zero.” Or, in fact, “interest could even be negative: 100 units today for 95 units tomorrow” (Machaj, 2017, p. 26).
Thus, Machaj throws a one-two punch at Mises’s PTPT. The first attacks the conditions under which the concept of time preference holds true, and the second focuses on the implications that can be derived from the concept itself. In the following two sections I will try to defend Mises’s exposition of time preference and the PTPT from both of Machaj’s criticisms. In doing so, I will begin with a defense against the initial blow, regarding the realism or lack thereof of the conditions under which the concept of time preference itself holds true, and will then deal with the second criticism, which focuses on whether the existence of time preference can explain a monetary surplus within a process of production.
III. HUMAN ACTION, VALUE JUDGMENTS AND VALUE IMPUTATION Before dealing with the specific criticisms that Machaj advances against the Misesian PTPT, I think it is important to mention and explain some important implications that follow from the existence of human action. These propositions, although they belong, first and foremost, to the realm of praxeology, and thus take us beyond the realm of catallactics, are still worth laying down in some detail since they are essential to my defense of Mises’s exposition of the theory of time preference and the PTPT.
Human action, as Mises defines it (Mises, 1998 [1949], p. 10), is purposeful behavior. It is the purposeful reaction of an individual to his (or her) environment and involves an attempt, on the part of this individual, to alter this given environment and to replace it with a different state or situation.
Such purposeful behavior, as Mises goes on to note (Mises, 1998 [1949], pp. 13–14), implies the existence of certain conditions. Action, to begin with, requires an individual to be less than fully satisfied. He must, in a given situation, be aware of certain unfulfilled wants, and must experience “some uneasiness” (Mises, 1998 [1949], p. 13). Given this lack or insufficiency in the conditions that define his existence, the individual must be aware of alternate states of the world that will enable him to satisfy one or more of these unfulfilled wants. Moreover, these alternate states must, in his eyes, be realizable and worth striving towards.
The ultimate goal or the ultimate purpose of all action, it follows, is the satisfaction of some unfulfilled wants, or the removal of the uneasiness that the actor experiences. Action, however, also requires the actor to choose between alternate states of satisfaction. It forces him to prefer and strive after one possible state of the world and the satisfaction that it opens up, and to renounce another realizable state of the world and the satisfactions that it has to offer.
These preferences, first and foremost, rank the ultimate goals of action: the alternate states of satisfaction that the actor has to choose between in any given situation. One or more unfulfilled wants that offer greater satisfaction are deemed to be of more importance to the actor’s well-being, and of greater value to him, and are ranked above other unfulfilled wants that offer less satisfaction and are valued less. These valuations then guide the conduct of the actor. Of two possible paths of conduct open to him at any given moment, he chooses the one that allows him to satisfy the wants that he values more, while renouncing the path that promises less value.
Now, although the actor attributes value to the possible states of satisfaction that he can bring about, he also necessarily imputes and attributes this value to the means that he uses to attain these states of the world. For, although the attainment of a state of satisfaction is the ultimate goal for an actor, he finds himself in a situation where these states of satisfaction are unattained or unfulfilled. And, it is in this current, given scenario that he plans to employ certain scarce elements in his environment, or means, to try and attain these ultimate ends. As a result, the value that he attributes to these states of satisfaction is also imputed to the means that enter into his action.
This holds true both for actions involving consumer goods, or first order goods, and for actions that involve producer goods, or higher order goods.For a detailed analysis of the valuation of first and higher order goods in a scenario of economic self-sufficiency, see especially Menger (2007 [1871], pp. 114–174), Böhm-Bawerk (1930, Bk. III) and Rothbard (2009, pp. 17–46). Thus, consider the case of Crusoe, all alone on his island, using a fish in his possession to satisfy a want. Since the fish, by assumption, is a first order good, the value that Crusoe attributes to it will be a reflection of the value that he attributes to the marginal utility that he expects to attain with it. The want that he will use it to satisfy has some importance to his well-being, and this importance is directly imputed to the fish at hand.
Now, consider a situation where Crusoe employs an hour of his labor-time to start producing a raft. When completed, he will use this raft to catch some fish. On what will the value of this first hour of labor devoted to raft production depend? The value of the services of the raft that it helps produce will be imputed to it. Thus, the value of the third order good, the hour of labor-time, reflects the importance that the second order good, the services of the raft, has for Crusoe’s well-being. And on what does the value of this second order good depend? It, in turn, reflects the value of the fish, or the first order good that can be produced with it, and therefore the value of the states of satisfaction that the fish will help Crusoe attain.
IV. CHANGE, UNCERTAINTY AND TIME PREFERENCE Just as action requires the actor to make value judgments, it also implies the existence of time preference. Since the actor strives towards the gratification of an unfulfilled want, it follows that he prefers to satisfy this want in the nearer as compared to the more distant future. And since the attempt to gratify an unfulfilled want is essentially an attempt to attain a state of satisfaction, it follows that, in the eyes of the actor, “other things being equal, satisfaction in a nearer period of the future is preferred to satisfaction in a more distant period” (Mises, 1998 [1949], p. 480). An individual’s actions necessarily reflect time preference: at any given moment, he attributes greater importance and more value to satisfaction that lies relatively close at hand, and less value to satisfaction that lies further away in time.As Mises argues, individuals “value fractions of time of the same length in a different way according as they are nearer or remoter from the instant of the actor’s decision…. If any role at all is played by the time element in human life, there cannot be any question of equal valuation of nearer and remoter periods of the same length” (Mises, 1998 [1949], p. 480).
Given that time preference is implied in every act, the conditions under which it exists or manifests itself will necessarily be identical to the conditions that necessitate action. Keeping this firmly in mind, let us now analyze Machaj’s first criticism of Mises’s PTPT, i.e., that time preference only exists under the unrealistic conditions that “circumstances…stay the same except for the passage of time” and that there is “full certainty and predictability of future states of affairs” (Machaj, 2017, p. 27).
Let us begin by clarifying the meaning of the first assumption. When Machaj states that “the circumstances surrounding them [the people: GPM] stay the same except for the passage of time” (Machaj, 2017, p. 27), I am going to assume that he means the following: the theory of time preference assumes that, when an individual acts, no changes in circumstances or conditions that are exogenous to the action itself can take place. To be sure, every action itself is an agent of change and implies an alteration in the conditions surrounding the actor. In fact, to effect such changes is the overarching goal of action. But no changes in an actor’s environment that are unrelated to the specific act that he undertakes are allowed.
Now, given that time preference is implied in human action, the veracity of Machaj’s claim can be assessed by answering the following question: does action require such an assumption? Does the existence of action require one to assume that only changes endogenous to action can take place and no changes that are exogenous to it can impact the environment of the actor? For, if this condition is not necessary for the existence of action, it is also not implied in Mises’s theory of time preference.
Turning now to the conditions necessary for the existence of action that I have mentioned earlier (Section III), one finds that action only assumes that there are unfulfilled wants. It does not, however, require any assumption regarding the lack of changes exogenous to action. Indeed, such changes can and indeed necessarily do buffet the world of the actor. But all that action assumes is that, despite such changes, the actor perceives and believes that there will still be certain unfulfilled wants. And it is only the existence of these ungratified wants that are necessary for him to act.
Now, what about the second unrealistic assumption? Does the theory of time preference assume away the endemic uncertainty that characterizes the real world? Once again, given that time preference is implied in the fact that human beings act, we can determine the validity of Machaj’s claim by answering the following question: does action imply perfect certainty? For, if this is not a necessary assumption for the existence of action, then it is also not a necessary assumption for the existence of time preference.
The answer to this question has been given, and given quite emphatically, by Mises in Human Action (Mises, 1998 [1949], pp. 105–106). Far from action requiring full certainty and predictability of the future, it is, in fact, impossible for any action to take place in a world characterized by perfect certainty and predictability of the future. Indeed, as Mises notes, “if man knew the future, he would not have to choose and would not act” (Mises, 1998 [1949], p. 105). Far from being a striving, purposeful creature, man, under these conditions, “would be like an automaton, reacting to stimuli without any will of his own” (Mises, 1998 [1949], p. 105).
Thus, far from perfect certainty being a necessary condition for action, it is the uncertainty of the future that is “implied in the very notion of action” (Mises, 1998 [1949], p. 105). And since the conditions necessary for the existence of action are also those that are necessary for the existence of time preference, it follows that Machaj’s claim that the latter exists only under the unrealistic conditions of “full certainty and predictability of the future state of affairs” is not true. Time preference exists and influences the actions and choices of individuals in the dynamic, real world of change and uncertainty.
Two important implications follow from this. First, since time preference does not appear only in the artificial and unrealistic thought construct of the ERE and does manifest itself in the real world that confronts acting man, it does, assuming that it can explain the price spreads that permeate the production structure, help explain the phenomenon of interest as it appears in the real world. And second, since it does influence the actions undertaken in the real world, and thus does influence the allocation of resources within the production structure, it does play a role in analyzing the step-by-step process by which the ERE would emerge and interest rates in the various processes of production would be equalized, if tastes, techniques and the stock of the original factors of production (land and labor) were assumed to be given.
Thus, the theorist who espouses the Misesian version of the PTPT does not, contrary to what Machaj claims, conclude that price spreads within the production structure are equalized in the ERE “merely by the assumptions of the model,” and “not by the mechanisms of the model.” And he is certainly not forced to conclude “that everything is the same because everything is the same” (Machaj, 2017, p. 25).
V. TIME PREFERENCE AND MONETARY SURPLUS WITHIN THE PRODUCTION STRUCTURE 1. Time Preference and the Value Spread Between Input and Output: The Case of a Crusoe Economy
The existence of time preference has important implications for the process of value imputation. Let us reconsider the case of Crusoe devoting an hour of labor to the production of a raft. As discussed above, both the value of the labor-time as well as the value of the services of the raft produced with it depend, proximately, on the value of the fish, and ultimately, on the value of the unfulfilled wants that these fish will help satisfy.
Nevertheless, although the services of the raft and the hour of labor-time both ultimately derive their value from the same states of satisfaction, their values will not be equal. The hour of labor that Crusoe plans to devote, right now, to the production of the raft is of less importance to his well-being, and therefore of less value to him, than the services of the raft that it helps produce. The cause of this spread or difference between the value of the input, the hour of labor, and the value of the output, the services of the raft, lies in how far away each of them is, in time, to the ultimate goal of Crusoe’s action: the attainment of satisfaction.For a more detailed discussion of this point see Böhm-Bawerk (1930, pp. 179–185).
Assume that it takes two days of labor-time for Crusoe to produce the raft. It follows, therefore, that when he is about to devote an hour to start its production his ultimate goal lies more than two days away. But when he has finished producing the raft, the services of it that this first hour helped produce are a few hours, or maybe just a few minutes away from the attainment of some satisfaction.
Now, as mentioned above, time preference implies that Crusoe, when embarking on a course of action, attributes greater importance and value to states of satisfaction that lie in the nearer future and less importance to those that lie further away in time. In this instance, the hour of labor-time contributes, ultimately, to the gratification of some unfulfilled wants that lie in the more distant future, whereas, the services of the raft, once it has been completed, help him to attain satisfaction in the nearer future. It follows, therefore, that at the moment when he is about to start producing the raft, he values the services of the raft more than the services of the hour of labor-time that help produce them; to the former he attributes the greater value of satisfaction that lies in the nearer future, and to the latter he imputes the lower value of satisfaction that lies in the more distant future.
- Time Preference and the Price Spread between Input and Output: The Case of a Monetary Economy
Turning our attention now to a monetary economy, consider the case of a capitalist-entrepreneur and his actions in the market for a producer good. Just as in the case of Crusoe, the value that the capitalist attributes to a unit of the good in question is ultimately determined by the contribution that it can make to the ultimate goal of his (or her) actions: the gratification of unfulfilled wants and the attainment of states of satisfaction. However, given the existence of the division of labor and specialization, the path that the capitalist takes to achieve this ultimate goal is very different from the one taken by Crusoe.
In Crusoe’s self-sufficient world, a unit of a producer good is utilized by him to produce a first order good either directly or indirectly, and then attain some satisfaction. As a result, the value of the producer good depends, proximately, on the consumer good that he produces with it, and ultimately, on the satisfaction that he can attain with the latter. The capitalist, acting in a different institutional scenario, uses a unit of the producer good to produce a product that he sells for a sum of money. He then proceeds to use this money to purchase consumer goods produced by other capitalists. These consumer goods, in turn, are used by him to gratify unfulfilled wants and to attain states of satisfaction.
The value of a unit of the producer good to the capitalist, it follows, depends proximately on the value of the sum of money that it helps him attain, and ultimately on the value of the states of satisfaction that it enables him to bring about. The value of the satisfaction that he can ultimately attain is imputed, via the consumer goods, to the sum of money, and finally to the unit of the producer good in question.
Now, the existence of time preference has significant implications for this process of value imputation. Assume that the capitalist, in his estimation, can earn 100 units of money by hiring and employing a unit of the producer good in a process of production. Thus, both the unit of the producer good and the 100 units of money derive their value from the satisfaction that they enable the capitalist to ultimately attain. Nevertheless, due to the existence of time preference, there is a difference in the value that he attributes to these two things. The 100 units of money that he expects to earn at the end of the production process, which is the marginal value product that he expects the unit of the producer good to contribute to his possessions, is of greater importance to his well-being than the unit of the producer good that helps him acquire this sum of money.
As in the case of the labor-time and the services of the raft considered above, there is a difference in how far away in time the 100 units of money and the unit of the producer good is to the capitalist’s ultimate goal of attaining satisfaction. Thus, assume that the production process takes a year to complete. The unit of the producer good, it follows, will take a year to yield the expected marginal value product of 100 units of money. At the moment when the capitalist hires this unit, the attainment of satisfaction lies more than a year away. However, once the product has been produced and the 100 units of money is in the hands of the capitalist, satisfaction lies merely a few days, or only a few hours away.
Thus, at the moment when the unit of the producer good is hired by the capitalist, it contributes to satisfaction in the more distant future, whereas the sum of money that it is expected to yield, once it is in hand, helps the capitalist attain satisfaction in the relatively near future. Given that he attributes greater importance and value to satisfaction that lies in the near future and less value to satisfaction that lies in the more distant future, it follows that he values its services less than he values the 100 units of money that he expects it to yield: at the moment when he hires the unit of the producer good, he attributes to the former the lower value of satisfaction that lies in the more distant future, whereas he imputes to the latter the greater value of satisfaction that lies closer at hand. As a result, the capitalist would only be willing to part with less than 100 units of money to hire the unit of the producer good.
Other capitalists competing to hire the unit of the producer good will be in a similar position. Due to the existence of time preference, they too would only be willing to offer the discounted marginal value product of the unit in question. Each of them would only be prepared to offer a sum that is less than the revenue that the unit of the producer good is expected to yield in the various production processes that they wish to embark upon.
Thus, contrary to the claim made by Machaj, time preference does provide an explanation for the existence for the spread between revenues and costs, or for a monetary surplus, within a production process. Specifically, it explains the ex ante existence of such a surplus or spread when the capitalist-entrepreneurs enter the markets for producer goods and bid for their services. Ex post, or after the product has been produced and sold, however, such a surplus may or may not characterize a production process due to the uncertainty that characterizes the real world. The actual, ex post rate of return consists of a mix of the rate of interest, owing to the influence of time preference, and profit (or loss), owing to the influence of the uncertainty that plagues the estimates of the marginal value products of the various producer goods.See Rothbard (2009, pp. 509–516) for an insightful discussion of this point.
It is only in the imaginary world of the ERE, where there is no uncertainty, that the ex ante and the ex post align, and where the surplus due to time preference appears in its pure form, distinct from profit and loss.See Rothbard (2009, pp. 367–410) for a detailed analysis of how the interaction of the valuations of the various participants in the time market that permeates the production structure gives rise to the rate of originary interest within each production process in the ERE. Nevertheless, time preference does influence the actions of the capitalists in the markets for producer goods even in the real world and does influence the bids that they are willing to make for their services, even in the presence of uncertainty regarding their estimations of the marginal value products involved.
VI. CONCLUSION In his recent book, Money, Interest and the Structure of Production (Machaj, 2017), Mateusz Machaj advances two significant criticisms of Mises’s theory of time preference and his pure time preference theory of interest (PTPT). First, he claims that time preference only exists under certain unrealistic conditions, and second, that the PTPT, as presented by Mises, is unable to provide a coherent explanation for the spread between the prices of inputs and output that characterizes production processes in a monetary economy.
In this paper I present a brief defense of Mises’s conception of time preference and of his PTPT from both of these criticisms. I argue that, contrary to Machaj’s claims, the existence of time preference does not require any unrealistic assumptions and also provide an analysis of how the PTPT can provide a satisfactory explanation of the monetary surplus that permeates the production structure.
Per Bylund explains the many contributions of Jean-Baptiste Say (1767–1832), a precursor to the Austrian school of economics. Today, Say is most well known for his “law of markets” which is now referred to simply as “Say’s Law.” Often misstated as “supply creates its own demand,” the law is that we produce and supply to the market in order that we may demand other goods in exchange. Production, therefore, is an indirect means to attain the goods and services we desire to meet our needs.
Say also made contributions in the theory of money, including how it emerges spontaneously, and why the commodity serving as a medium of exchange needs characteristics of durability, divisibility, and high value per unit, with the choice of commodity should be left to consumer preferences. Other highlights include his distinction between banks of deposit and banks of circulation.
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[Full issue of the Quarterly Journal of Austrian Economics 20, no. 4 (2017)
ABSTRACT: Although Austrian literature does not usually dwell on this particular aspect, there are differences between the direct investment of savings and adding to one’s personal cash balance (hoarding). Following Bagus’s (2016) critic of my original article, the present paper will introduce supplementary qualifications. I will argue that in the course of ordinary business activity, there is no (plausible) reason why hoarding should imply disinvestment. Furthermore, I claim that the market rate of interest is the main indicator for entrepreneurs in a developed society which uses an advanced credit system. Finally, the paper will summarize the differences between investment and cash building and put these differences in connection to economic growth in order to see whether any of the two methods offers additional benefits.
KEYWORDS: Austrian school, market rate of interest, structure of production, investment, economic growth, hoardingJEL CLASSIFICATION: B13, B53, E14, E22, E31, E41, E43, O40INTRODUCTIONIn “A Comparison of Direct Investment of Savings and Cash Building of Savings” Philipp Bagus (2016) makes a thorough critique of my original article which attempted to analyze the intricate relation between hoarding, investment and economic growth. Interestingly enough, it appears that we generally agree regarding the differences between hoarding (or cash building, as Bagus [2016] prefers to call it) and investment, but we are at odds concerning the demonstration I employed in the original article, which was meant to show that investment would be more swift in promoting growth.
The original article (Pătruți, 2016) employed a Wicksellian framework that focused on the divergence between the natural rate of interest (NRI) and the market rate of interest (MRI) in order to point out the different effects of hoarding and respectively investment. This type of investigation is customary to the Austrian school, since it supplies the keystone for business cycle theory (Mises, 1998; Hayek, 2008). It is certainly not new, but it has not been applied, to my knowledge, to this specific issue in a coherent fashion.
The general claim I made was that the real movements in the structure of production could be affected by monetary frictions determined by individual hoarding. In this sense, directly investing the savings through the banking system would appear as a “preferable” alternative that could temper these short-term frictions.
In his reply to my original article, Bagus (2016) first raised a number of critical remarks regarding the two scenarios1 I used and afterwards identified, correctly in my opinion, additional differences between the two phenomena. In the present paper I will first restate my thesis by incorporating as much as possible of the pertinent observations made by Bagus, in the belief that our differences are not as many as would originally appear. Secondly, I will attempt a rejoinder of the conclusions regarding the differences between hoarding and investment and their effect on potential growth.
THE CRITIQUEThe main observations raised by Bagus (2016) are, to my understanding, the following: that (1) I overstressed the importance of the MRI, that (2) cash building by saving does not necessarily imply a longer time period and that (3) cash building does not necessarily stem from saving. I will try to address all of them in an orderly fashion.
Restating the original analysis comprising the two scenarios would be superfluous, since I believe that generally Bagus should find it acceptable. The only critique I could find was that I was somewhat “vague” regarding the explanation of the real adjustment process of the structure of production in the second scenario (Bagus, 2016, p. 364). If this was the case, the only reason I had for that was brevity. I fully agree that the real processes of readjustment in the structure of production are the fundamental phenomena and that monetary processes are derivatives. I fully concede to his additions in this sense to my text. However, just claiming that “These spreads between buying and selling prices are the most fundamental phenomenon. The market rate of interest is just a derivative of this phenomenon” (Bagus, 2016, p. 365) does not solve the problem. It is clear that the natural rate of interest is the fundamental phenomenon, but entrepreneurs have no knowledge of this magnitude, which is more or less a theoretical concept. The signal they can use in practice is the market rate of interest. As Hayek (2008, p. 264) puts it:
But there is one medium through which the expected ultimate effect on relative prices should make itself felt immediately, and which, accordingly, should serve as a guide for the decisions of the individual entrepreneur: the rate of interest on the loan market.
This is the reason why I stress the importance of the market rate of interest (1), even though the pure rate of interest is the fundamental phenomenon. The belief that adjustment of relative prices in the structure of production is a slow and time consuming process is also documented by Hayek2 (2008, p. 264):
As the initial changes in relative prices which are caused by a change of the relative demand for consumers’ goods and producers’ goods give rise to a considerable shifting of goods to other stages of production, definite price relationships will only establish themselves after the movements of goods have been completed. For reasons which I shall consider in a moment, this process may take some time and involve temporary discrepancies between supply and demand.
This additional argument should suffice, in my opinion, to show why I stress the importance of the MRI and why it would be a faster tool in promoting growth. Would it be impossible for entrepreneurs to anticipate/speculate the change in cash balances? Of course not. As Bagus (2016, p. 368) claims:
Market participants can anticipate effects of cash building on prices and bid a negative price premium into the market rate of interest. Therefore, there is no necessary time lag. In the case of cash building through an increase in saving, the market rate of interest rate can fall immediately if the increase in purchasing power is correctly anticipated.
But to my understanding, this is nothing else than presuming perfect foresight on behalf of the entrepreneurs and, paraphrasing Keynes, “assuming our problems away.”3 It is in this spirit that I claimed that hoarding “necessarily” involves a time lag (2).
Regarding the last comment raised by Bagus, respectively that hoarding does not necessarily stem from saving (3), it would probably be best to start by pointing towards two premises that I employed in the original scenarios, but which I probably failed to stress enough. My original analysis refers to a society in which there is a smooth operating credit system (banks, stock exchange) during normal business activities. A smooth operating credit system is the prerequisite of a developed economy, as Strigl (1934, p. 111) colorfully explains:
Clearly, the introduction of credit makes a significant increase in economic returns possible, because the interpersonal transfer of capital will make it easier to direct capital into those usages in which its return—and consequently also the return from the other cooperating factors of production—will be greater. It is clear that only a smoothly operating credit market, or one operating with the least possible friction, will provide the prerequisite for “correctly” taking advantage of the supply of capital in the economy. Finally, it is also clear that a fully developed credit market is the prerequisite for the formation of a uniform interest rate, and that only a uniform interest rate makes the reliable calculation for the use of capital possible. Although we have said that credit is not a necessary prerequisite for an exchange economy using capital, we must qualify this here by adding that the institution of credit is certainly an adequate prerequisite for a relatively developed economy using roundabout methods of production.
Of course, I fully concede Bagus that if entrepreneurs would directly invest their savings, the MRI would be irrelevant. Credit would actually be irrelevant in that case. But such a society does not resemble our society at all. All I tried to show was that during normal business activity, in a society which uses an advanced credit market, the MRI could be a more efficient tool for entrepreneurs than waiting for the movements in relative prices to run their full course, due to an increase in the value of money.
I say ordinary business activity (and this relates to claim [3]), because the only examples that Bagus (2016, p. 363) can find in which hoarding implies disinvestment—i.e., it stems from investments—are bank runs, looming wars, internal riots and natural disasters.
Finally, there is only one more argument which I preferred to address last because, surprisingly, it does not have an economic nature but rather an ethical one. Bagus claims: “But who is to say what is optimal and what is not? From whose perspective is an action optimal?” I assume that I triggered this kind of reaction because if hoarding would be considered suboptimal, it would automatically result that the recommended policy program would be some sort of tax on cash holdings. Perhaps I did not stress enough that this was not my policy suggestion in the original article. I do not think that it would be useful or recommended to coerce people to put their money in the banks. I just consider that it would be advantageous for them to know that if they did (of course, considering that the banking system is healthy), they would indirectly contribute to faster economic growth.4 Of course, if people desire economic growth, i.e. an increase in material prosperity, hoarding would not be optimal. If the “uncertainty avoidance,”5 as Bagus puts it, caused when keeping cash around is greater than the desire for potentially faster growth, hoarding becomes the optimal solution. But considering that individuals usually want to increase the quantity of consumer goods that they own, investing through the credit system would probably bring these goods faster to their doors.
A REJOINDER REGARDING THE DIFFERENCES BETWEEN HOARDING AND INVESTMENTIn the previous section, I included additional qualifications to my thesis in the attempt to clear away most of the problems raised by the systematic critique made by Bagus (2016). In this second part I am left with the relatively easy part of summarizing the differences between hoarding and investment, an area in which Bagus actually brought more detailed contributions than myself.
First, hoarding implies a (monetary) tendency of prices to fall and implicitly generates Cantillon effects, as Bagus (2016, p. 370) points out. The positive feedback loop which he mentions, i.e. the fact that deflation encourages hoarding and that hoarding generates deflation, is a compelling argument. If this were the case, negative effects such as the redistribution of wealth associated with changes in purchasing power would be unavoidable.
Second, there is an additional selection process regarding which entrepreneurs will benefit from the credit pool. I am indebted to Bagus (2016) for pointing out this effect. Specialized intermediaries such as banks do tend to spend time and effort in choosing good entrepreneurs, as opposed to the case of hoarding in which the increase in purchasing power indiscriminately benefits all entrepreneurs, good and bad.6
Third on the list is what I referred to as the “wholesaler” argument, i.e. the fact that the pooling of resources can direct huge amounts of credit to specific large scale investments which could not be available by direct investment. This is, to my mind, an argument distinct from the one above.
The fact that investment can foster a more stable structure of production than hoarding is a fourth difference. I was not aware of this argument, based on the theory of maturity mismatching (Bagus and Howden, 2010), in my original article. The idea is, if I understand correctly, that savers committed to long term projects give entrepreneurs an increased assurance for undertaking longer production processes. The longer the maturity of the deposit, the safer it is for businessmen to invest, because it is less likely that the saver will withdraw his money. Cash holdings, on the other hand, have zero maturity and the owner can instantly change his mind and consume the saved resources.
Finally, keeping in mind the additional qualifications I added to the original thesis, I still hold to the idea that investment would generate faster economic growth as compared to building up cash holdings. If the market is an evolutionary (and implicitly time-consuming) process through which entrepreneurs learn by trial and error which investment projects best serve consumer preferences, a swift adjustment of the market interest rate should help them in their endeavors, given that they do not possess full knowledge. In fact, all the above arguments produced by Bagus, i.e. the tamping down of the Cantillon effects, the additional selection process and the fact that we get a more stable structure of production, all add to the idea of optimality.7
[Full Issue of the Quarterly Journal of Austrian Economics 20, no. 4 (2017)]
ABSTRACT: According to Hayek’s “theory of the Ricardo Effect” there is a “decline of investment” on the part of the consumer goods industries that starts halfway through the cyclical upswing. This “decline of investment” then gradually leads to the “scarcity of capital” in the consumer goods industries, which is the proximate cause of the upper turning point. This thesis was hardly made convincing by Hayek. I develop the theory of the Ricardo Effect by rebuilding it around the alternative theses that a decline of investment by both the machine producing industries and the raw materials industries leads to the “scarcity of capital.”
KEYWORDS: Ricardo Effect, Austrian Business Cycle Theory, upper turning point, circularities, structure of production JEL CLASSIFICATION: D24, D25, E14, E22, E32 , E51, G31 1. INTRODUCTION The concrete thesis in Hayek’s theory of the Ricardo Effect is that the business cycle’s upper turning point is brought about by a decline of investment in fixed capital on the part of the consumer goods industries, a decline that starts during the upswing. To Hayek, the upswing begins with a credit-induced “acceleration effect,” a somewhat exaggerated demand for machinery by the consumer goods industries. Roughly halfway through the upswing, falling real wages make investment in machinery less attractive. This is the “Ricardo effect,” which counteracts the acceleration effect. The decline of investment, on the part of the consumer goods industries, commences. Labor is reallocated from the machine producing industries to the consumer goods industries, because the funds destined for capital expenditure are reallocated to additional operating expenditure. There is increased capital utilization in the consumer goods industries in the latter half of the upswing, which initially strengthens the boom. However, the decline of investment leads in the longer run to a crisis, because machines in the consumer goods industries are not replaced once worn out, or only replaced by less-labor saving machinery. This eventually causes a diminished productive capacity in the consumer goods industry, a “scarcity of capital.” The decline in investment spending leads, of course, also to a slump in the machine producing industries.
Hayek’s thesis that a decline of investment by the consumer goods industries would take place, starting roughly halfway through the upswing, was hardly made convincing by him. His theory of the Ricardo Effect has generally not been well received (Klausinger, 2012, pp.15–24). I also believe that this concrete thesis is largely incorrect. But when Hayek’s theory of the Ricardo Effect is looked upon more broadly than by just focusing on this concrete thesis, I believe it contains a lot of material that would support an alternative thesis that very much resembles Hayek’s thesis.
In this paper I develop Hayek’s theory of the Ricardo Effect by rebuilding that theory around the alternative thesis that a decline of investment by the machine producing industries leads to the “scarcity of capital.” This means to visualize the Ricardo Effect not as an economy-wide shift of workers from the machine producing industries towards the consumer goods industries, but as a re-allocation of productive capacity within the machine producing industries itself. Instead of the “acceleration effect” becoming dominated by the “Ricardo effect” in the second half of the upswing, I will twist Hayek’s argumentation a bit. I will argue that the “acceleration effect,” which emanates from one half of the economy (the consumer goods industries), gives rise to the “Ricardo effect” in the other half of the economy (the machine producing industries). I will also attempt to demonstrate a secondary thesis on top of this primary thesis. This secondary thesis is that, because the “acceleration effect” causes the machine producing industries’ capacity to become fully employed, continued credit expansion will lead, somewhere halfway the boom, to increasing operating expenditure by all industries. This increasing operating expenditure will drive towards a Ricardo Effect in the raw materials industries, causing an increasing scarcity of “circulating capital,” and finally flipping over the upswing into the downswing.
The rest of this paper is organized as follows. In the following section I will summarize Hayek’s theory of the Ricardo Effect with more detail than in this introduction. Here I will also highlight the main points of the debate over the Ricardo Effect in the early 1940’s, and I will highlight the main capital-theoretic problem that Hayek deals with in his theory of the Ricardo Effect. In the third section following that, I provide a list of points on which my development of the theory of the Ricardo Effect originates in Hayek’s theory. The fourth section can be seen as the core of this paper. It deals with a conceptual difficulty of the stages-of-production model that Hayek recognized in his theory of the Ricardo Effect ([1935] 2012, pp. 223–226). The difficulty is that of so-called “circularities” in the structure of production, in particular how to model these circularities verbally or graphically. Hayek did not really resolve this difficulty and I will attempt to do so by re-examining the capital-theoretic issue of combining the intertemporal stages-of-production viewpoint with the cross-sectional viewpoint that divides the economy into a consumer goods industries and a machine producing industries. Here I propose a new type of cross-sectional model that should better help understand the near-future/distant-future trade-offs. In section five I will argue in detail for my primary thesis and therefore go into the reasons why a Ricardo Effect (i.e. a decline of investment) would occur within the machine producing industries during the boom. In the sixth section I will come to my secondary thesis, and I will argue that the increased capital utilization that appears during the boom leads to a Ricardo Effect in the raw materials industry. Hereto I will extend the cross-sectional viewpoint that divides the economy into a consumer goods industries and a machine producing industries with the raw materials industries as a third sector.
- A SUMMARY OF HAYEK’S THEORY OF THE RICARDO EFFECT AND ITS PROBLEMS 2.1 Hayek’s Revised Business Cycle Theory
Profits, Interest and Investment ([1939] 2012) and “The Ricardo Effect” ([1942a] 2012) Hayek published what may be called his “theory of the Ricardo Effect” (Wilson, 1940, p.171).Apart from these two essays Hayek’s theory of the Ricardo Effect can also be seen to be restated in two short replies to Kaldor ([1942b] 2012). Also, without using the term “Ricardo Effect,” Hayek raised similar points in chapter XXVII of The Pure Theory of Capital ([1941] 2009) and in “Full Employment Illusions” ([1946] 2009). Then he returned to the issue roughly a quarter of a century later in “Three Elucidations of the Ricardo Effect” ([1969] 2012). Profits, Interest and Investment was partly a revision of his business cycle theory of Prices and Production ([1935] 2008) in order to provide a more detailed explanation of the upper turning point of the business cycle. Hayek identified as a main difference with his earlier explanation of crises that in his “revised version” he believes that “a rate of profit rather than a rate of interest is the dominating factor in this connection” ([1939] 2012, p. 212). Hayek would initially assume the rate of interest as given, which apparently implies that the supply of credit is simply “elastic” and that there is a credit expansion going on throughout the upswing (ibid., p. 230). Hayek attempts to demonstrate that “the turn of affairs will be brought about in the end by a “scarcity of capital” independently of whether the money rate of interest rises or not” (ibid.). Professor Klausinger has explained the importance of these revised aspects:
The new features of the model—in comparison to Prices and Production—are crucial for the novel explanation of the upper turning point. For without an elastic supply of credit and with the circulation of money limited, eventually the rate of interest would rise sufficiently to choke off investment demand […] what Hayek is now attempting to demonstrate is the inevitability of the breakdown of an inflationary boom, even […] with unlimited credit creation and with less than full employment. (2012, p. 17, footnote omitted.)
Because Hayek would concentrate on the latter half of the upswing, he was brief about the first half. He simply asserted that in the first half of the upswing, credit expansion and increasing consumer spending would give incentives to the consumer goods industries to order more machinery. This more or less exaggerated ‘derived demand for machines’ Hayek called the “acceleration effect,” following the terminology of “a well known doctrine, the so-called ‘acceleration principle of derived demand...’” (Hayek, [1939] 2012, pp. 222–223). However, Hayek did not quite follow that doctrine itself till the end.
Hayek assumed that “at a point somewhere half-way through a cyclical upswing […] prices of consumers’ goods do as a rule rise and real wages fall” (ibid., p. 217). On this Hayek builds his concrete thesis: At this halfway point the incentives for entrepreneurs are strong enough to:
...make the tendency to change to less durable and expensive types of machinery dominant over the tendency to provide capacity for larger output. Or, in other words, in the end “the acceleration principle of derived demand” becomes inverted into a “deceleration principle....” (ibid., p. 231)
Besides calling this weakening ‘derived demand for machines’ simply a “decline of investment” (ibid., p. 230), Hayek also calls this tendency the “Ricardo effect.” In short, the “acceleration effect” dominates the first half of the upswing, the “Ricardo effect” the second half.
Hayek’s visualization of this Ricardo Effect is that while the consumer goods industry decreases its capital expenditure, it will start to increase its operating expenditure. Workers are then re-allocated from the machine producing industries towards the consumer goods industries. Fewer machines, or “less durable and expensive types of machinery,” are manufactured in the machine producing industries, while machine-utilization in the consumer goods industries goes up ([1942a] 2012, pp. 275–276). However—this seems to be Hayek’s point—higher machine-utilization can only sustain higher output for as long as those machines are not yet worn out. Since less machines are manufactured to replace worn-out machinery, there must come a point at which that higher output cannot be maintained. The decline of investment results in a decreased productive capacity, and “the classical maxims that a scarcity of capital means a scarcity of consumers’ goods […] assert their fundamental truth” ([1939] 2012, p. 231). The relationship to the business cycle of this theory of the Ricardo Effect is that this “scarcity of capital” becomes the real reason why the high level of output during the boom-phase cannot be sustained (ibid., pp. 230–232). The upswing must reach a “turn of affairs” (ibid.). Besides this, the decline of investment by the consumer goods industries would, of course, also lead to a slump in the machine producing industries.
2.2 The Debate on the Theory of the Ricardo Effect
The debateOther summaries of the debate can be found in Haberler (1943), Blaug (1997) and Klausinger (2012). Klausinger (2012) is the introduction to the 8th volume of Hayek’s Collected Works in which most of the theory of the Ricardo Effect can be found. Klausinger (2011) provides some more background to the debate. For example, Wilson, Kaldor, and Hayek were all attached to the London School of Economics during the debate, Kaldor being Wilson’s thesis supervisor. that followed, between Wilson (1940), Hayek ([1942a] 2012) and Kaldor ([1942] 2012), centered around the rather micro-economic question of what firms in the consumer goods industries would do under the circumstances that Hayek described. Wilson compared Hayek’s thesis, that “with a perfectly elastic supply of credit, a fall in real wages will lead to the adoption of less roundabout methods of production,” to a treatment of a similar case by Kaldor (Wilson, 1940, p. 173). To Kaldor, a representative firm would combine, in the words of Wilson, “direct labour and indirect labour […] in the same proportion as before; the change in prices will change the scale of output but leave the degree of capital intensity unchanged” (ibid., p. 174; cf. Kaldor, 1939, pp. 49–50). Kaldor’s conclusion was that the method of production (i.e. the ratio of direct to indirect labor) at which profits are maximized, in the case of elastic credit, will be entirely determined by the interest rate. The real wage rate has no influence. The reason is that falling real wages (selling prices that go up relative to money wages) do not affect the initial costs (expenses on wages for indirect labor plus interest charges) of each different method of production (Wilson, 1940, p. 177). Hence, under elastic credit and falling real wages, such a representative firm would would not change its “ratio of indirect to direct labour” (ibid., p. 176). But it would hire more indirect labor and direct labor in the same proportion as it did before. In other words, it would purchase more machines similar to what it already has, and also hire more workers to man those machines. The representative firm enlarges its scale of operations by “capital widening.” With respect to the consumer goods industries as a whole, this means that maximum aggregate profits are achieved when each consumer goods firm enlarges the scale of operations on its particular profit-maximizing “ratio of indirect to direct labour” until for each firm marginal revenue will have equaled marginal costs (ibid.; cf. Klausinger, 2012, p. 19). In the aggregate of the consumer goods industries this means, as Professor Klausinger has explained, that “the increased demand for consumers’ goods will bring forward ‘capital widening’ but no ‘capital enshallowing’...” (Klausinger, 2012, p. 19). Wilson pointed to the crucial role of Hayek’s assumption of a perfectly elastic supply of credit, which would play an important role in the rest of the debate. Even if that assumption is dropped, Hayek’s thesis would not stand, according to Wilson. Under a rising supply schedule of credit, he argued, an increase in consumption may diminish capital intensity (there will be less use of indirect labor relative to direct labor), but it will not lead to a fall in investment (less use of indirect labor in the absolute) (ibid.).
Hayek subsequently defended his case in “The Ricardo Effect” ([1942a] 2012). Instead of discussing a choice among a number of different ratios of indirect to direct labor, Hayek now built his argument on the more practical idea that entrepreneurs must choose between “expenditure on wages (or investment in ‘circulating capital’) and expenditure on machinery (investment in ‘fixed capital’)” (ibid., p. 262).Increasing capital utilization is not exactly the the same as increasing the ratio of direct to indirect labor (i.e., decreasing the “ratio of indirect to direct labour”). The former means that existing machines will be utilized more intensely, the latter that replacement machines which are to be built will be “less automatic” than the machines they will replace. These two concepts are intertwined in the theory and debate on the Ricardo Effect. Of course, they may have something to do with each other if increased capital utilization of the consumer goods industries is made possible by shifting labor away from the machine producing industries, leaving the latter with less manpower to built more automatic machines. This was precisely Hayek´s thesis. Hayek maintains that in the upswing at some point entrepreneurs prefer to use their funds to increase output by increasing the utilization of their existing capacity rather than by purchasing more capacity. The obvious objection against Hayek’s line of argumentation was raised by Hayek himself: “To this it will no doubt be answered that there is no reason why the entrepreneurs should not do both: provide for the output in the near future by the quick but expensive methods and provide for the more distant future by ordering more machinery” (ibid., p. 278). Kaldor indeed responded in such a way:
When the price of a product rises (or strictly: the expected price of the product rises) it becomes profitable to increase output, and to extend output-capacity, until the expected price, or the marginal revenue, is back again to conformity with cost. As Ricardo said: “an unusual quantity of capital would be employed till their price afforded only the common rate of profit”.... ([1942] 2012, p. 296)
Hayek must show what is precisely that thing that propels entrepreneurs in the consumer goods industries to only increase operating expenditure when demand for their product rises. Increasing output by increasing capital utilization can only go so far. There are capacity constraints in the consumer goods industries which can only be lifted by purchasing additional machinery. Under the circumstances that Hayek initially stipulated—an “elastic” availability of credit and increasing consumer spending—there should be ample room to also increase capital expenditure and install more capacity. Output would be increased by a combination of operating expenditure and capital expenditure, contrary to Hayek’s claim that there is a tendency to shift to operating expenditure only (Haberler, 1943, p. 490).
This brings us to the one point on which Hayek is seen as having admitted defeat (Klausinger, 2012, pp. 21–22). For in “The Ricardo Effect,” Hayek retreated from his assumption of an elastic supply of credit during the upswing, towards the assumption that “every prospective borrower will have to face an upward sloping supply curve of credit” ([1942a] 2012, p. 270). Hayek argues that the funds in the hands of entrepreneurs are limited and that therefore operating expenditure will at some point in the upswing be increasingly preferred above capital expenditure. This change of assumption implies that a decline of capital expenditure by the consumer goods industries—if that indeed happens during the upswing—occurs mainly because the supply of credit is drying up, rather than that the rate of profit on investment in fixed capital is declining vis-à-vis investment in working capitalNote that Hayek used the phrase “investment in working capital” in the sense of what nowadays would be called operating expenditure. It does not necessarily mean “investment in net working capital” (i.e. the cash buffer between receipts and expenditures) although increasing operating expenditure may very well imply that an increase in net working capital is needed since expenses on wages and raw materials would increase. (Hayek, [1939] 2012, pp. 215–217; Kaldor [1942] 2012, p. 302). Professor Klausinger has interestingly commented that “in the end the Ricardo effect was salvaged by giving up most of what had distinguished it from alternative explanations of the upper turning point” (ibid., p. 22; cf. Blaug, 1997, p. 526). Indeed, because Hayek now made the increasingly limited availability of credit the “dominating factor” in bringing about the decline of investment, the superior profitability of investing in more labor-intensive methods of production no longer plays that role of the “dominating factor” that Hayek initially had assumed for it ([1939] 2012, p. 212).
Hayek himself did not admit defeat ([1942b] 2012). His stubborn resistance comes from relying on another argument he brings to the table:Hayek, in “The Ricardo Effect” ([1942a] 2012), interweaves the “scarcity of money capital” argument (based on changing the assumption towards an upwards sloping supply curve of credit” with the “scarcity of real capital” argument. As does Kaldor ([1942] 2012), I treat them separately.Investment must also be constrained because of the scarcity of real capital. An individual firm may be so lucky that the machine it wants to acquire stands “waiting in the shops,” but what “might be true for any one firm [...] will not be true when all firms are simultaneously in the same position” (ibid., p. 278).This argument was probably directed against called Kaldor’s “representative firm subterfuge” (Desai, 1991, p. 67; cf. Kaldor, 1939, p. 44). Hayek uses the limited availability of real capital as evidence that “additional equipment and still more the output produced by it will be available only after considerable delay. And in the interval till this output is available profits which might have been made by quicker methods will be lost and ought to be counted as part of the cost of the production for the most distant future” (ibid.). Besides arguing that realizing profits in the near future will take precedence, Hayek also argues that the the decline of investment comes about for two other reasons. One is that the price of machinery would go up because of an increasing scarcity of labor in the machine producing industries, as labor is being reallocated to the consumer goods industries. The other is that, in so far as new machines are ordered, these will be the cheaper (less labor-saving) types of machines which can be installed more quickly (ibid., p. 281).
Kaldor responded that a rise in prices of machines has nothing to do with what Hayek is trying to prove. A rise in the price of machinery will not lead to a decline in investment from the consumer goods industries:
[Hayek] confuses influences coming from the side of demand with influences coming from the side of supply. If the price of machinery rises, the demand for machines will be less than if it did not rise. But the price of machinery has only risen, on his assumptions, because demand has risen; how does this explain then the emergence of unemployment [in the machine producing industries]? His business is to prove that demand will fall; not that a rise in demand will be checked by a rise in price. ([1942] 2012, p. 307, footnote omitted; cf. Wilson, 1940, p. 176)
There is one part of Hayek’s main thesis that Kaldor cannot put aside completely. This is that entrepreneurs in the consumer goods industries will prefer cheaper but less labor-saving machinery (which can be installed more quickly) over more labor-saving equipment (which will take longer to put in place). But to Kaldor even this does not prove much:
It is only if the entrepreneur expects higher prices for his products in the near future than in the more distant future that it might become more profitable to install the machine with the shorter construction period, even though the rate of interest is the same [...] assuming that the latter is the case, what does it prove? […] Professor Hayek has taken on himself to prove that this will cause a fall in demand for capital goods, and thus unemployment in the capital goods trades; and to the latter contention the argument contributes nothing at all.” ([1942] 2012, p. 308)Hayek did not use the phrase “construction period” in his theory of the Ricardo Effect. Kaldor’s use of this term, which was used by a number of authors in the 1930’s capital debates, is a good indication that this point has more to do with the capital-theoretic questions that form part of the background of the debate. The idea behind both Hayek’s and Kaldor’s reasoning is the law of roundabout production, i.e that longer construction periods (given “wisely chosen” methods) result in more labor-saving machinery (Hayek, [1941] 2009, p. 77).
2.3 Hayek’s Visualizing Problem
One problem that Hayek himself identified with his theory was that he admitted to “find it difficult to visualise precisely how [the Ricardo effect] will be brought about” (Hayek [1942a] 2012, p. 280). That Hayek did not really have a precise visualization how the Ricardo Effect would occur may also be evident from his description of that effect:
the [Ricardo] effect [...] will be twofold. On the one hand it will cause a tendency to use more labour with existing machinery, by working over-time and double shifts, by using outworn and obsolete machinery, etc. On the other hand, in so far as new machinery is being installed, either by way of replacement or in order to increase capacity, this, so long as real wages remain low compared with the marginal productivity of labour, will be of a less expensive, less labour-saving, and less durable type.” ([1939] 2012, p. 219)
In fact we find here three different effects. The first is increased capital utilization (“over-time and double shifts”) The second is an asset replacement delay (“using outworn and obsolete machinery”). Only the third is the narrow interpretation of the Ricardo Effect as factor substitution (changing to “less labour-saving” machinery). There is not one concrete manifestation of the Ricardo Effect. The common aspect is simply that they all help produce output in the near future at the expense of output in the distant future. A Ricardo Effect could thus be defined more broadly than just a decline of investment on the part of the consumer goods industries. In Hayek’s intertemporal framework a Ricardo Effect can simply mean any shift of resources, a “redistribution of production factors in time as a consequence of a change in the rate of profit” (Birner, 1999, p. 805). This may also suggest that the thesis of the decline of investment on part of the consumer goods industries might only have been an initial rough sketch to visualize what is going on during the latter half of the upswing. In other words, that it is an attempt to concretely visualize a more abstract thesis behind it, namely that towards the end of the upswing resources are shifted towards near future output.
What might Hayek’s visualizing problem be? A clue lies in section 7 of Profits, Interest and Investment ([1939] 2012, pp. 223–226) in which Hayek raises problems with his own visualizing tool, the stages-of-production concept. It involves the capital-theoretic question of combining two different points of view (cf. Birner, 1999, p. 805). On the one hand there is the viewpoint of the Austrian theory of capital, which is intertemporal. It makes a “longitudinal section” of the economy. It considers what happens over a stretch of time and looks upon production as going on in stages through time. On the other hand there is the view of an economy as a dichotomy of a consumer goods industry and a machine producing industry. It is a viewpoint often encountered in the theory of the Ricardo Effect, and it is usually considered a “cross section” viewpoint of production. It considers what happens at a moment or a single interval of time (Wicksell, 1934, pp. 236–237; cf. Garrison, 2001, p. 47; cf. White, 2007, p. xxiv).
Hayek makes use of both the cross-sectional and the intertemporal viewpoints, although as an Austrian capital theoretician, it seems to me, he is principally thinking in intertemporal terms. Therefore Hayek has to translate the meaning of the “lengthening and shortening of roundabout production”—which is going on in multiple “stages”—into the cross-sectional scheme of a division of just two “industries.” When we lay the intertemporal stages-of-production concept over the cross-sectional concept, we can say that the the machine producing industries is the preceding stage of the consumer goods industries, while the consumer goods industries is the following stage. The words “stage” and “industry” seem to have roughly the same meaning.
There is a complication, however, in laying the stages-of-production concept over the cross-sectional scheme of two industries. The consumer goods industry is the last stage; the machine producing industries comprise the one before that. But which industry is the preceding stage of the machine producing industries? The straight answer is that the machine producing industries are their own suppliers of capital goods—the industries are their own preceding stage. This phenomenon was called the “circularity” of the “partial self-reproduction of real capital” in the 1930’s capital debates (Kaldor, 1937; Eucken, 1940). In this lies Hayek’s visualization problem. The complication is the question how to fit such a “circularity” into the linear stages-of-production concept (Hayek, [1935] 2012, pp. 224–225).
Hayek recognizes this difficulty, but he also avoided exploring in which way he could come to a model that would include such circularities. The only clue he left was a reference to a study by Burchardt (1931) which commenced the German 1930’s capital debates ([1939] 2012, p. 225). This issue of “circularities” was also not drawn into discussion in the debates on Hayek’s theory of the Ricardo Effect in the early 1940’s (Wilson, 1940; Hayek, [1942a] 2012; Kaldor [1942] 2012). Nor has a discussion of its possible significance for “Ricardo Effects” appeared in the secondary literature since then (Lachmann, 1940; Lutz and Lutz, 1951; Gilbert, 1955; O’Driscoll, 1977; Haberler, 1986; Moss and Vaughn, [1986] 2010; Steele, 1988; Hagemann and Trautwein, 1998; Birner, 1999; Gehrke, 2003; Klausinger, 2012).
- POINTS OF DEVELOPMENT OF HAYEK’S THEORY OF THE RICARDO EFFECT In what follows is a list of points on which my development of the theory of the Ricardo Effect originates in Hayek’s theory of the Ricardo Effect. In my development I will deviate at various points from the importance that Hayek gives to certain aspects of his theory, such as his concrete thesis and his conclusions. I believe I can still call my theory a “development of the theory of the Ricardo Effect,” since almost all of these deviations are the result of re-evaluating or developing the ideas and concepts of Hayek’s original theory of the Ricardo Effect.
(1) I follow Hayek in believing that “a rate of profit rather than a rate of interest is the dominating factor in this connection” (ibid., p. 212). It means, I think, that the lead role in bringing about the crisis, at least in the second half of the upswing, lies not with capitalists that have malinvested their expenditure on fixed capital because of misguidance by the rate of interest (Hayek [1935], 2008, p. 272). On the contrary, it has to do with capitalists that unmisguidedly reap profits by decreasing their capital expenditure and increasing their operating expenditure (cf. Kaldor, 1939, p. 64; [1942] 2012, pp. 286–290; cf. Huerta de Soto, 2006, pp. 368–370).This thematic difference perhaps accounts for the fact that Hayek’s theory of the Ricardo Effect is hardly integrated into modern versions of the Austrian Business Cycle Theory (ABCT). Modern versions of ABCT often build on Hayek’s Prices and Production (e.g. Garrison, 2001, p. 11) and are largely occupied by explaining the malinvestment of capital expenditure during the business cycle through analyzing the circumstances of committing capital expenditure (ibid., p. 81).
(2) I will stick to Hayek’s initial assumption of a continuing credit expansion throughout the upswing, which was more or less tied to the rate of profit as the “dominating factor.” I believe Hayek’s ‘retreat,’ by changing his assumptions on the supply of credit during the upswing in “The Ricardo Effect” ([1942a] 2012), and so giving up most of what was original in his approach in Profits, Interest and Investment ([1939] 2012), has everything to do with his sticking to his concrete thesis that during the upswing the capitalists of the consumer goods industries decrease their capital expenditure.
(3) In terms of understanding the structure of production through theoretical concepts, section 7 of Profits, Interest and Investment ([1939] 2008, pp. 223–226) offers some very interesting suggestions for developing the “stages of production” concept from Prices and Production ([1935] 2008, pp. 223–252). Hayek left here much room for development, especially in incorporating the role of fixed capital and “circularities” into the concept of the stages of production.
(4) Comparing Hayek’s theory of the Ricardo effect ([1939] 2012; [1942a] 2012), with Mises’s chapter on the business cycle in Human Action ([1949] 1998, pp. 535–583), there is an interesting difference between these two originators of the Austrian business cycle theory. To Mises, the “very well known fact” is that the machine producing industries are “overloaded with orders” when the business cycle is approaching the upper turning point (ibid., p. 583). This ‘stylized fact’ suggests that only in the downswing the machine producing industries will start to experience idle capacity. Hayek’s theory of the Ricardo Effect, however, posits the thesis that somewhere half-way the upswing of the business cycle, the consumer goods industries increasingly do not replace their worn-out machines and do not invest in modernizing their machinery ([1939] 2012, p. 219; [1942a] 2012, pp. 267–268). This suggests that the ‘stylized fact’ should be that there is already a fair amount of idle capacity in the machine producing industries when the business cycle approaches the upper turning point.
The interesting difference between Mises and Hayek is thus a difference in what is (according to Mises) and what theoretically ought to be (according to Hayek) the ‘stylized fact’ concerning the level of idleness in the machine producing industries as the business cycle approaches the upper turning point. I believe Mises is right about his stylized fact, which partly accounts for the main deviations between Hayek’s theory of the Ricardo Effect and my development of it. However, the connection with Hayek’s original theory is that I believe that Hayek was right in principle about the occurrence of a Ricardo Effect.
(5) Hayek relies in his theory of the Ricardo Effect on the wage rate as the major element in the profit mechanism, for capitalists will compare the “profit earned on the turnover of any amount of labor” invested for different periods ([1939] 2012, p. 215). The role of the wage rate seems therefore crucial in the theory of the Ricardo Effect, as Hayek clearly says that the “substance [of the Ricardo Effect] is contained in the familiar Ricardian proposition that a rise in wages will encourage capitalists to substitute machinery for labor and vice versa” (ibid.). However, Hayek subsequently also argued that “it is through this [Ricardo] effect that the scarcity of real capital will make itself ultimately felt” ([1942a] 2012, p. 259). In my development of the theory of the Ricardo Effect, I will deviate from Hayek’s original theory by taking the profit earned on the turnover of versatile fixed capital as the major element determining “the rate of profit.” This is also consistent with point (3) above.
(6) In his theory of the Ricardo Effect, Hayek argues that a shift from capital expenditure towards operating expenditure takes place ([1939] 2012, p. 219; [1942a] 2012, p. 262; [1946] 2009, p. 149). Hayek’s suggestion that this increase in operating expenditure would occur “at a point somewhere half-way through a cyclical upswing” (Hayek [1939] 2012, p. 217) seems almost identical to Keynes’s finding that “the characteristic secondary phase of a credit cycle” was “due to the growth of investment in working capital” (Keynes, 1930, p. 252). Much earlier Lord Overstone, a leading member of the Currency School, had pointed towards widespread “overtrading” ([1857] 1972, p. 31)—pushing operating expenditure to or beyond the sustainable margin—in the excited last phase before the upper turning point. Now, whether increasing operating expenditure is the result of a shift from capital expenditure or not, it remains a ‘stylized fact’ of cyclical upswings that workers are employed in “over-time and double shifts.” Hayek’s theory of the Ricardo Effect can be seen as an attempt to explore this aspect of the business cycle, and its possible link to overconsumption (cf. Salerno, 2012). Although I will attempt to demonstrate a slightly different thesis than Hayek’s, the task remains to explain this increase in operating expenditure.
(7) In discussing the role of rising costs, and especially rising prices of raw materials, during the upswing, Hayek expands the model of a “crude dichotomy of industry into consumers’ goods industries and capital goods industries” into a trichotomy that also includes a raw materials industry ([1939] 2012, pp. 229–230). With Hayek this trichotomy remains a short verbal sketch, which I will attempt to develop.
- THE STRUCTURE OF PRODUCTION 4.1 The Difficulties of the Stages-of-Production Model
In Prices and Production ([1935] 2008) Hayek introduced his famous triangles of the structure of production, what he called the “stages of production.” What is important to mention about his triangles in that book, is that the first triangle he provides is a longitudinal or intertemporal triangle, reproduced as Figure 1 below (ibid., p. 228). The second to sixth figures of triangles (such as Figure 2 below) are cross-sections of the first figure (ibid., pp. 232–247).
Figures 1 and 2
The difference between them is that Hayek’s cross-sectional triangles deal with the current distribution of inputs (and spending) among stages that are performed simultaneously “in a given period” ([1935] 2008, p. 232). A cross-section can be likened to a snapshot of a situation at a moment in time. The intertemporal understanding of the economic process follows from imagining the sequence of such cross-sections, much like a moving picture is actually a sequence of snapshots. Hayek moves from one cross-section to another in order to portray the changes in the structure of production due to either increased (voluntary) savings or (fiduciary) credit expansion (ibid., pp. 232–247). However, only the first figure is really intertemporal in it self (or “longitudinal,” as Wicksell would say). It not only represents current output of consumer goods and intermediate goods on the one hand, it also serves as a picture of future output due to the present allocation of resources. Hayek’s particular intertemporal triangle deals with the output due to the average length of production in a “stationary society” (ibid., p. 229). In a stationary society future output of consumer goods and intermediate goods is as high as the current output of those goods. The intertemporal function of this triangle may seem somewhat purposeless therefore, because there are no intertemporal differences of output in a stationary society. The point is that if such a stationary society would be transformed into another stationary society with a longer average period of production, then after a period of transition in which the output of consumer goods is lowered, the current production of both intermediate goods and consumer goods will have increased. During the “traverse” between two stationary societies, some stages are partly abandoned, in order to perform stages not previously engaged in. After the traverse, the intertemporal triangle has become wider and longer.
As mentioned before, in Profits, Interest and Investment ([1939] 2012) Hayek reflects on the question of how the demand for capital goods plays out in the “structure of capitalistic production.” He argues that “a crude dichotomy of industry into consumers’ goods industries and capital goods industries is wholly insufficient to reproduce the essential features of the complicated interdependency between the various industries in real life” (ibid., p. 224). Certainly, this dismissal of the “crude dichotomy” is rather incompatible with the fact that he uses such a dichotomy in various parts of his theory of the Ricardo Effect. A telling example is Hayek employing a verbal model of “integrated firms” which consist of two departments; one department that produces commodities, another department that produces machines ([1942a] 2012, pp. 279–280).The (Marxian) dichotomy of consumers goods industries and machine producing industries was called the Abteilungsschemen in German (Eucken, 1940, p. 118), which literally stands for “departmental scheme” (Nurkse, 1935). Hayek also extensively uses the closely related distinction between “expenditure on wages (or investment in ‘circulating capital’) and expenditure on machinery (investment in ‘fixed capital’)” (ibid., p. 262).
Besides commenting on the insufficiency of the “crude dichotomy,” Hayek also addresses the insufficiencies of his own stages-of-production model, which consists of more steps in the production process than just two.Hayek does not make explicit whether his doubts concern the longitudinal or the cross-sectional stages-of-production concept. I believe it refers to the crosssectional stages-of-production concept. To Hayek, the stages-of-production model “is not quite adequate for the purpose” either ([1939] 2012, p. 224). He points out that it “gives the impression of a simple linearity of the dependency of the various stages of production which does not apply in a world where durable goods are the most important form of capital” (ibid.). This is because, as he admits, it was based on the “assumption that all capital used was of the nature of circulating capital” (ibid., p. 224). Hayek then speculates on a modification of his stages-of-production concept, by designating some stages as responsible for producing fixed capital:
If we designate the production of consumers’ goods as stage I we can then classify the various industries which directly supply the consumers’ goods industries with capital goods of various kinds as stages II, III, IV, etc., according to the more or less “capitalistic” character of the equipment which they supply. Stage II would supply the consumers’ goods industries with the least capitalistic type of requirements, such as the raw materials and their simplest tools. Stage III would supply them with equipment of little durability and machinery of the least automatic type. Stage IV would supply a somewhat more capitalistic (more durable or more labour-saving) type of machinery, and so on to stage V, VI, etc., in ascending order. (ibid., p. 224)
Through this modification, a machine from stage IV could be delivered immediately to the consumer goods producers at stage I. That machine does not have to pass a number of stages in between. It is in the nature of circulating capital that it often does pass a number of stages when it is processed from raw materials into consumer goods. In this respect, Hayek certainly revises his expository device of Prices and Production ([1935] 2008).
But Hayek still feels that such an adaption of the stages-of-production concept “gives an undue impression of linearity of these relationships while in fact they may in many respects be rather circular in character” (ibid., pp. 224–225). What Hayek means must be something like this: The more labor-saving equipment provided by stage IV would be used to help produce the “simplest tools” that will be put out by stage II, while at the same time the “simplest tools” provided by stage II could also help to produce the “more labor-saving equipment” at stage IV. So for fixed capital, it is not only the case that a number of stages could be passed over when it travels from a higher to a lower stage. Its services may also be “put back” to a higher stage (Eucken, 1937, p. 541 et passim). This phenomenon of “circularities”The phenomenon of “circularities” has also been described as “whirlpools” (Dorfman, Samuelson, and Solow, [1958] 1986, p. 205) and recently as “looping” (Cachanosky and Lewin, 2016, p. 17). While Dorfman et al. and Cachanosky and Lewin seem to use these phenomena against the determinability of a structure of production, Lowe (1976, p. 34) uses it as evidence for such a determinability. in the structure of production played an important role in the 1930s capital debates as it formed a challenging aspect to the ‘Austrian’ stages-of-production concept (Kaldor, 1937). Hayek alludes to this phenomenon by referring in a footnote to a study by Burchardt that started the 1930s capital debates in Germany (ibid., 225). Hayek even notes Burchardt as having given “the most fruitful of all the recent criticisms of the ‘Austrian’ theory of capital” (ibid.).
This is the point in the original theory of the Ricardo Effect where Hayek practically invites it to be developed. Hayek offers a few pages of doubts and ideas about the stages-of-production model, but it does not lead up to a systematically elaborated improvement over Prices and Production ([1935] 2008). In what follows I will treat the relation of cross-sections to intertemporal output first, before addressing the “circular” relationships in the cross-section itself.
4.2 Sequences of Cross-Sections to Picture Intertemporal Changes
The longitudinal and cross-sectional aspects of the Hayekian triangle may easily get confused because the first figure on the one hand, and second to sixth figures on the other hand, are all triangular. In fact, Professor Garrison argues that “the Hayekian triangle has a double interpretation” (2001, p. 47). This double interpretation has resulted from fusing the two different kinds of triangles into one. For the further discussion, I propose to disentangle these purposes by keeping the cross-sectional and longitudinal aspects apart by not fusing them into a single stages-of-production concept. As far as the question of understanding the relationship between the intertemporal aspects of production and the interdependencies of industries, I find it useful to employ a cross-sectional model (not necessarily a triangular model) that pictures the current distribution of input, and then think of the future consequences of that current distribution in order to draw a subsequent cross-section.
As a simple cross-section of an economy, we can take Professor Garrison's production possibilities frontier or “PPF.” The PPF depicts the current distribution between consumption-spending C and investment-spending I, as depicted in the three PPFs in Figure 3. Therefore, it could be said that “a crude dichotomy of industry into consumers’ goods industries and capital goods industries” is implied in Professor Garrison’s PPF, simply because it crudely divides the economies’ output into consumer goods and capital goods (ibid., p. 46). The underlying thought of Professor Garrison’s PPF is intertemporal, because “the economy grows to the extent that it uses its resources to the production of capital goods rather than the production of consumer goods” (ibid., p. 41). However, the PPF does not depict future output or future output capacity. But if we imagine a sequence of PPFs we could say that any PPF at time t is the result of the distribution between consumption-spending (C) and investment-spending (I) along the PPF at time t-1.
Such a sequence is actually depicted in Figure 3: Suppose a movement along the PPF towards more investment (a to b) takes place at t=1. This would imply that the economy has more resources at the next cross-section at t=2. In other words, it will have more resources at t=2 as the result of more resources being devoted to producing capital goods rather than consumer goods at t=1. The PPF shifts outwards from t=1 to t=2 (the dotted line at t=2 representing the PPF at t=1). Then at t=2 a new allocation would have to be made among consumption-spending and investment-spending. Suppose that this choice involves an allocation of such a small amount of investment-spending that the capital stock of the economy cannot be maintained intact (from b’ to a’). This will mean that the PPF will shift inwards from t=2 to t=3.
In the post-World War II period, a number of developing countries in Asia and Africa had just gained independence from their colonial masters. Raising living standards for their citizens became the focus of the leaders in these new countries. Development Economics emerged as a distinct field during this time, primarily devoted to economic growth. The focus of this course will be to present the Austrian perspective on Development Economics, with particular attention on capital accumulation and the structure of production.
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Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017) ABSTRACT: The aim of this paper is to examine the non-price effects of monetary inflation. An increase in the money supply may lead to price inflation, but it may also affect the non-price parameters of goods and services, such as quality or the quantity enclosed in packaging. Based on our analysis, we claim that an expansionary monetary policy may cause a decline in quality (quantity) of produced goods and services if the rise in costs prompts the entrepreneurs not to increase nominal prices of their product but to decrease their product’s quality (quantity), increasing its effective price—price adjusted for quality (quantity). In this way, the increase in money supply may have, ceteris paribus, a negative impact on innovativeness of entrepreneurs who, instead of improving the quality of products they offer, may in fact take the opposite action in order to avoid evident nominal price increases of their products.
KEYWORDS: monetary inflation, non-price parameters of goods and services, non-price effects of monetary inflation, pricing strategy, product quality JEL CLASSIFICATION: B53, D40, E31, E51, L11 1. Introduction The influence of monetary inflationOriginally the term “inflation” stood for increase of the money supply, though nowadays this term is identified with the effects of this phenomenon: the increase of prices. Therefore, the term “monetary inflation” is used in this work and it stands for increase of money supply. “Price inflation” stands for increase of prices (Mises, 1998 [1949], pp. 419–421). on price changes has been subject to many research studies (e.g., Cantillon, 1959) [1975]; Mises, 1953 [1912]; Hayek 2008], Friedman and Schwartz, 1963). However, less attention has been paid to the analysis of the relation between monetary inflation and the changes in remaining parameters of goods and services, such as quantity (actual volume enclosed in packaging), quality, or the type and the date of delivery, etc.There is a question whether goods of different quality are still the same goods. Therefore, economists investigate the impact of monetary inflation on prices taking into account the ceteris paribus clause. However, we believe that focus on the factors economists usually abstract from can be helpful in better understanding the inflationary process and the behavior of entrepreneurs confronted with monetary inflation. There is plentiful anecdotal evidence on quality or quantity adjustments (e.g., Martin, 2008), but the academic literature on the subject is modest.
Armstrong and Chen (2009) argued that producers may use non-price (rather than price) adjustment mechanisms, if they have more information than consumers about goods’ attributes, while Snir and Levy (2011) found that producers are more likely to decrease quantities than increase nominal prices when consumers are more price attentive than quantity attentive, especially in periods of high inflation and in markets where producers face strong competition.
Imai and Watanabe (2013) examined the extent to which product downsizing occurred in Japan in 2000–2010. They found that one pricing strategy adopted among firms reluctant to raise nominal prices was to reduce the size or the weight of a product while leaving the nominal price practically unchanged, thereby raising the effective price. Importantly, the number of product downsizings has been particularly high since 2007, when firms faced substantial cost increases due to the rise in the price of oil and other imported raw materials.
Cakir, Balagtas, and Okrent (2013) analyzed the effects of package downsizing in the United States on household food-at-home consumption and expenditure in 2004–2010, while Cakir and Balagtas (2012) examined package downsizing in the Chicago ice cream market. Both studies found that producers use downsizing to implicitly increase prices in order to pass through increases in production costs.
These mainstream articles, although interesting, do not mention explicitly the link between monetary inflation and the changes in the non-price parameters of goods and services. They also tend to focus only on the package downsizing, omitting the changes in product quality.
Although Austrian economists analyze thoroughly the harmful consequences of rising money supply under the fiat monetary system and fractional-reserve banking, they are not interested in the problem of non-price effects of monetary inflation either. The only two exceptions known to us are Rothbard (2005) and Hülsmann (2008). The former (Rothbard, 2005, p. 53) assumed that consumers are more price sensitive than quality sensitive and wrote:
The general atmosphere of a “sellers’ market” will lead to a decline in the quality of goods and of service to consumers, since consumers often resist price increases less when they occur in the form of downgrading of quality.
The latter (Hülsmann, 2008, pp. 187–88) was a bit less laconic:
Then there is the fact that perennial inflation tends to deteriorate product quality. Every seller knows that it is difficult to sell the same physical product at higher prices than in previous years. But increasing money prices are unavoidable when the money supply is subject to relentless growth. So what do sellers do? In many cases the rescue comes through technological innovation, which allows a cheaper production of the product, thus neutralizing or even overcompensating the countervailing influence of inflation. This is for example the case with personal computers and other products made with large inputs of information technology. But in other industries, technological progress plays a much smaller role. Here the sellers confront the above-mentioned problem. They then fabricate an inferior product and sell it under the same name, along with the euphemisms that have become customary in commercial marketing. For example, they might offer their customers “light” coffee and “non-spicy” vegetables—which translates into thin coffee and vegetables that have lost any trace of flavor. Similar product deterioration can be observed in the construction business. Countries plagued by perennial inflation seem to have a greater share of houses and streets that are in constant need of repair than other countries.
However, neither Rothbard nor Hülsmann analyzed the above-mentioned problem in a systematic way, in contrast to our article. This limited interest in the literature is puzzling for three reasons. First, researchers have already shown that other goods’ attributes can also change depending on market conditions. Price is one of several elements that matters for consumers. Actually, in many marketplaces, adjustments in non-price attributes of products may be more important than changes in price. Thus, entrepreneurs may also compete on service quality, product quality, size or weight of a product, methods of distribution, delivery time, and so on. The non-price competition is well established in the literature (Blinder et al., 1998). Carlton (1987) even claims that markets may clear in terms of other factors than price—for example, delivery lags (Carlton, 1983). Therefore, the assumption that entrepreneurs always increase nominal prices in response to monetary inflation and rises in costs is not true.
Second, the growth of consumer prices resulting from monetary inflation is not automatic and deterministic, but depends on autonomous decisions made by entrepreneurs who, dealing with higher expenses, may or may not raise the prices of their products. Austrian economists always criticized the deterministic approaches of mainstream economics, particularly the hydraulic interpretations of the quantity theory of money, which postulate that a given increase in the money supply would lead to a proportional and mechanistic rise in the general price level (e.g., Mises, 1998 [1949], pp. 398–416). Although they are aware that increases in the money supply do not need to be revealed in increases in the consumer price level (e.g., Shostak, 2002), Austrians hardly analyze the impact of monetary inflation on non-price parameters of products.
Third, historically, until the implementation and distribution of banknotes in use, monetary inflation occurred in fact as a coin debasement—that is, a reduction in the weight or a deterioration in the quality (fineness) of coins, without changing the nominal value (Hülsmann, 2008, pp. 89–91). Therefore, economists should be aware that increases in money supply may be reflected in changes in non-price parameters of products, such as quality or weight (size).
The aim of this article is to fill the gap in the literature and thoroughly examine how the increases in money supply influence the non-price parameters of goods and services, especially how it affects the actual volume enclosed in packaging and the quality of the products. In other words, our goal is to draw a connection between monetary inflation and the non-price adjustments. Hence, we develop a theory of inflation and changes in the non-price parameters of goods and services. It turns out that neither are entrepreneurs greedy individuals who want to cheat consumers all the time, nor are downsizing and reduction in product quality always the optimal market outcome and beneficial for consumers. Our conjecture is that an expansionary monetary policy may, ceteris paribus, cause a decline in quality (quantity) of produced goods and services if the rise in costs prompts the entrepreneurs to not increase nominal prices of their products, but to decrease the products’ quality (quantity), raising rather their effective prices—prices adjusted for the volume or quality. In this way, the increase in money supply may have a negative impact on innovativeness of entrepreneurs who, instead of improving the quality of products they offer, may in fact take the opposite action in order to avoid explicit nominal price increases of their products.
The remainder of the paper is organized as follows. Section 2 analyzes the link between monetary inflation and non-price changes of goods and services. Section 3 focuses on the downsizing, and section 4 on decreasing quality. Section 5 examines the indirect effects of monetary inflation on quality of goods. Section 6 concludes.
- Monetary Inflation and Non-price Changes of the Goods and Services The starting point for our analysis is the Cantillon effect, a distributional effect and price effect resulting from the uneven increase in the money supply (Cantillon, 1959 [1755]). The new money is not evenly distributed in the economy but only runs through specific channels (Sieroń, 2015). This implies that only some entrepreneurs observe the increase in monetary demand for their products (or they observe it earlier than others). Other market actors will be confronted with a relative increase in the price of the factors of production used by them in the production process. The increase will be particularly widespread if the new money entered the economy through credit expansion (Huerta de Soto, 2006), which would lower the interest rates and, as a consequence, increase the monetary demand for raw materials and producer goods.
The rise in commodity prices was particularly strong in the 2000s (Trostle et al., 2011), when the annual percentage changes in the producer price index (PPI) were usually bigger than changes in the consumer price index (CPI), as one can see in the chart below.However, the percentage changes in the PPI were often smaller than changes in the CPI in other decades. This chart shows that producers faced significantly rising costs at that time, which could prompt them to reduce either quality or quantity of products, without adjusting nominal prices. Hence, focusing on the CPI is not sufficient in order to understand the inflationary process taking place in the economy. It cannot be ruled out that the greater increases in the PPI in the 2000s could partially have resulted from the fact that producers of consumer goods changed either the quantity or the quality of their products (and these changes were not properly reflected in statistics).
Figure 1: The percentage change from a year before in the PPI (blue line) and CPI (red line) in the 2000s
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Entrepreneurs facing the increase in costs may raise their nominal prices. However, such a solution is not always an optimal one. If the demand for a good is elastic, then an increase in price causes a decrease in revenues.It is worth mentioning that entrepreneurs always try to establish the price on the level maximizing profit, so any raising of price above the optimum value may lead to a decrease of revenue. Therefore it is not true that entrepreneurs can smoothly pass the rise in costs on to their consumers (Rothbard, 2009). Moreover, a few articles show that consumers are more sensitive to price than non-price changes due to lack of appropriate knowledge about non-price parameters or cognitive costs associated with processing information about both products’ prices and non-price parameters (Gourville and Koehler, 2004; Snir and Levy, 2011).On the other hand, Imai and Watanabe (2013) did not agree that consumers are sensitive to price changes but not to size/weight changes. Moreover, some consumers may be completely aware of an increase in an effective price (price per unit) but focus more on the nominal (absolute) price due to being short on cash.
What is more, sometimes entrepreneurs are not permitted to freely change prices. Price controls implemented by governments to keep inflation in check force them directly to change non-price attributes of products and, for example, reduce the quality or lengthen the delivery time during inflation (Carron and MacAvoy, 1981).Under the communist system, inflation was repressed. The increase in money supply led to shortages and non-price rationing—for example, in terms in time spent in lines (Kolodko and McMahon, 1987). For these reasons, entrepreneurs are forced to adjust non-price parameters of products in order to sustain their level of profitability.A similar example may be a minimum wage. The increase in the minimum wage may prompt employers to reduce fringe benefits or worsen the working conditions (Wessels, 1987).
There are many ways to deal with the rising costs. In certain sectors and at a certain point in a company’s development, the technological process plays the most important role (Hülsmann, 2008, p. 187).Please note that these efforts to deal with monetary inflation decrease the officially reported consumer inflation rate due to hedonic adjustments. However, the role and the rate of technological progress vary from one sector to another (Castellacci, 2004). For that reason, some entrepreneurs, operating in industries when the technological progress plays a much smaller role, may try to implement one of the two following major strategies (or both of them at the same time):
a) curtailing the amount of product, but keeping the nominal price unchanged (i.e., downsizing); orb) reducing costs through offering products of inferior quality.The difference between them is often very subtle as producers may use cheaper substitutes reducing quality and, for example, add water to foodstuffs in order to reduce the quantity of the primary nutrient used in the production of given goods. It seems however that it is worth distinguishing between these two methods, as the first one does not influence the quality of the products per se.
Surely, entrepreneurs may also adopt other solutions in response to monetary inflation and a surge in costs. However, we focus on the above-mentioned strategies because quantity and quality are the most important (and most general) non-price parameters of products. In particular, entrepreneurs can also increase the costs of shipping, reduce customer service, or move production to cheaper locations. They can also lower product variety because an increase in costs resulting from monetary inflation may reduce their companies’ profitability, which may lead to a narrowing of product range only to those products with the highest margin (instead of hiking prices). This is important because the literature shows that product variety enhances customers’ welfare (Dong, 2010).It is worth noting that non-price changes of a product may cause the relative underestimation of the CPI. We write about “relative” underestimation because it is difficult to determine whether there is absolutely positive or negative measurement bias in the CPI (Rossiter, 2005). However, goods substitution in the basket does not cover the loss of usability resulting from replacing more expensive goods of high quality by cheaper ones with lower quality. On the contrary, economists generally believe that substitution bias overstates the CPI.
- Downsizing Downsizing means decreasing the quantity of a product sold at the same nominal price. It seems to be a relatively new strategy, and can be either illegal or legal. The illegal one consists in placing less of the product in the packaging than was mentioned on the label, while the legal one consists in explicitly reducing the net content,The number of items or units in the packaging may also decrease, which is not easy to identify—for example, in the case of toilet paper sheets. often in a way unnoticeable for consumers, however. Although sellers are obliged to present unit price as well—that is, price per unit of weight or per product unit—the studies show that consumers are far more sensitive to changes in nominal prices than to the quantitative changes even if they both lead to the same change in effective price (Gourville, Koehler, 2004; Snir and Levy, 2011).Although this fact seems to prove that consumers do not always act rationally, it is worth mentioning that comparing both prices and quantity of different products involves additional costs in the form of time and effort (Snir and Levy, 2011). It should also be noted that unit prices are not always given, and even if they are, they are usually written with small characters. Therefore, consumers comparing only nominal prices can be considered rationally ignorant.
The nature of this phenomenon is complex. On the one hand, some argue that the above-mentioned actions show how greedy producers are and that the actions may be perceived as examples of fraud, or at least misleading packaging practices (Lawrynowicz, 2012). On the other hand, one can claim that producers almost always inform consumers about the actual quantity of the product in the packaging and indicate the unit price, whereas the consumers voluntarily make decisions on the purchase. It may also be true that some of the changes in the packaging may have an innovative character and may be an attempt to meet consumers’ needs.For example, beverages sold in tiny cans are often far more convenient though much more expensive in comparison with bigger containers when adjusted for per-unit volume.
However, it may be that downsizing is only an attempt to ensure profitability by companies facing rising costs and price-sensitive clients. This is not due to the entrepreneurs’ greed, but due to inflationary monetary policy. Because of inflation, entrepreneurs devote their time, energy, and scarce resources to producing smaller packaging in an unobvious way instead of offering products in the most appropriate form of packaging from the consumers’ point of view.
- Reduction of Quality of Goods and Services ("Cantillon Defect") Although the phenomenon of decrease in quality of some goods is a subject of research, nevertheless economists generally do not relate it to inflation policy. In this paper, we consider the reducing of quality of goods and services while keeping the same nominal price as a second non-price strategy for enterprises to adjust to monetary inflation and an increase in price of the means of production.
Reducing quality while keeping a stable nominal price, just like decreasing the quantity of the product, may turn out to be an attractive strategy aiming at increasing the effective price of goods or services as it is a parameter substantially harder to measure than price.
Two basic ways of lowering the quality are as follows: reducing durability or modifying components.Deterioration of durability may be the result of modifying components used to produce given goods. However, not every modification of components reduces durability, which is why these methods shall be discussed separately. Reducing durability of the products can be achieved mainly through the use of cheaper components of lower quality. It was recognized in the literature long ago (Swan, 1972; Gregory, 1947; Goering, 1993), but it seems this phenomenon, at least in general perception, has taken on more significance in the last several years.
The modification of components has a particular meaning in the case of non-durables, especially food. Contrary to durables, modifying components of given foodstuffs may rely on extending their durability to the detriment of nutritional values. This phenomenon is based on decreasing the content of the primary component in the product in the face of rising prices of raw materials. It may occur through replacing it with cheaper substitutesAn example of this problem is the European horse-meat affair, as the horse meat used for bovine hamburgers was cheaper (Wikipedia, 2013). (including diluting it with water), using raw materials of lower quality, or adding chemical substances (and applying production methods) that make the product more tasty or durable but harm health.One research area of particular interest is the coexistence of unprecedented monetary inflation since the 1970s (as a result of President Nixon’s definitive break from the gold standard in 1971) and the development of the world obesity epidemic, which in OECD countries dates to the 1980s (OECD, 2010; NIDDK, 2012). There are some indications that low-quality components used for production of foodstuffs, which may partly result from cheaper methods of production adopted by entrepreneurs in the inflationary environment, cause increase of obesity (Schoonover and Muller, 2006). Wiggins and Keats (2015) found that in high-income countries over the last thirty years, the cost of healthy items in the diet has risen more than that of less healthy options, thereby encouraging unhealthy diets. The reason may be that it is more difficult to cut costs associated with production of fruits and vegetables than with production of processed foods.
t is very difficult to evaluate the strategy of reducing the quality of products while keeping the same nominal price. Some will try to find reason for this in entrepreneurs’ willingness to increase sales and profits by all means, though some will defend this phenomenon and claim that clients purchase these products voluntarily. However, it should be noted that the voluntary nature of a transaction does not preclude that consumers’ utility could be higher if they were offered goods and services of better quality. Public monopoly is an example of such a situation. Clients purchase products voluntarily from the public monopoly, but their situation would be better if there were more competitors on the market.
Analyzing this phenomenon is difficult also because decreasing the quality of goods may result from many reasons, not only from expansionary monetary policy. First, it may result from monopolization of the market (Bulow, 1986). Second, government regulationWe refer in particular to price regulations, which often apply to the so-called public utility companies. Changes in the quality of services offered by public utilities due to the monetary inflation may have particular significance (Troxel, 1949). Carron and MacAvoy (1981) researched the quality of services of public utilities in the United States in the 1970s. As regulators did not give their consent to increasing prices, the quality of services and the volume of investment expen-diture decreased, while delays in delivery appeared. may influence the quality of the products. Third, the literature on the subject points to asymmetric information (Grout and Park, 2005). Finally, decreasing quality may correspond with real consumer needs. Market actors may prefer less durable goods because of lower prices, changing trends in fashion, or rapid pace of technological developments.It should also be noted that “quality” is a wider notion than “durability.” Some goods may be characterized by shorter durability, but, for example, extra conve-nience and functionality. It can therefore be reasonably concluded that though some goods were once of the higher quality, only the wealthiest people could afford them. Nowadays, thanks to lower prices, but lower quality as well, these goods are available for a wider range of consumers. From this view point, decreasing quality allows most consumers to purchase desired goods at low price. Simultaneously, there are goods of high quality on the market offered for more demanding and richer consumers.
It is notable, however, that consumers, ceteris paribus, prefer more durable goods as they “render more total service” (Rothbard, 2009, p. 16). As Reisman (1990, pp. 214–216) proved, if higher costs of producing more durable goods on the free market are less than proportionate to the product’s longer life, entrepreneurs have incentives to produce more durable products. Thus, it seems that the decreasing quality—including durability—of some goods and services may result from different government interventions, including monetary inflation, that impose higher costs on companies. Monetary inflation decreases innovation of companies, which may choose methods of production not necessarily the most innovative and favorable for consumers but that guarantee the highest rate of return in an inflationary environment.We can argue that inflation, in a sense, forces innovation by producers in cutting costs and investments that allow them to reduce the use of raw materials whose prices increase. However, it should be noted that such an allocation of resources does not have to coincide with a counterfactual free market allocation of resources. Therefore, we can state that though the inflation may, in a sense, cause innovative behavior, it would be innovation going in the wrong direction in comparison to the one that would have occurred in a reality deprived of monetary inflation.
Hence, we call the decline in quality due to monetary inflation “Cantillon defects,” as it occurs because the new money supply does not distribute itself evenly through the economy, but runs only through specific channels. Therefore, if new money enters the economy through the capital-goods and commodity sectors, entrepreneurs producing consumer goods may face rising costs that could prompt them to adjust non-price parameters of products they sell.
- Indirect Effects of Monetary Inflation on Quality of Goods and Services It is worth pointing out that reduction of the quality of goods and services offered does not have to follow directly the increase of costs of production and be the direct aim of entrepreneurs. The reduction may be only relative and occur with a delay as a result of restricting investment expenditures, including spending on research and development, in the face of inflation (Able, 1980). Moreover, monetary inflation reduces the supply of savings and increases uncertainty, negatively affecting the volume of investments (Horwitz, 2003, p. 78).
The reduction of the quality of goods and services may also result from other indirect effects of monetary inflation. First, monetary inflation decreases the real value of borrowings and thus discourages saving and prompts debtors, including consumers, to buy goods on credit. Consumers in such a situation, instead of saving for goods of higher quality, which would serve their functions for several years, may prefer to buy cheaper goods of shorter durability on credit.Encouraging borrowing would be enhanced if monetary inflation took place through credit expansion, which lowers (ceteris paribus) interest rates. The credit expansion (especially if recurrent) does not only cause a market rate below the natural level resulting from time preference, but can also lead to an increase in time preference, which encourages consumption. In other words, “easy money” policy, which leads to higher prices and higher time preference, may prompt consumers to buy cheaper, less durable goods. Consumers in such economic conditions may prefer lower expenditures in the present day, even if over the years their decision will mean higher total costs for purchasing specific goods (because of their frequent replacement). It happens so because they pay less attention to the future. Such an attitude may be supported through the possibility of buying new products thanks to reduced-interest loans. In this context, it is worth pointing out that the relatively loose monetary policy run by the Federal Reserve System contributed to the development of consumer credit in the 1920s and after the Second World War (Eichengreen and Mitchener, 2003, pp. 36–42; Huerta de Soto, 2006, pp. 487–493).
Second, monetary inflation leads to disturbances in a correctly functioning price mechanism (Horwitz, 2003). Increases in prices resulting from a higher money supply disrupt information conferred through prices, which can unbalance the structure of consumption and the allocation of production factors between goods of higher and lower quality. High price for consumers often stands for high quality (Leavitt, 1954). Therefore, consumers may interpret higher prices resulting from monetary inflation in an incorrect way as an indication of high quality. In fact, they may buy more expensive products of lower quality, which can negatively affect the profitability of companies producing goods of high quality and in this way reduce the supply of high-quality goods.
Third, an increase in prices along with lower variety and lower quality of products may stimulate individuals to self-production. What we can currently observe is the growing popularity of the movement called do-it-yourself (Wolf and McQuitty, 2011). Such a movement reduces innovation as it decreases the division of labor as well as efficiency of production.
- Conclusions In this article, we have challenged the common view that monetary inflation automatically leads to increases in prices of consumer products. Changes in prices are always a result of conscious actions of entrepreneurs who, in response to the rising prices of means of production—and according to the Cantillon effect, an increase in money supply does not affect all prices uniformly and simultaneously—may apply other strategies, consisting in decreasing the quantity of product or reducing its quality, keeping the nominal prices unchanged.
Thus, monetary inflation is a factor passed over in the literature that may be partially responsible for downsizing and decreasing quality of some products. From this perspective, the above-mentioned actions taken by entrepreneurs do not have to result from their ill will or inherent greed, but from their effort to remain in business in inflationary and competitive environment. Therefore, it seems that the Austrian theory of inflation should be extended to incorporate non-price effects of monetary inflation.
The non-price effects of increases in the money supply clearly show that the impact of monetary inflation on innovation is negative. Instead of promoting products of higher quality, entrepreneurs spend scarce resources to hide the increase in an effective price through changing packaging or reducing quality, which is detrimental to innovation. That impact does not have to be direct, but can result from cutting costs through limiting expenditures on investments.
This paper does not exhaust the subject, but it contributes to further research, perhaps of a quantitative nature. We believe that the presented considerations on non-price effects of monetary inflation have a solid foundation and contribute to the literature on inflation and business strategies adopted in an inflationary environment.
The minimum wage was a hot topic in the 2016 presidential campaign. By law, on January 1, 2017, the first group of Seattle workers reached $15 per hour with an average of $11 per hour in the rest of the state. Proponents in Washington and across the country claim that the increase will reduce poverty and income inequality, and finally allow workers to afford housing and everyday essentials. This is in spite of the accepted economic principle that wages are a result of the marginal productivity of the worker, not housing costs and disparity in incomes. Is this social interference economically sustainable?
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The roundabout or technological process"Production" is the general term for the natural and artificial processes by which indirect goods (or uses) are combined and advanced one or more stages toward ripeness or readiness for direct use by men.See Chaps. V, X, and especially the section on "direct and indirect uses" in Chap. 17. In the processes of production, goods are changed in various ways in their stuff, form, place, time, or ownership. Nature is the great primary producer. The amount of labor employed in the various processes of production — whether measured in time, trouble, effort, or price — varies from an almost negligible amount to a great deal. Man's part often might be likened to the mere pulling of a gun trigger to set off a load of natural forces, or to the unlocking of a door to release the imprisoned uses in indirect goods. Production under human guidance has been called "the roundabout process,'' because the end sought — the direct enjoyable goods — is attained by a succession of indirect steps. The adjective "technological," implying the action of one thing upon another, is also used in place of roundabout.
Technological changes are usually accompanied by increasing valuations of the goods, and it is this desired result which motivates men to produce. The increment of valuation belongs to the responsible owner of the products after all the legal claims of others who supplied part of the indirect goods have been satisfied by the payment of wages, rents, purchase prices, and claims of all sorts. The erroneous notion that the increased valuation is caused solely by the labor used in the process of production is known as "the labor theory of value."
Men often have to choose between the direct and the indirect uses of concrete goods. For example, should a piece of wood be used for fuel, or as material to build a house, or to make some implement such as a fence or a hoe handle? These choices depend on the owner's differing valuations of present and of future uses, and durative and of consumptive uses, contained in same agents. One kind of use may be had only at the price of the other kind, as discussed further below in connection with alternative costs, or alternative valuations.
The enterpriser's functionThe enterpriser, or entrepreneur, as pointed out in Chapters V and XI, is the middleman who undertakes the financial responsibility of carrying on some roundabout process one step further for the next group of buyers, and eventually for the final users. He is a self-appointed agent of the proximate and ultimate buyers. On his judgment of the probable difference between his outlays and his sales he risks his own time and services together with whatever capital he has embarked in the enterprise — that is, the financial fund embodied in his money, credit, lands, houses, tools, and so on.
The outcome of large or of small profits depends partly on mere chance and accidents beyond any human control or prediction, such as earthquakes, floods, fires, wars, and fashions, which are the incalcuable risks of any enterprise. Other profits may result from unfair, fraudulent, and criminal conduct or from monopoly and special governmental favors. Under more normal conditions, however, profits depend mainly on the comparative skill with which the enterpriser chooses his investment and operates his business, combining the agents in the right proportions to obtain product that may be sold at profitable prices.
The current prices at which indirect agents can be bought is rather narrowly fixed in free markets, and one enterpriser usually has little advantage over another in this regard. Except when he has some monopolistic power, he must take the system of prices for his necessary agents pretty much as he finds it. The success of the competitive enterpriser in making profits depends the agents far more after on good judgment in selecting and in proportioning the agents after he buys them, than on buying them at less than current prices.
Optimum size of an enterpriseIt may be recalled that the point was made in Chapter XI that the first question the enterpriser must decide regarding his plant is that of external proportion: How big a plant should he build? For how large an output? There is an ideal, or at optimum, proportion between plant capacity and the demand at a profitable price within the market area of the plant. An excess of consumptible agents such as coal and raw materials can be used up in a short time with little loss. The greater chance of error is determining the capacity of the durable plant; if it is too small it frequently can be enlarged as output increases, only at disproportionate expense. Therefore it may seem better to provide for the future by purposely building some parts of the plant larger than is needed at the time, in the hope that the present cost (recurring interest on investment) may be defrayed from future profits.
If the plant is built too large, the unused capacity, whether land, floor space, power plant, or machines, represents an outlay useless for present and near-future needs. A question of theory and of practice arises: Should a normal return on either an intentional or a mistaken original outlay for unused plant be treated as part of the "costs" of the actual smaller output?
Overhead costsCosts for unused capacity which is already paid for are merely that part of the capital outlay on which an estimated fair annual return is expected. Often such costs are represented by outstanding bonds calling for regular interest payments. These costs for unused capacity, whether they be estimated or actually incurred, and a number of other costs which do not vary with the size of the output — executives' salaries, taxes, and depreciation charges — are known as overhead costs.
When overhead costs are included in the costs of the actual output, what happens if the output increases in response to an enlarged demand? As the external proportionality of plant to market moves during this time toward the optimum, total costs increase slowly, unit costs decrease, and profit increases. This period, during which a former mistake in the size of a durable plant is being point has corrected, is a stage of decreasing costs. After the optimum point has been passed, unit costs in the enterprise, calculated in the same way, will again increase because of lack of proper proportionality in the use of the agents of production. This is the stage of increasing costs.
This use of the terms "decreasing" and "increasing costs" as applied to a single enterprise is often confused with the very different problems of diminishing physical returnsSee Chaps. V and VI. to an entire national industry. An example is agriculture, where increasing population and the more intensive utilization of a limited ares of land results in diminishing physical returns.
Optimum internal proportion of agentsAs the optimum size of a plant in relation to its market area is a problem of external proportion, so the optimum amount of each factor of production within the single plant presents a problem of internal proportion. Land, buildings, power plant, machines and tools of various kinds, and labor of all grades should be bought in just the right amounts and kinds in view of their relative prices. The two conditions are not entirely distinct, but they mutually affect each other. An unwise external proportioning of capacity of a whole plant to market demand upsets the right internal economic proportion within the plant. When the investment in durable plant is too great, the excess investment would yield a larger profit either in making other products or in other enterprises.
The internal proportion of variable agents within the plant may also be mistaken when the capacity of the plant as a whole is not out of line. Even in a small enterprise, many choices of agents must constantly he made, choices involving a comparison of costs at the prevailing prices with the expected addition to the prices of the products. At one time it is better to hire another laborer or another skilled worker; at another time it is better to buy more tools or better machines, or to use more materials of certain kinds. So far as these choices are wisely made, they serve both to ensure a profit to the single enterprise and to maintain the equilibrium in the general system of prices. As a result of the differing judgments of enterprisers, costs in various competing enterprises within the same industry may differ widely in their items and in their total amount. There is no common standard cost in this sense for an entire industry; each enterprise has its differing outlay costs.
The empirical law of costsThe total of the prices (costs) of the agents used in an enterprise tends to correspond pretty closely in amount with the total price of the products. It is assumed in this statement that costs include a "fair profit" to the enterpriser on his invested capital, as measured by the opportunity costs as explained later. If, however, profits were defined as the remainder left after deducting costs from receipts, then the wording of the principle would be that cost plus a fair profit tend to be equal to the price of products. Total costs and total price of products, divided by the number of units of product, gives unit cost and unit price of product.
This tendency of costs and product prices to come into agreement is the empirical law of costs. It is called empirical to denote that it is a simple fact of observation and not an assertion regarding causal relationship. As such it must be accepted by all economists as true, subject to various frictions and lags in practical experience.
Question of the causal order of costs and product-pricesDifferences of opinion, however, have arisen among economists in their attempts to state a causal order of cost and price. Thus some have maintained that the business costs in each industry determine, set, fix, or regulate the prices in that industry — in other words, that the causal order runs from the costs in an enterprise or industry to its prices. Few have seriously attempted to oppose this view with its direct opposite, that is, to maintain that the prices in any one industry (or enterprise) determine the costs in that one industry. But seeing that costs and product prices are merely two sets of prices in the same industry, the question arises as to whether either set necessarily is the cause of the other. May not these two sets of prices in the same industry be the effect of a common cause, be merely parts of the larger system of prices determined by forces and conditions lying outside any single enterprise or even the wholeindustry? Let us try to find the answer to this question.
Technological adjustment of costs to higher product-pricesIt is through the action of middlemen that the empirical law of costs operates. With no such purpose in view they are constantly bringing costs and product-prices into accord; they do so merely through seeking to make a better profit by buying indirect agents more freely when their cost is low compared with the product-prices, and vice versa. If but a single kind and grade of goods is produced, as cement in a cement mill, the estimation of unit costs is simplest, and yet even here there is no problem of estimating and distributing overhead costs fairly. When a variety of by-products is produced, as in a flour mill or in a meat-packing house, nearly all items of variable costs are spread over two or more products, and, like overhead costs, are joint costs. Under such conditions the problem of relating costs to prices becomes complex.
What happens when it becomes known that an industry generally, or some plants in certain neighborhoods, are making profits higher than "normal." The output of some plants will be. increased, some plants will be enlarged, new plants will be started, and goods will be shipped into that territory from greater distances. The increasing supply will decrease the product-price or at least retard its rise, and at the same time the cost-price of the more limited agents (labor, local materials, and the like) will be bid up somewhat. The result is a new relationship, a tendency toward a new equilibrium between cost-prices and product-prices in such plant and in the entire industry.
Technological adjustment of costs to lower product-pricesThe whole process is reversed when product-prices and profits are abnormally low. Output is curtailed by those so situated that they cannot male a profit in that area; some marginal producers go out of business entirely; some shift a part or all the capicity of their plants to the making of other products, and the industrial equipment that wears out or is otherwise destroyed goes unreplaced so long as normal profits cannot be made on the cost of upkeep. The effect of deceasing supply is to raise product-prices (or at least to check further tendency to fall), whereas the decreased demand in that market for the more limited cost goods reduces their prices until again there results a new equilibrium of product-prices and costs.
AII such methods of bringing costs and product-prices into accord by physical changes in plant capacity and in the amount of products may he grouped under the general description of the technical, or technological, adjustment of costs and product-prices.
Friction and lag in adjustmentsSolely by such technological methods the equilibrium between costs and product-prices might eventually be brought about but here is much friction and lag in the process. To explain these facts the doctrine of quasi rents, with its contrast between the long- and the short-time relationship of costs and prices, was developed by the English economist, Alfred Marshall. In this view of the cost and adjustment process, it is assumed that original investment has the same capital value as long as the physical agents last, and that the "fair" rate of return on this investment may be accounted as parted of the costs of present products.
Adjustment of costs by resaleBut this is not all. A certain flour mill which cost originally $100,000 continued for years to earn the expected annual return on that investment. Fifty years later it was still in good repair and usable, yet no one was willing to pay more than $10,000 for it, and that only because of the water power. Why so? Because that region no longer produced wheat, the chief raw material of the mill, and no buycr could be found who thought the present and prospective net income (rental value) of the mill would justify his paying that much for it.See the capitalization theory in the chapter on Interest. On the other hand an old business may sell for more than its original cost as a result of various changes in economic conditions.
This illustration of the mill is no imaginary case, and there have been thousands like it. That particular mill is now entirely abandoned. If someone did buy it for $10,000, implying that he estimated its net earning power (rental value) at about $500 or $600 a year, neither he nor anyone else could assume that a fair allowance for annual overhead costs would be $5,000 (say 5 per cent of the original cost). Was that, then, a fair estimate of costs by the former owner up to the moment of sale? Can or ought nothing change the fair estimate of overhead costs, based on original capital investment until the property changes hands?
Adjustment of costs by recapitalizationOriginal investment cost is merely the price paid by the investor at the moment he buys the business, at a valuation reflecting his forecast and hopes of its future earning power (rental value). Experience must tell whether that valuation (capitalization) was right. If he discovers by the end of the first, or any later, year that he has made a mistake, the original cost figure merely records that error.
In the price system economic agents are worth what they will earn, not what they cost, and the capital value of agents with future uses is the present worth of their expected incomes. Frequently, present worth is much greater than past cost, a fact which business men are rarely slow to recognize by reappraising their assets upward. In other cases present worth is less than past cost.See the chapter on Interest. Past costs are ancient history, and if an enterpriser continues to carry his original capital costs and inventory unchanged on his books, and to use these figures as the basis for "fair" prices based on costs, he is, to say the least, a laggard accountant. If he is in a competitive enterprise, his error will cost him dearly, but if he has sufficient monopoly power, it will cost the public dearly.
The cost-of-reproduction doctrineIf present and estimated future earning power is the logical and practical basis for the present "capital value of business agents for a new owner, why was it not likewise so for the old owner before the sale? Once one departs from original investment price (less depreciation) as the standard of costs, even in the case of resale at a lower or a higher price, it is hard to find any logical stopping place in modifying the theory that past costs determine the just and fair basis of present prices.
Recognizing this, some economists,For example, Francis A. Walker, as early as 1880. seeking a way out of the difficulty, many years ago adopted the view that present "cost of reproduction," not past cost of production, is what determines product-prices. If, as is clearly implied by this doctrine, the present cost of indirect agents is not determined by their past cost, what does determine it? To this no direct answer is given by the cost-of-reproduction theory, although the thought is near that costs somehow are shifted up or down with current prices of products.
In one text which professes to accept the cost-of-production theory, the doctrine is developed that future costs of production determine present prices. Whatever else that may mean, it is something very different from the older cost-of-production doctrine.
Actual costs versus costs from past investmentIf all costs in an enterprise were actual current outlays, and all products were sold within a single year, it would be comparatively easy to calculate costs and profits. The real conditions, however, as to the time and form of costs and sales are usually such that any statement of the amount of costs and profits is largely the result of somebody's conjecture rather than the outcome of completed business transactions. Note a few of the difficulties.
Besides the agents bought and used at once (or within a single year), there are usually some stocks of consumable things such as coal, oil, lumber, cotton, grain left over from previous years; and in turn some such things bought this year may not be all used up. The current prices of these stocks at the time they are used is usually either more or less than their actual cost, and the longer the lapse of time the more the two figures are likely to diverge. Even greater changes occur in the costs of durable agents such as land, buildings, and machinery, and of intangible rights such as patents, charters, good will, and the like, acquired in the past for a price, but the benefits of which continue over a series of years. Of the total original monetary costs of such durable agents and rights, evidently only that fraction of separable uses that goes into the making of one year's output could reasonably be counted in the current costs.
Guesswork in calculations of annual cost itemsThe amount of cost allotted to the making of one year's output is decided only by somebody's valuation. There is, first, an estimate of the "fair" capital value of the durable agents, and, second, an estimate of the "fair" annual rate of return upon that capital value (as say $100,000 at 10 per cent, giving $10,000 as one year's cost). The question has been raised above whether the original cost of the durable plant should remain unchanged through the years, regardless of changed conditions which have revealed such facts as that the location was a mistake, or that the plant has become obsolete and nearly worthless, or that there is no longer a market demand for the output. Or the conditions might seem to call for an increase in the valuation of the present worth.
Then a further question arises. Whatever be the capital value, is the rate at which the investor merely hoped to profit to be taken now as the "fair" rate regardless of whether it is the rate which new investors now expect to earn? Evidently such cost figures are merely personal estimates and contain a large element of guesswork. Calculations of cost made by sellers for the purpose of convincing the public that their prices afford them only a "reasonable" profit over costs of production are peculiarly open to suspicion of biased judgment.
Opportunity costsUnder our system of private property and enterprise a producer is entitled to decide whether to continue in business at all or to continue making any specific product. He may get out of his business at once by selling it outright; or he may gradually reduce its scope, neglect repairs, and finally sell the rest at its salvage value; or he may choose not to rebuild after a fire; or he may shift its uses to products of another industry (sewing machines to bicycles, phonographs to radios, and so on). Whatever he does in this way tends to reduce the supply of the products and thus to raise or to check the fall of their prices as already described. The reverse process occurs when profits are temptingly high.
Any of these things may happen even if the enterpriser owns his entire plant without indebtedness and even if he and his family do all the labor so that his actual cash outlays are very small. His leaving the business would be evidence that his valuation of his fund of economic agents (lands, buildings, tools, working capital in the form of cash, his own labor and that of his family) is greater for some other uses than it is for this particular business. This is true, even if he loses a large part of his original investment in making the change. The estimate of the return which can be obtained from economic agents in an alternative use has been called an opportunity cost, which is merely an alternative valuation. If in any given employment the use of an agent will not yield as great a return as its valuation in another use, the agent will tend to be shifted to the other use. It is plain that opportunity cost is not an actual cost but an estimate or personal valuation. The costs in every business in which the enterpriser owns and supplies a part of the economic agents are partly actual costs and partly the owner's personal valuations of alternative applications.
Personal preferences in alternative valuationsSuch valuations are often made by the residual method of comparison. As a simple example, suppose a small manufacturer calculates that he is making an average annual income of $9,000, this being both for his investment and for his own services. He can get a salary of $5,000 in another business, and thinks he can sell the business for $100,000 and invest the proceeds safely at 5 per cent and get an income of $5,000. His total alternative valuation in money incomes is therefore $10,000, as against $9,000 which he is now getting. Under these circumstances he might sell, but again for purely personal reasons — habits, sentiments, hopes, and so on — he might not. Or he might shift the factory to other products in which he believes he could earn a net income of $12,000. He might make this shift, or he might not if he prefers the business he is in. There are factors of psychic income in all such personal decisions; estimates of incomes and opportunity costs merely in terms of dollars are not alone decisive, The example shows, too, that the marginal producers, those most likely to come into or go out of the production, are not necessarily the least efficient. When price falls, those who drop out may be among the most efficient as measured by their monetary costs of production and by profits, but they may have other better alternatives, and may be influenced by psychic factors such as prestige, social ambition, health, temperament, aesthetic and personal tastes, and other considerations.
Price relationship implicit in demandIn all their transactions in search of profits, entrepreneurs and other middlemen operate within an all-embracing system of prices which no one of them makes, but which each has to take as he finds it. Let us consider further how the price system takes form, and how it influences the demands and supplies of individual enterprisers. Recall here some elementary truths of valuation. Every individual valuation is the numerical expression of the importance to that person of one thing in terms of another. The quantity of any valuation is finite, because purchasing power is limited in amount. If more money is given for a commodity having a direct use to its owner, the marginal valuation to him of his remaining money rises in terms of that commodity.
The market demand at a certain price is merely the sum of individual demands. It is the number of units of a given commodity for which buyers are willing to pay the total price called for (unit price times units bought, say 100,000 bushels of wheat at ninety cents a bushel, or $90,000). Buyers will buy to that point because, individually and collectively, they value that amount of wheat more than any assortment of other goods they could buy at the time for that sum of money. Beyond that point further (extramarginal) units of wheat have not so great a valuation as the marginal units of the remaining purchasing power.
And what is the source of the value of purchasing power in terms of money? It is merely the reflected value to its possessor of the other desirable things which money can buy. Whatever be the actual demand for any specific commodity in a market, each and every buyer is choosing it in preference to every other good which could be bought for the same price. Of course, lack of vision, impulse and various accidents cause many mistaken choices which later may be recognized as such. Every personal and family budget is a system of valuations, linked through exchange with the existing system of prices.
Middlemen and final buyersThe market demand for a commodity is a cumulation of the demands of many individuals who have many different uses for the goods and many motives for their demands at various prices. Two classes of buyers particularly may be distinguished here: The first class consists of final or ultimate buyers, whose valuations are based on their own uses; the second class consists of intermediate buyers, or middlemen, who buy not with any purpose of using the goods for their own enjoyment but only to sell again. Such resale may be of goods in nearly unchanged form (as in merchandising), or after fabrication (as in manufacturing), or after their use as agents in various other sorts of enterprise (as seed and fertilizer in agriculture, or fuel for power in transportation). Middlemen may sell either to buyers for personal use or to other middlemen who, in turn, sell either to other middlemen or to final users. But in any case, the analysis finally gets to the starting point of all valuations, namely, valuation for direct use. All intermediate market-demand valuations are but reflections, or forecasts, or estimates, of the prices which ultimate users of goods may be expected to pay for them.
Middlemen's supply and demand reserve valuationsIn only a comparatively small number of trades, mostly retail, have many of the buyers direct-use valuations for the things they are buying. Even more rarely is this true of the sellers. In our developed system of exchange, raw materials and fabricated products pass through numerous hands before coming in completed form to the final users. Therefore, in the markets for most goods, both demand and supply are determined immediately, though not ultimately, by businessmen's valuations. In viewing the ordinary diagram of demand and supply, we must not think that demand is determined immediately by final users and that only supply is determined by businessmen's estimates. In most business deals, both the buying and selling groups are made up of businessmen and middlemen, and, to repeat, their estimates determine immediately both demand and supply. But what is the basis, or the final criterion, of their valuations?
Business demand and ultimate buyers' demandFollow this process step by step, starting from the valuation of the direct commodity by the final users. The commodity being scarce and valuable (say bread), enterprisers in stage one (bakers) undertake to produce more of the commodity by combining other indirect things. The limit which they dare pay (their total costs) for these means is fixed by the valuations of the direct users of bread, and this limit will be approached under competitive conditions. In turn, the millers purchase wheat and advance it one step further toward completion (flour). Their demand for wheat is fixed by the amount which bakers will pay for flour. Continuing, the original step in roundabout production will be the ultimate factors of natural resources and human labor; the demand for them, too, is at valuations determined from the valuations of the direct users, not of one final product only (bread), but of the various products for which any part of these original factors are used.
The valuation in each of these possible uses is an opportunity cost, or alternative valuation, for each of the other uses. Such original factors as land and labor have no prior, or original money cost: their price is derived from the price of the final products.In and old country, however, present owners may have bought natural agents directly or indirectly from the first owners, at prices determined by the bidding of the whole community for these useful and scarce indirect economic agents. In such cases these agents have a monetary price constantly readjusted the same as that of any other agents in the price system.
Supply valuation determined by ultimate buyers' demandThe answer to the question: "What is the ultimate source of middlemen's supply valuations?" is suggested in what has just been said of middlemen's demand valuations. Every enterpriser is operating in the midst of a system of prices. All business costs at each stage of the roundabout process are incurred in the expectation of selling the product for enough above costs to allow a profit. The enterpriser buys each agent up to the point where his marginal valuation of it is just equal to that of any other factor which he can buy with the same amount of money. The costs include the prices not only of the physical materials — textiles, lumber, metals, grains, and the like — but rents, wages and salaries, advertising, freights, taxes, and many minor outlays. Why are the agents which are an enterpriser buys worth what he pays for them, or worth any amount whatever? Evidently it is because each enterpriser in turn expects, or hopes, to sell the products for more than they cost him, selling always in the direction of the ultimate buyers. Any one middleman may not need to consider the source of demand beyond the sale of his own product, and usually he does not try to. He bids for and buys the indirect agents needed by him on the basis of the prices for which he in turn hopes to sell his products. And this goes on in every stage of production until the final user of the finished goods is reached. A middleman has no independent buying or selling valuations for agents, outside the system of prices in which he operates. In final analysis, therefore, all middlemen's buying valuations are traceable to, or derives from the value of goods to final direct users.
The moment a middleman has paid a price for any factor of production it becomes a cost of production to him. Product-prices and costs are both prices within the price system, the former for more nearly direct uses, the later for less direct uses or goods at each stage of production. There is, however, no antecedent price for scarce natural agents at the very first stage of production in the roundabout process. Their price is, so to speak, the auction price which competing ultimate users pay for these agents through the medium of middlemen competing at each stage of production. Business costs of indirect goods are reflections of the prices of the final direct goods of all kinds with which they are connected in the whole system of prices.
Various conditions of the theoretical price equilibriumThe various prices constituting a system of prices at a certain time in a community are not the result of separate accidents, and they are not arrived at independently. As the very word "system" implies, they are related by some principle in a more or less orderly way. That principle is the marginal valuation of both direct and indirect goods.
First, the final buyers of direct goods apportion their purchasing power (money and other salable goods in their possession, including their labor power) among the various direct goods so that to each user the direct-use valuations are brought into equilibrium. Then each middleman apportions his purchasing power among the various indirect agents at this stage of production so that in his business the marginal valuations of the indirect uses are in equilibrium. When this condition is attained, there is, for the moment at least, no motive for anyone to rearrange his budget either of personal and family expenditures or of business outlays. Each budget is for the moment at its optimum proportionality. The outside limit of middlemen's valuations, either in buying or selling indirect goods, lies in his estimation of the valuations and demands of the buyers of his products, and so on to the final buyers. Under these conditions of equilibrium of individual valuations, demand and supply for each king of goods also tend to be brought into equilibrium, thus forming a system of prices which for the moment is also in approximate equilibrium.
A perfect equilibrium of valuations and of prices is a theoretical ideal, an abstraction never fully realized. It is an end toward which the forces of human desire and choice at each moment are always tending without every fully attaining. There is a lag and friction in choice and in the processes of production; in the meantime changes occur in desires as well as in the material conditions of plenty and scarcity of goods — weather, plagues, crops, accidents, discoveries, sickness and health, peace and war, a thousand vicissitudes. Each new total set of conditions involves a new theoretically correct equilibrium. Despite the ceaseless flow of the tides toward adjustment with the forces of gravitation, the oceans never come to rest.
Prices under static and dynamic conditionsThere is no need of two distinct price theories, a static thenry, concerned only with a condition of rest and equilibrium, and a quite different dynamic theory to explain the behavior of contemporary prices when new forces violently disturb such an equilibrium. The function of price theory is to give a rational explanation of the choices and actions of men which tend to bring about an equilibrium of valuations and prices, rather than to study and explain a mere motionless equilibrium itself. The most static human society of which we have any knowledge, one with the least progress in the technical arts and with population stationary during long periods, is yet full of much internal movement and fluctuation. Children are born, grow to maturity, are well or ill, suffer accidents, grow old and finally die and are replaced in the population by other individuals. Education must be constantly repeated; the young must chose and master their occupations. There is the constant round of the seasons, changes of weather, heat, cold, floods, drought, insect pests, plant blights, scanty or bountiful harvests, for years, lean years, pestilence, plague, famine, and war.
A price theory which serves to explain how an equilibrium of contemporary prices tends to be constantly re-established in these conditions merely needs to be extended — speeded up, as it were — to apply in more dynamic conditions of society where there is rapid population growth, revolutionary progress in science and in the practical arts, and striking changes in manners, tastes, education and culture, with accompanying changes in human tastes and desires and in the kinds and amounts of goods and services. We have not undertaken to treat the special dynamic problems of price changes during the successive time phases of the business cycle — the sudden disruptions, the marked inequalities between the price changes of the various commodities and industries, and the differing lags in their recovery. However, numerous passages in chapter and the next one are not without bearing upon those questions.
Summary and conclusionsIn this chapter our attention now returns to man's part in the process of production. The purpose is to consider particularly the part played in the determination of prices by middlemen who have no use-valuations of their own for the goods they buy or sell, but only exchange-valuations.
The roundabout process in production is directed by enterprisers who, if successful, thereby obtain profits on their investments and for their efforts. To obtain profits it is essential that the enterpriser keep his outlays (costs) below the receipts frm the sale of his products.
The observed tendency is for the product-prices and costs (including normal profits) of the various industries and separate enterprises to come into accord, through with frequent lags and imperfect adjustment. This statement is called the empirical law of costs. Business costs are merely one sort of prices in the price system. The theory of price has to explain the relationship of two sets of prices in the price system, those of direct final goods and those of indirect or intermediary goods, or agents of production. The motives which lead businessmen to pay any amount whatever for the agents of production (that is, to incur costs) is the hope of reselling the goods (further fabricated) in the direction of the final users.
The enterpriser's "costs" are in business language understood to include not only actual cash outlays for a specific agent, but also estimated (opportunity) costs of various kinds. Costs of both kinds are traceable immediately to the marginal valuations of the purchasers of the products of each stage of production and ultimately to buyers' demand for final direct goods.
The price system as a whole is made up of a number of sets of prices, each of which is constantly tending toward internal and external equilibrium. These various equilibria are constantly being upset by new forces. When the disturbance is gradual and moderate, the condition is called relatively state; if rapid and extensive, it is spoken of a dynamic.
Suggested ReadingsBöhm-Bawerk, Eugen von. The Positive Theory of Capital. D.E. Stechert and Co. New York. 1923. Reprint. Pp. 428.
Carter, Thomas N. The Distribution of Wealth. The Macmillan Co. New York. 1904. Pps. xvi, 290. Chap. 2 contains a statement of the principle of proportionality.
Clark, John M. Studies in the Economics of Overhead Costs. The University of Chicago Press. Chicago. 1923. Pp. xiii, 502.
Davenport, Herbert J. The Economics of Enterprise. The Macmillan Co. New York. 1913. Pp. xvi, 544. An analysis of opportunity costs is found in Chaps. 6 and 8.
——. Value and Distribution. The University of Chicago Press. Chicago. 1908. Pp. xi, 582.
Fetter, Frank A. Economic Principles. The Century Co. New York. 1915. Pp. x, 523. Chap. 28 contains an analysis of the relation of cost to price. In Chaps. 12 and 31 will be found additional data on the internal and external proportioning of the productive agents.
Green, D.I. "Pain-cost and Opportunity-cost." The Quarterly Journal of Economics. 1894. Vol. 8. Pp. 218–229.
Mund, Vernon A. "The Financial Adjustment in the Empirical Law of Cost." The American Economic Review. March, 1936. Vol. 36. Pp. 74–80.
Robinson, E.A.G. The Structure of Competitive Industry. Harcourt, Brace and Co. New York. 1932. Pps. viii, 184. A consideration of the optimum size of an enterprise.
Questions and Problems1. How would you characterize an enterpriser? What is the function of the enterpriser?
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Distinguish between the optimum external and the optimum internal proportion of the agents in productive activity.
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What is the "empirical law of costs"? What individuals bring about the operation of the law?
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By what methods or adjustments is the correspondence of cost and price effected? Explain fully.
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When is the price of a good "normal"?
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How is market price determined by the interplay of demand and supply?
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Distinguish between actual (contractual) costs and estimated costs. Give examples of each.
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What are "opportunity costs"? Give examples of conditions in which agents have an opportunity cost; of conditions in which they do not have an opportunity cost.
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Show by means of an illustration the way in which opportunity costs influence the use made of economic agents.
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How would you characterize the "marginal" producer? Give an example. In what sense is he the weakest? In what sense not?
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What is the basis for ultimate buyer's valuations of direct use goods? For intermediate buyers' or middlemen's buying valuations?
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What is the basis for the selling valuations of middlemen?
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Trace the process of making valuations in each principal stage involved in the making of a wool dress or suit. In your answer show how product-prices become cost prices.
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What is the final source of demand for goods of any degree of indirectness?
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A business executive recently said: "Over a period of years, from 1925 to 1934, the steel industry averaged only 2 1/2 per cent return on its aggregate investment. In the best of those years, it showed a return of only a little more than 9 per cent and in the four years, 1925 to 1928 inclusive, the industry averaged less than 4 per cent return after all charges but before dividends." How was the "aggregate investment" of the whole industry determined, and by whom?
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
ABSTRACT: When individuals save more and invest directly in projects there results capital accumulation and growth. When individuals save more in order to add to their cash holdings, consumer goods are liberated that can be used for capital accumulation causing also economic growth. At first sight, the processes seem similar. But are there differences? And if so, what are they? In this article and responding to Pătruți (2016), we will first emphasize that cash building does not necessarily stem from saving. Second, we will argue that cash building by saving does not necessarily imply a longer time period for capital accumulation to materialize. Third, we will criticize the argument that hoarding would be suboptimal vis-à-vis direct investment. Finally, we will analyze the differences between cash building by saving and saving through investing.
KEYWORDS: Austrian school, capital theory, structure of production, investment, interest, hoardingJEL CLASSIFICATION: B13, B53, E14, E22, E31, E41, E43, O40
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 4 | 345–358Winter 2016
The Interest Rate and the Length of Production: A CommentDavid Howden
David Howden (dhowden@slu.edu) is professor of economics at Saint Louis University – Madrid Campus. In addition to Jeffrey Herbener and Shawn Ritenour, I would also like to thank, without implicating, an especially insightful referee.
ABSTRACT: Machaj (2015) does a great service in pointing out a key assumption, heretofore unaddressed, in Filleule (2007) and Hülsmann (2010). Machaj errs, however, in stating that who saves will have an ambiguous effect on the interest rate and that where savings are directed can have ambiguous effects on the length of production. In this brief comment I will first show that who saves will have no effect on the interest rate. I then turn my attention to what it means to “lengthen” the structure of production. Although extended production time or additional “stages” of production make convenient placeholders for increased roundaboutness, they fail to grasp the core concept as it pertains to capital theory: what is it about production processes that makes more or better consumer goods?
KEYWORDS: capital theory, interest, production structure, roundaboutness, labor intensityJEL CLASSIFICATION: B13, B53, D24, E43What is the relationship between the rate of interest and the length of the structure of production? Austrian School economists often claim an unambiguous negative relationship between these two variables. Indeed, the assertion that artificial reductions to the interest rate cause an unsustainable lengthening in the structure of production is the central tenet of the Austrian theory of the business cycle.
Recently, Fillieule (2007) and Hülsmann (2010) have challenged this claim by deriving the logical outcome of a drop in the interest rate given a fixed stream of aggregate expenditure. As the rate of interest falls, current consumption is discounted at a lower rate. The result is a shorter production structure, with production activities moved closer to final consumption, or to what Menger (1871, ch. 1) referred to as goods of the first order. While such an outcome is opposed to traditional analysis, it is the logical consequence of a reduced interest rate on a constant expenditure stream.
While such reasoning is correct, bypassing an important causal relationship creates an outcome more apparent than real. Within a fixed expenditure stream, the interest rate can only decrease if consumption falls or savings increase. Both of these outcomes represent different sides of the same coin, as the market rate of interest is the intertemporal price differential between present and future goods, i.e., between consumption and investment expenditures.Technically the pure rate of interest is the intertemporal price differential between equivalent satisfactions, as provided for by the use values embodied in goods. To the extent that financial assets, such as money, circulate according to their exchange and not use value (Howden 2015: 17; 2016a), the intertemporal price differential of the physical goods will be the same as that of their satisfactions. Machaj (2015, p. 279) is quite correct in challenging Fillieule’s and Hülsmann’s novel conclusion that a lower interest rate will shorten the structure of production since they give no cause as to why the interest rate would fall. Realizing that a decrease in the level of consumption is a necessary precondition for a falling interest rate goes far in illustrating the traditional negative relationship between the interest rate and the length of production.
Machaj overreaches with this conclusion, however, in then positing that who increases his savings will have an ambiguous effect on the interest rate. He does so by describing scenarios where the interest rate decreases without decreases in total consumption. This outcome gives the seeming result of “total savings increasing without total consumption going down” (Machaj, 2015, p. 279).
Imagine a simple scenario of capitalists decreasing their consumption by X units (total savings increase). Imagine that this additionally saved money is being spent only on higher wages. Under the framework—for the purpose of simplicity—workers are being treated as pure consumers, so that wages are fully spent on consumption. Hence a decrease in capitalists’ consumption by X units is fully (under such scenario) counterbalanced by an increase in X units of laborers’ consumption. At the same time, total savings are increased (because capitalists are saving more), and the interest rate can fall with total consumption unaltered. (Machaj, 2015, pp. 279–280)
The belief that the relationship between consumption and the rate of interest depends on who saves, lower time preference capitalists or higher time preference workers, is attractive but misplaced. What matters is the aggregate level of savings and not its composition amongst individuals.Indeed, the stock of savings has only a value dimension and does not acquire a temporal aspect until it is invested (Braun, 2014, p. 55).
Assume a closed economy in a no-profit equilibrium. Aggregate income Y accrues to factor owners in the following manner (Rothbard, 1962, p. 334): workers in the form of wages w, capitalists in the form of a return r on their investment, and landowners by payments l for the use of land. Workers consume CW, capitalists consume CK, and landowners consume CL, with total consumption C being the sum of worker, capitalist and landowner consumption. There is no income hoarded in the form of money.
Workers’ savings SW are given as:
SW = w – CW
Capitalist savings SK are given as:
SK = r – CK
And landowners’ savings SL are given as:
SL = l – CL
Since savings in the closed economy can only come from workers, capitalists and landowners, total savings S simplifies to the standard expression:
S = Y – C
Since the interest rate is negatively related to the savings-consumption ratio, and since aggregate savings and aggregate consumption are two sides of the same coin, we find the standard result that increases in consumption must drive savings lower and thus increase the rate of interest.
In this scenario, all income flows to the factor owners in the form of wages, a return on capital and rental payments for land use, and these groups then decide whether to save or consume this income according to their own preferences. Taken together, it is clear that aggregate savings cannot increase except by either 1) an increase in income, or 2) a decrease in aggregate consumption expenditures. The composition of the originators of the savings, however, has no bearing on the rate of interest.
Machaj’s example aims to show that savings can decrease even if total consumption is unchanged. Since he assumes explicitly that the expenditure stream Y is constant, the inconsistency between a falling interest rate with unchanged consumption must be explained through other means. Machaj assumes the worker is a pure consumer with no savings (CW = w). He then proceeds to shift the income distribution so that r increases by the same amount as w decreases. It is here that he states that savings must rise since workers save less than capitalists. However, the total sum of consumption expenditures will also have decreased by the same amount and not remain constant as Machaj states.
To summarize, the redistribution of income will decrease consumption by the same amount as savings have increased, resulting in a lower interest rate. Consequently, Machaj has not demonstrated that a decline in saving need not be offset by a commensurate increase in consumption expenditures.Before moving on I must point out one more quibble with Machaj’s presentation of the relationship between the length of the structure of production and changes of the consumption-savings ratio. He (2015, p. 279) points out correctly that what is relevant is the interest-rate elasticity to the consumption-savings ratio, though he comments that a sufficiently high elasticity would shorten the structure of production. Actually, the sign on the elasticity is the only relevant determinant of whether the structure of production shortens, lengthens or is neutral with respect to changes in the consumption-savings ratio. As we will see, the answer to this question hinges critically on what one means by changes to the “length” of the structure of production.
Still, the second part of Machaj’s paper focusing on intertemporal labor intensity (ILI) has great merit, though not because it pertains to the consumption-savings relationship. Instead, it helps to answer the question of “where does the saved money go?” (Machaj, 2015, p. 280). This question has heretofore been answered in peculiar ways, e.g., Fillieule (2007) sees any change in savings as being distributed evenly across the stages of production, and Hülsmann (2010) assumes all savings are directed to the first stage of production. Machaj’s contribution is in relaxing these assumptions.
Machaj gives a series of three examples where a lowering of the equilibrium rate of interest induces either no change, a lengthening or a shortening of the number of stages of production. All three examples share a common interest rate and the only differentiating factor is the ILI. The ILI is the degree to which labor is employed in production and, more importantly, where within the production process this takes place. Machaj’s examples illustrate that labor employed at the later stages of production will have the intuitive (and standard) effect of lengthening the structure of production. If, however, capitalists employ laborers at the earlier stages of production, the result will be a reduction in the number of stages of production.
Machaj uses this insight to question Hülsmann’s central conclusion that a shortening of the production structure will result from a lower interest rate. Effectively, Machaj demonstrates that this result has nothing to do with the rate of interest but rather depends on where labor expenditures are directed.
Machaj sheds light on what Howden and Yang (2016; forthcoming) refer to as the “structure of labor” by which they mean the temporal and qualitative ordering of labor that complements capital along the structure of production. Superficially, one could believe that Machaj’s example relies on an adequate answer to whether human capital is indeed capital in the same sense that physical capital is. I claim only a “superficial” relevance to that question since the labor/capital ratio of 85/200 is constant in all of his examples and thus the relationship between the length of the production structure must be contingent on some factor other than the relationship between any definition of human capital and physical capital. Freed from commenting on controversies concerning the quality of labor, I will point out two deficiencies with the problem as it is structured.
The first is that, as in Fillieule (2007) and Hülsmann (2010), Machaj has no causal explanation for why the interest rate falls. The interest rate decreases from an equilibrium level of 1/9 to 1/19 in all three of Machaj’s examples, though this is not caused by a change in the consumption-savings ratio, which remains constant at 1/2. Nor does a change to the money supply or its velocity affect the interest rate, as the expenditure stream (MV) is fixed at 300 in all examples. Given no causal reason to explain why the interest rate was more than halved, it is difficult to treat Machaj’s conclusion as anything more than a theoretical example of passing curiosity, but which has no bearing on the real world.
More seriously, attempts to show paradoxical changes in the production structure due to changes in the interest rate without giving a reason why the rate changed are analogous to reasoning from a price change. Although they represent seemingly plausible and logically consistent examples, they lead to vacuous results. To give an analogy, the physicist could, e.g., wonder what the effect would be on a 120-mile journey that takes two hours at 60 miles per hour if we increased the speed to 90 miles an hour. If our travel time remained constant it would be obvious that the distance magically lengthened to 180 miles. Of course, the correct answer would lie in identifying that travel time is the result of speed and distance, notwithstanding that the three variables are all defined tautologically in terms of each other. The journey cannot take on multiple lengths, and the time must change to equate the new speed with the existing distance.
Likewise, attempts to derive changes to the length of production when the interest rate changes and the consumption-savings ratio and aggregate level of expenditure remain constant suffer the same deficiency. The rate of interest is not sui generis. It is determined first and foremost by the savings-consumption ratio. Thus the interest rate is the dependent variable that changes in response to the savings-consumption ratio and cannot be treated as the independent variable affecting savings or consumption.
Still, we can let this objection pass and question whether there is something else of interest in his result. Implicit in the statement that the structure of production changes length according to changes in the interest rate, or dependent on the degree of ILI for that matter, is that we share a common understanding of what units the production structure is measured in. Machaj uses two units interchangeably. On the one hand, the production structure is reckoned in “stages” and to lengthen the structure means to add a new stage. On the other hand, each stage is defined as having a duration of one year. To lengthen the structure thus implies a greater amount of temporal units necessary to produce a given amount of output.
Such beliefs about how best to measure the structure of production are common. Fillieule (2007, p. 201) makes the same assumption, as does Hülsmann (2010). The use of “stages” is deficient, however, in that adding more stages is analogous to a lengthened production structure but gives no reference to whether the stage is added closer or further from consumption. In other words, the temporal ordering of stages does not affect the length of the production structure, provided that somewhere in the structure there is productive activity.One could quibble that defining each stages as a fixed temporal length, e.g., one year, is ad hoc though as an assumption there is nothing unmeritorious about doing so.
If stages or time are deficient units, when the Austrian-school economist refers to the “length” of the structure of production, in what units must he measure this dimension? Although increased production time is the conventional usage of the term “lengthening,” there are good reasons to doubt its applicability.
The most obvious doubt should come from the apparent, if contrived, examples that show an ambiguous relationship between the rate of interest and the temporal length of the capital structure. One of Machaj’s great contributions is in demonstrating that where savings (signaled as they are by a lower interest rate) are invested is more complicated a question than was once thought. Of course we know that savings will be directed more profitably at a temporal stage further from final consumption as the interest rate falls due to the discount effect. At the same time if, as is the case in an Austrian business cycle, consumers increase their demand for consumption goods, entrepreneurs will be enticed to invest resources closer to final output to take advantage of the derived demand at these lower stages. Garrison (2001, p. 72) refers to the “tug-of-war” that occurs at both ends of the structure of production, but doesn’t have a clear way to answer whether the strain at the higher and lower stages is “lengthening” the production structure.
Results that show an ambiguous relationship between the length of the production structure and the interest rate do so by defining the length in terms of “stages,” or what is analogous, time. There is great ambiguity in the Austrian literature as to what a “lengthening” of the structure actually means. Examples abound of the lengthening being the addition of more stages (e.g., Garrison, 2001, p. 82; Rothbard, 1962, pp. 519, 996; Huerta de Soto, 2006, p. 280; Hayek, 1935, p. 156).Of these authors, only Hayek (1941, p. 73) has paid attention to defining what a “stage” of production actually means: separate operations performed by distinct firms. I doubt this definition is readily shared by others using the concept. Other authors stress the lengthening of the time element of production (Böhm-Bawerk, 1889, p. 82; Strigl, 1934, pp. 3–4; Rothbard, 1962, p. 423; Reisman, 1990, p. 460; Mises, 1912, p. 360; 1949, p. 556; Hayek, 1935, p. 150).
Both views on lengthening are consistent with the approach used by Machaj, which he uses to illustrate his counter-intuitive result. One could also point to more nuanced views that could be consistent with Machaj’s examples of a lengthened structure of production. Rothbard (1962, p. 1006 n113; 1963, p. 10), Huerta de Soto (2006, pp. 337, 365, 369), and Hayek (1935, p. 310) all allude to the weighting of investment according to what stage it is directed to. Under this chain of thought, it is possible to conceptualize an investment made in a higher stage as lengthening the structure of production more than an equivalent investment in a lower stage since the investment is further from final consumption.
Equating additional stages with a lengthened period of production is not without its drawbacks. Böhm-Bawerk (1889, p. 82) first noted that there was no strict proportionality between the number of stages and the length of production time, and Hayek developed this chain of reasoning more fully (Hayek, 1941, pp. 73–74). In a section devoted to “Capital Accumulation and the Length of the Structure of Production,” Rothbard gives an example where there is an ambiguous relationship between Robinson Crusoe’s investments, total consumable output produced and the temporal period of production of this output (1962 p. 543). Hayek gives the most comprehensive examination of this point:
It is frequently supposed that all increases in the quantity of capital per head (at least when they do not involve changes in the quantities of durable goods) must mean that some commodities will now be produced by longer processes than before. But so long as the processes used in different industries are of different lengths, this is by no means a necessary consequence of a change in the investment periods of particular units of input. If input is transferred from industries using shorter processes to industries using longer processes, there will be no change in the length of the period of production in any industry, nor any change in the methods of production of any particular commodity, but merely an increase in the periods for which particular units of input are invested. The significance of these changes in the investment periods of particular units of input will, however, be exactly the same as it would be if they were the consequence of a change in the length of particular processes of production. (Hayek, 1941, pp. 77–78)
Machaj relies on labor reallocations to show scenarios in which the structure of production is temporally lengthened or shortened given the same interest rate, but Hayek was critical of any approach to understanding the lengthening of the structure of production by means of looking at shifts in labor instead of capital (1936, p. 496, n16). This stemmed from his belief that focusing narrowly on labor shifts would not explain why an increase in that specific factor was being pursued, something which he believed could take place only after a capital investment had increased the marginal productivity of labor. Thus the term “period of production” (including capital and labor) was an unfortunate term to describe the intended phenomenon, i.e., more roundabout production processes. (One alternative offered by Hayek was to measure roundaboutness by way of the “period of investment” [Hayek, 1936, p. 496].)
By providing multiple production structures differing only by the stages at which payments to an originary factor are made and in what magnitude, Machaj gives no explanation for why the rearrangement of the structure of production should occur. Capitalists will not rearrange deliberately the input factors along the structure of production unless the consequence is greater productivity or decreased costs. In Machaj’s examples, the total amount of expenditure directed to labor relative to aggregate expenditures (actually to the originary factors in general, but he focuses on labor) increases from 70/300 to 85/300. This bidding for labor, either in terms of higher wages or more workers, only occurs if labor productivity is enhanced. The only way for labor productivity to increase is by increasing the capital stock per worker. Note that this final point is a not just an empirical tendency, but rather a praxeological law. Contriving examples to illustrate where labor will be reallocated to within the production structure without making reference to the reasons why labor will command a higher wage or be demanded in greater quantities are technical questions that do not fall within the scope of economic theory. Any consequent discussion of changes to the length of the structure of production that starts by assuming away the reasons why the length would change provide answers to questions that do not concern the economic theorist.I thank an astute referee for this point.
If lengthening the structure of production has any relevance for capital theory, it is only as a placeholder for roundaboutness. After all, it was the more roundabout methods of production that Böhm-Bawerk stressed as the cause of economic growth (1889, pp. 10–15). (Economic growth is here understood to mean more or better consumer goods.) A greater amount or more highly valued output could be produced for a given amount of inputs only if the inputs were arranged in such a way that coincided with more capital intensive means of production.I ignore here technological advances. In this way roundabout production processes are those that are more capital intensive. Consequently, when the Austrian-school economist discusses lengthening the structure of production, he must not entertain notions that it is a temporal extension (although it could be). Nor must he consider the addition of more stages or operations in the productive process (although this too will likely occur). Instead he must reckon lengthening in physical terms—an increase in the capital intensity of the production process.
That conclusion only pushes the problem one step further back: what is the best measure of capital intensity? There are only two ways that the production structure could be said to become more capital intensive (Howden, 2016b, c). The first is through the production of a greater amount of durable capital goods. Thus if the output mix between capital goods and consumption goods shifted in favor of the former, the result would be a greater intensity of the capital stock.This is subject to a minimum threshold. Capital suffers depreciation and a portion of the newly produced capital goods in any given period will be necessary to replace the lost productivity of the existing stock. Thus, the structure of production can only be said to become more capital intensive if a sufficient amount of capital goods are produced to replenish the depreciation of the existing stock. This increase in capital intensity of the overall production process can be achieved by 1) substituting more capital-intensive production processes for shorter labor-intensive processes, 2) shifting production to existing goods that entail a more capital-intensive production process, 3) producing new goods in a capital-intensive way without changing the production plans of existing goods, or 4) increasing production of existing goods in less capital-intensive industries (e.g., oranges) while not retrenching production of goods in more capital-intensive industries (e.g., heavy machinery). All of these examples increase the capital intensity of the structure of production, and in a roundabout way they will also result in temporally lengthened production processes since the capital goods themselves embody not just the originary factors of production, but also “time stored up” (Mises, 1949, p. 492). Furthermore, method 4 would result in an increase in the ratio of temporally shorter to longer production processes but would still require additional capital, which is consistent with the goal of increasing the roundaboutness of a production process.
The depreciable nature of durable capital goods leads us to the second method to increase the capital intensity of the production structure. Production of more durable capital implies that less future output will be needed to keep the existing stock intact. Thus, capital intensity can be increased if the durability of the newly produced capital goods is greater than previously was the case.
While these two definitions of increased roundaboutness concern the production of capital exclusively there is also a third, less explored, way. Roundaboutness is undertaken to produce more or better consumer goods. If the average duration of serviceableness, i.e., durability, of such goods were increased with no change in the aggregate production methods, one could still say an increase in roundaboutness had occurred. Böhm-Bawerk (1888, pp. 89–94) discusses this outcome though is hesitant to include changes to the durability of consumer goods as a type of roundaboutness in production, but rather as a “parallel” process that augments the phenomenon.I have noted elsewhere the relationship between the durability of consumer goods and the term structure of interest (Howden, forthcoming), but Böhm-Bawerk focuses here on the relationship between the durability of consumer goods and the demand for future goods, which then affects the pure rate of interest.
Machaj abstracts from the output mix in his examples, and thus we cannot be sure whether any of them represent a lengthened structure of production, notwithstanding the appearance that this has happened by focusing on the temporal aspect of production. In conclusion, changes to savings preferences alter the “length” of the structure of production, which is reflected in the interest rate. In the unhampered economy, the interest rate does not change the structure of production but rather it is through preference shifts between present and future goods on the structure of production in conjunction with the credit market that the interest rate obtains. Of course, the role of the production structure in determining the rate of interest on the loan market has been discussed already and at length in Rothbard (1962, ch. 6 and esp. p. 378).
The Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
The Interest Rate and the Length of Production: A Commentby David Howden
David Howden (dhowden@slu.edu) is professor of economics at Saint Louis University – Madrid Campus. In addition to Jeffrey Herbener and Shawn Ritenour, I would also like to thank, without implicating, an especially insightful referee.
ABSTRACT: Machaj (2015) does a great service in pointing out a key assumption, heretofore unaddressed, in Filleule (2007) and Hülsmann (2010). Machaj errs, however, in stating that who saves will have an ambiguous effect on the interest rate and that where savings are directed can have ambiguous effects on the length of production. In this brief comment I will first show that who saves will have no effect on the interest rate. I then turn my attention to what it means to “lengthen” the structure of production. Although extended production time or additional “stages” of production make convenient placeholders for increased roundaboutness, they fail to grasp the core concept as it pertains to capital theory: what is it about production processes that makes more or better consumer goods?
KEYWORDS: capital theory, interest, production structure, roundaboutness, labor intensityJEL CLASSIFICATION: B13, B53, D24, E43
REFERENCESBöhm-Bawerk, Eugen von. 1889. Capital and Interest, Vol. II: Positive Theory of Capital. George D. Huncke, trans. South Holland, Ill: Libertarian Press, 1959.
Braun, Eduard. 2014. Finance Behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market. Liberty.me.
Fillieule, Renaud. 2007. “A Formal Model in Hayekian Macroeconomics: The Proportional Goods-in-Process Structure of Production,” Quarterly Journal of Austrian Economics 10, no. 3: 193–208.
Garrison, Roger W. 2001. Time and Money: Macroeconomics of Capital Structure. London: Routledge.
Hayek, Friedrich A. 1935. “Prices and Production,” reprinted in Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, pp. 189-329. Auburn, Ala.: Ludwig von Mises Institute, 2008.
——. 1936. “The Mythology of Capital.” In Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, pp. 489–520. Auburn, Ala.: Ludwig von Mises Institute, 2008.
——. 1941. The Pure Theory of Capital. Chicago: University of Chicago Press.
Howden, David. 2015. Money in a World of Finance. Journal of Prices & Markets 4(1), Papers & Proceedings of the 3rd Annual International Conference of Prices & Markets, Toronto, Canada, Nov. 6-7, 2014: 13-20.
——. 2016a. “A Refinement to the Typology of ‘Goods’” Journal of Prices & Markets 4, no. 2: 4–11.
——. 2016b. “Fifteen Elucidations of Roundaboutness.” Working paper.
——. 2016c. “’Lengthening’ the Structure of Production.” Working paper.
——. forthcoming. A Consumption-Based Theory of the Term Structure of Interest. Journal of Prices & Markets, Papers and Proceedings of the 5th Annual Conference of Prices & Markets, Nov. 4–5, 2016, Toronto, Canada.
Howden, David, and Yang Zhou. 2016. “The Structure of Labor.” Working paper.
——. forthcoming. The Structure of Labor and Capital Ordering. Journal of Prices & Markets, Papers and Proceedings of the 5th Annual Conference of Prices & Markets, Nov. 4–5, 2016, Toronto, Canada.
Huerta de Soto, Jesus. 2006. Money, Bank Credit, and Economic Cycles. Melinda A. Stroup, trans. Auburn, Ala: Ludwig von Mises Institute.
Hülsmann, Jörg Guido. 2010. “The Structure of Production Reconsidered.” Working paper.
Machaj, Mateusz. 2015. "The Interest Rate and the Length of Production: An Attempt at Reformulation,” Quarterly Journal of Austrian Economics 18, no. 3: 272–293.
Menger, Carl. 1871. Principles of Economics. James Dingwall and Bert F. Hoselitz, trans. Auburn, Ala.: Ludwig von Mises Institute, 2007.
Mises, Ludwig von. 1912. The Theory of Money and Credit. H. E. Batson, trans. Irvington-on-Hudson, New York: Foundation for Economic Education, 1971.
——. 1949. Human Action, the Scholar’s Edition. Auburn, Ala.: Ludwig von Mises Institute, 1998.
Reisman, George. 1990. Capitalism: A Treatise on Economics. Laguna Hills, Calif.: TJS Books, 1998.
Rothbard, Murray N. 1962. Man, Economy, and State: A Treatise on Economic Principles, with Power and Market: Government and the Economy. Auburn, Ala.: Ludwig von Mises Institute, 2007.
——. 1963. America’s Great Depression, 5th ed. Auburn, Ala.: Ludwig von Mises Institute, 2000.
Strigl Richard von. 1934. Capital and Production. Margaret Rudelich Hoppe and Hans-Hermann Hoppe, trans. Auburn, Ala.: Ludwig von Mises Institute, 2000.
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
ABSTRACT: Machaj (2015) does a great service in pointing out a key assumption, heretofore unaddressed, in Filleule (2007) and Hülsmann (2010). Machaj errs, however, in stating that who saves will have an ambiguous effect on the interest rate and that where savings are directed can have ambiguous effects on the length of production. In this brief comment I will first show that who saves will have no effect on the interest rate. I then turn my attention to what it means to “lengthen” the structure of production. Although extended production time or additional “stages” of production make convenient placeholders for increased roundaboutness, they fail to grasp the core concept as it pertains to capital theory: what is it about production processes that makes more or better consumer goods?
KEYWORDS: capital theory, interest, production structure, roundaboutness, labor intensityJEL CLASSIFICATION: B13, B53, D24, E43
Quarterly Journal of Austrian Economics 19, no. 3 (Fall 2016): 248–266ABSTRACT: The relationship between investment, hoarding and economic growth is a rather complex one. Although both investment and monetary hoarding can be considered different instances of capital accumulation in the long run, their short term effects on economic growth can diverge. These transitory variations are based precisely on the fact that money has a driving force of its own, i.e. it is not neutral. I argue that hoarding necessarily implies a longer period of time between the moment when resources are saved and the moment when new consumer goods reach the market (economic growth), as opposed to the case in which the same amount of resources would be invested through the banking system.
KEYWORDS: capital theory, gross market rate of interest, structure of production, investment, economic growth, hoardingJEL CLASSIFICATION: B13, E14, E22, E31, E41, E43, O40
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 3 | 248–266Fall 2016
An Analysis on the Relationship between Hoarding, Investment and Economic GrowthAlexandru Pătruți
Alexandru Pătruți (alexandru.patruti@rei.ase.ro) is assistant professor in the Department of International Business and Economics at the Bucharest University of Economic Studies, Romania.
ABSTRACT: The relationship between investment, hoarding and economic growth is a rather complex one. Although both investment and monetary hoarding can be considered different instances of capital accumulation in the long run, their short term effects on economic growth can diverge. These transitory variations are based precisely on the fact that money has a driving force of its own, i.e. it is not neutral. I argue that hoarding necessarily implies a longer period of time between the moment when resources are saved and the moment when new consumer goods reach the market (economic growth), as opposed to the case in which the same amount of resources would be invested through the banking system.
KEYWORDS: capital theory, gross market rate of interest, structure of production, investment, economic growth, hoardingJEL CLASSIFICATION: B13, E14, E22, E31, E41, E43, O40INTRODUCTIONEconomic growth is the declared goal of virtually every policymaker in the world. From a pragmatic point of view, one can argue that the main purpose of political economy is to prescribe public policies which generate prosperity (Fetter, 1928). It is beyond the scope of the present article to systematically analyze all the determinants of economic growth. I will focus instead on the relationship between capital accumulation and economic growth, in the attempt to link any increase in a country’s welfare to a previous increase in its stock of capital goods. However, in a monetary economy, capital can be accumulated in more ways than in a simple barter economy. The general medium of exchange grants people the possibility to accumulate resources simply by adding to their personal cash balances—an economic process which is usually referred to as hoarding.
It is thus the fact that money has a driving force of its own—i.e., it is not neutral in the short run—that offers the foundation for the present study. I argue that increasing a society’s cash balances will generate economic growth, but at a later date as compared to the situation in which the same amount of money would be directly invested. This can be proven in an a priori fashion by resorting to capital theory and using the method of comparative statics.
Output growth will lag behind its potential rate in the short run if people increase their cash balances because of the inability of factors’ costs, especially the market rate of interest, to rapidly adjust to the variations in the demand for money. Using an organized market for saving (e.g. the financial market) could probably offer additional benefits in terms of speed. Thus, although hoarding is a growth-promoting tool in the long run, it is probably not the optimal one due to lagged adjustment in interest rates.
LITERATURE REVIEW ON HOARDING AND ECONOMIC GROWTHAs an economist, I hold that capital accumulation is the fundamental cause (or determinant) of economic growth.It would probably be over-simplistic to say that total production is a function of capital and labor, as the familiar Cobb-Douglas function pictures it (Cobb and Douglas, 1927). Although we cannot determine a numerical relationship between the two variables, it seems clear there is a direct link between capital accumulation and economic growth. This is by no means equal to saying that it is the only cause. One can coherently argue that there are at least three determinants of economic growth (Hülsmann, 2011): (1) capital accumulation; (2) an increase in the division of labor; and (3) technological innovation. The present article is a ceteris paribus analysis of economic growth, which assumes technological progress and the level of specialization (i.e. division of labor) to be constant. This idea of linking capital accumulation to economic growth is a rather common one. The history of economic thought teaches us that it goes as far back as Adam Smith’s Wealth of Nations (2007 [1776], p. 213), in which the author writes that: “…the accumulation of stock is previously necessary for carrying on this great improvement in the productive powers of labour, so that accumulation naturally leads to this improvement.” However, it was not until the writings of Eugen von Böhm-Bawerk (1890, 1930) that capital theory became a self-standing branch of political economy, having a distinct and systematic set of economic principles. Later, capital theory came to be associated with the so called Austrian school of economics, flourishing in the works of Hayek (1936, 2008 [1931], 2009 [1941]), Mises (1998 [1949]), Strigl (1934) and Rothbard (2009 [1962]).Two extremely interesting exceptions here would be J. A. Schumpeter and Carl Menger. Schumpeter (1934) differentiated himself from the “main body” of the Austrian school by focusing on technological innovation (and not capital accumulation!) as the main determinant of economic growth. Although he does mention that there is a strong link between credit and growth, “savings” as such do not play a significant role in promoting innovation, which is the Schumpeterian driving force of economic development (Croitoru, 2012, pp. 142–143). Carl Menger is the other notable member of the Austrian school who does not endorse Böhm-Bawerkian capital theory (Hayek, 2009 [1941], p. 46). In a comment made to Schumpeter by Menger, the latter points out that “…time will come when people will realise that Böhm-Bawerk’s theory [of capital and interest] is one of the greatest errors ever committed” (Endres, 1987, p. 291). This was the case mainly because Böhm-Bawerk’s approach towards the capitalist production process was much more objectivist/materialistic than that of his master (Endres, 1987).
The phenomenon of hoarding, on the other hand, was less noticeable in the history of economic thought. It took the forefront of economic disputes for a short while in the famous debate between Keynes and Hayek in the 1930s. Briefly put, in 1932 J. M. Keynes, A. C. Pigou and four other economists drafted and cosigned a letter in which they discouraged savings and advocated public spending in order to fill the gap caused by the “reluctant” private sector. The letter was published by The Times and became what was later known as “the paradox of thrift.”For a detailed analysis of the “paradox of thrift” see Hayek (2008 [1931], pp. 131–189). A response letter written by F. A. Hayek, Lionel Robbins, T. A. Gregory and Arnold Plant was published only two days later in the same newspaper (Leeson, 2014, pp. 90–91). The famous LSE economists argued that although the deflationary perils of hoarding are well known since the writings of the classics, it would be a disaster for the economy if the public would stop saving through deposits in banks or securities (ibidem). After Keynesian economics became the mainstream theory, hoarding generally became classified as an antisocial and detrimental economic habit. The desire to hold cash at hand, which is in Keynesian terms determined by people’s liquidity preference (Keynes, 1936), was considered to be a process which drags the economy backwards. Nearly all policymakers today embrace the Keynesian paradigm of trying to boost aggregate demand through increased consumption in order to generate growth.
Interestingly enough, scattered theoretical insights related to this particular subject can be found in the discussions around the doctrine of forced savings. This should not come as a surprise, since the two topics are connected. The forced savings doctrine largely analyzes a classical case in which the producers benefit in the short run from an increase in the quantity of money to the detriment of fixed income earners (Ahiakpor, 2009). Thus, it represents an analysis on how a general increase in prices gives producers a surplus purchasing power in the short run, because of the lagged adjustment of producers’ costs (wages, rent and interest). Entrepreneurs can use their increased real earnings to lengthen the structure of production and boost economic growth. The present article, on the other hand, studies a reverse situation. The goal is to demonstrate that hoarding (i.e. an increase in monetary capital accumulation) is a rather suboptimal growth promoting tool, because of the short run lagged adjustment of the market rate of interest.
I argue that Hayek (2008 [1931], pp. 131–187), in particular, and the Austrian school (De Soto, 2006; Rothbard, 2009 [1962]), in general, have given abundant arguments as to why consumption cannot increase prosperity by itself. However, there seems to be a lack of economic literature which comparatively analyzes whether in a monetary economy hoarding is in any way different from investment with regards to economic growth. There are of course some notable exceptions, two of which, in my opinion, give us a glimpse of the possible attitudes one can adopt towards hoarding.It is worth mentioning that the two conflicting views are present within the same school of thought. In spite of the fact that numerous researchers accuse “Austrians” of being too dogmatic, one can easily show that there is wide disagreement between its main proponents, even on critical discussion points.
The first type of attitude towards this issue is revealed to us by Eugen von Böhm-Bawerk (1930, pp. 115–116) in “The Positive Theory of Capital”:
“[…] an economically advanced people does not hoard, but puts out what it saves—in the purchase of valuable paper, in deposits in a bank or savings-bank, in loan securities, etc. In these ways the amount saved becomes part of productive credit; it increases the purchasing power of producers for productive purposes; it is thus the cause of an extra demand for means of production or intermediate products; and this, in the last resort, induces those who have the regulation of undertakings to invest the productive powers at their disposal in these intermediate products.”
It becomes clear from this quotation that according to Böhm-Bawerk, economic progress stems from the ability of a people to invest their saved resources. By doing so, economizing individuals transfer their excess purchasing power to producers, who can now start longer and more industrious production processes.
Rothbard, on the other hand, takes a somewhat different stand on the issue. He (Rothbard, 2009 [1962], p. 776) states that:
“[Hoarding] is simply an increase in the demand for money, and the result of this change in valuations is that people get what they desire, i.e., an increase in the real value of their cash balances and of the monetary unit.[…] No other significant economic relation—real income, capital structure, etc.—need be changed at all.”
From this last sentence, the message we seem to get from Rothbard is that hoarding does not have any generalized effect on the structure of production, and implicitly, on economic growth. This would mean that the dynamic of the capital structure is not affected by an increase in people’s desire to hold cash and that no direct relation can exist between hoarding and economic growth.
I aim to prove in the following passages that one can present economic arguments in defense of the first view and against the second. Comparative statics can be used to show that hoarding essentially implies a lengthening of the structure of production in the long run. However, increasing monetary cash balances does not represent the optimal growth promoting tool, because of its short run transitional effects on the configuration of prices.
A SHORT GLOSSARYAlthough such a list of terms is usually found at the back of a book, given the high level of dissent among economists concerning the particular notions we are going to use, I find it useful to define them before starting the exposition.
The first terms that we should dwell on are consumption, savings and hoarding, and the particular relations between them. At this point in the discussion it has hopefully became clear that I define savings as non-consumption. Therefore, savings and consumption are two mutually exclusive notions—i.e. a person can either consume a certain quantity of resources or not, in which case he is saving resources.
In a monetary economy savings can take twoIt is true that the individual also has a third possible option, namely non-monetary hoarding. This would be the somewhat pathological stashing away of physical goods without a clear goal in mind. However, we consider that this is only a marginal phenomenon and therefore has a negligible impact on an aggregated level. main forms, which are additions to private cash balances (i.e. hoarding) or investments (time deposits, buying stocks or bonds, or directly procuring capital goods and starting new production processes on the market).The terminology employed here is essentially a Keynesian one. Hayek (2008 [1931], pp. 442, 443) employs the same terms in his Reflections on the Pure Theory of Money of Mr. J. M. Keynes:Clearly recipients of income must make a choice: they may spend on consumption goods or they may refrain from doing so. In Mr. Keynes’s terminology the latter operation constitutes saving. Insofar as they do save in this sense, they have the further choice between what one would ordinarily call hoarding and investing or, as Mr. Keynes (because he has employed these more familiar terms for other concepts) chooses to call it, between “bank-deposits” and “securities.”However, the careful reader will immediately observe that the analysis is not a Keynesian one. For Keynes a decrease/increase in saving is assumed to be the only independent factor which impinges on a relatively rigid structure of production (Hayek, 2008 [1931], p. 429). The aim of the present article is precisely to analyze how the structure of production adapts to different monetary stimuli. We agree in this respect with Milton Friedman who points out in an interview that one of the benefits of Keynes’ influence on economic theory was the fact that he developed a terminology which proved useful even for those economists who do not agree with his theory (Blaug, 1990, p. 89). It is clear that both hoarding and investing are instances when acting man foregoes present consumption, having in mind greater future satisfactions. They have fundamentally the same nature in the sense that they are dependent on people’s time preferences, i.e. their willingness to sacrifice present consumption for the prospect of increasing future consumption (Mises, 1998 [1949], pp. 483–490). When people hoard, they normallyI say normally because, at least theoretically, there is a possibility that hoarding can come from disinvestment. But this is, to my mind, a rather improbable outcome. Why would an investor rationally choose to withdraw his investments and keep the cash stocked away for a significant amount of time? This would mean that he would willingly choose to forgo the amount he used to receive as return on his past investment, for no income whatsoever. The only probable reason I can think of for such an action would be the fact that our would-be investor would need to make an imminent payment (i.e. he needs liquidity to buy something else), either for a consumption good, or another investment. In this case, the hoarding he generates is an extremely transitory phenomenon and can be neglected from our analysis. withdraw a certain sum of money from their present income, a sum which they would have previously used for consumption purposes, and hold on to it for future use.
Now that we hopefully cleared out all possible confusions around the conceptual relationships between savings, consumption, monetary hoarding and investment, we can move on to the even more complicated, if not impossible, issue of defining economic growth. In this article I will follow Hülsmann (2011, pp. 36–37) in defining economic growth as a systematic increase in the physical output of consumer goods. I am fully aware of the shortcomings of the chosen definition. However, we consider that it is almost impossible to define economic growth in monetary terms, because there is no possibility of subtracting the overlapping effects triggered by variations in the purchasing power of the monetary unit over a certain period of time from the underlining effects caused by real forces. Thus, the increase in monetary value of final goods produced in, let us say, a year, is irrelevant since the purchasing power of the monetary unit could have varied in any way because of cash induced variations (i.e. changes in the supply of or demand for money).For a detailed analysis regarding cash induced and goods induced changes in purchasing power see Ludwig von Mises’s Human Action (1998 [1949], pp. 419–424). To my mind, if we are not willing to drop the term of “economic growth” altogether, we must be willing to refer to it in physical terms. It is true on the other hand that we are now facing another serious problem, namely that in a society which is producing nonhomogeneous goods, there can be situations in which the production of some goods has increased, while the production of others has decreased. The economist finds himself in this case in the impossibility of deciding ex post whether society has experienced growth or not. Hence, the solution I propose is to refer to economic growth as a systematic upward trend in the production of nearly all final goods. If this general tendency exists, we can say that a society has experienced growth.I fully concede that it is probably more rigorous from a theoretical point of view to define economic growth as an increase in the overall value in a society. But monetary calculation is the only way value can be gauged in a complex economy, and as I previously explained, variations in the purchasing power of the monetary unit can render this concept almost useless in practice.
THE CAUSAL RELATIONSHIPS BETWEEN HOARDING, INVESTMENT AND ECONOMIC GROWTHGiven the fact that we have already defined the economic notions that will be employed in the present analysis, and that we put the discussion into historical context, one can now proceed to the main topic of the article, which is the study of the causal relationships between hoarding, investment and economic growth. The way in which I aim to conduct this study is by using comparative static analysis applied on two hypothetical scenarios. After showing that both monetary hoarding and investments are growth promoting tools, I will briefly give additional arguments to suggest that hoarding brings about certain short term vagaries which can postpone future economic growth.
The Thesis
I aim to demonstrate that both hoarding and investments lead to a lengthening of the structure of production and consequently to future economic growth in the long run. However, I argue that savings through investment does generate additional benefits in terms of speed (i.e., economic growth will be somewhat faster) and that these advantages stem from the impossibility of the price structure to adjust instantaneously to variations in the total demand for money.One would be tempted to use the term “time lag” to describe this adjustment process of the price structure from the old equilibrium point to the new equilibrium point. However, this would probably not be the best strategical option because this notion gives an econometric connotation to the phenomenon, which by its specific nature is unquantifiable. This is the same thing as saying that both hoarding and investments are growth-promoting tools in the long run, but the latter appears to be the optimal one because of its additional short run positive effects.
It is useful to point out that when I refer to “the long run,” I am merely indicating that there is a tendency law involved, in the classical sense of the word. Thus, there is a systematic trend in the economy to push the market towards a certain equilibrium point, even though that point will never be reached in real life.For a systematic analysis of tendency laws from the perspective of economic thought, see Blaug (1997, pp. 59–62). For a detailed inquiry of the role of imaginary constructions (including the final equilibrium model) see Mises (1998 [1949], pp. 236–251).
Now in order to prove the above mentioned thesis, respectively that both hoarding and investment have the same effects in the long run, but that investment offers increased benefits in terms of speed, a few additional theoretical premises are necessary. Thus, one requires the Hayekian theory of the structure of production, as presented in Prices and Production (Hayek, 2008 [1931])I was tempted to include here also a third reference, namely Böhm-Bawerk’s (1930, p. 20) famous thesis that longer production processes are necessarily more productive from a physical point of view. However, this was already included in Hayek’s work (2008 [1931], p. 156): “The proposition that savings can only bring about an increase in the volume of production by permitting a greater and more productive ‘roundaboutness’ in the methods of production has been demonstrated so fully by the classical analysis of Böhm-Bawerk that it does not require further examination.” and Ludwig von Mises’s analysis on the interest rate from Human Action (1998 [1949], pp. 538–550).According to some sources (Hayek, 2008 [1931], p. 454; Ahiakpor, 2009, p. 167), this type of analysis in which the market rate of interest diverges from the equilibrium rate of interest is originally associated with the Swedish economist Knut Wicksell. Aside from these two pieces of theoretical knowledge, all that is needed is to employ the method of comparative static analysis on a hypothetical example which includes two scenarios.
The Two Scenarios
Let us assume a closed economy where, for the purpose of simplification, people have only three options: to consume, to hoard cash or to open time deposits in banks (i.e. consumption, hoarding and investment). Again, for the same purpose let us assume that we are dealing with a 100 percent reserve banking system, where the only available saving products offered by the bank are time deposits, i.e. deposits that carry interest, and once you opened them you cannot withdraw the money until the specific date is due.I willingly avoid fractional reserve banking because it allows the possibility of credit expansion, in which case the market rate of interest can virtually deviate permanently from its equilibrium level.
In this hypothetical economy we can build two scenarios: one in which all the saved resources are invested and one in which part of the saved resources are kept in individual cash balances. The purpose of the exercise is to use capital theory to demonstrate that both scenarios lead to the same result in the long run,I will argue further in the article that an underlining tendency to push the market to the same equilibrium point is present in both scenarios, but the two “paths” towards this point are rather different. but also to gather sufficient arguments to suggest that investment would promote faster growth.
Scenario One
The first scenario consists in the assumption that equilibrium is reached in our hypothetical society and that people invest—i.e. make time deposits of—20 percent of their annual income and use the rest for consumption purposes. Now let us again suppose that (for whatever reasons) the social rate of time preference changes and that people now save 40 percent of their annual income. Society will now move from the previous equilibrium point to a new one, in which the structure of production will be lengthened. Certain additional economic assertions can be made in this case.
First of all, the decrease in the social time preference has caused an increase in savings from 20 to 40 percent of the total income of the society (which in this particular case is equal to investment because we assumed that all the money was deposited in the banks). This means that the market rate of interest must decrease, because there are more resources that entrepreneurs can advance. Businessmen are now free to invest in longer production processes since credit is cheaper.They are stimulated to follow this course of action by the variations in the net present value of different investment projects. A decrease in the market rate of interest, which in this scenario coincides with the pure rate of interest, makes longer production process more attractive to investors. They now have the necessary purchasing power to drag resources away from production processes which are closer to final consumers, towards superior stages of productions. For a detailed analysis on the role of the net present value in Austrian economics see Fuller (2013). By doing this, they increase future economic growth, since longer production processes are necessarily more productive from a physical point of view, as we know from the above cited Böhm-Bawerkian principle. In the theoretical framework we designed, this practically means that there will be an increase in the future production of consumption goods, as a consequence of the present increase in capital stock.
This should all sound rather simple and clear cut to anyone familiar with Austrian capital theory. The only thing I would like to highlight is the role played by banks as financial intermediaries in the whole process. After receiving the new funds, the banks can use them to give productive credit. The only way they can accommodate these credits on the market is, ceteris paribus, at a lower rate of interest. Thus, the interest rate will almost immediately drop on the loan market because of the monetary influx.
However, the situation gets more complicated when we introduce a new “disturbing” factor into the picture—monetary hoarding.Again, I am using the term disturbing factor not because hoarding is detrimental to the economy, but because it is a temporary variation which superimposes itself over the long term trend. This will be done in the following scenario.
Scenario Two
The second scenario consists basically in the same economic tendency, i.e., a society which increases its savings from an aggregated level of 20 percent to an aggregated level of 40 percent of total annual income. However, we will now introduce a further assumption, in the sense that the newly saved monetary resources (representing 20 percent of total annual income) will not be invested via the banking system, but hoarded away in people’s homes. The question which arises is whether there is any difference between this situation and the first one.
…and yes, there is. The key is to keep in mind that money has a driving force of its own and that any variation in the supply or demand for money will affect the purchasing power of the monetary unit. But the problems concentrated around the rate of interest are even more interesting and they should attract our attention in order to answer the research question.
When referring to interest, one usually has in mind the premium obtained over a principal sum of money which is being lent. This natural occurring phenomenon is nothing else than the market rate of interest, i.e., interest on short to medium term loans on the money market (Mises, 1998 [1949]). This is the relevant real life indicator for gauging people’s time preference and thus the one that entrepreneurs use to adjust the structure of production (Strigl, 1934; Mises, 1998 [1949]). We know that a decrease in the rate of interest causes a lengthening of the structure of production and that this will in turn increase future economic growth (Hayek, 2008 [1931]). This is one of the main theses of Austrian capital theory and one on which the whole argument of the present paper is built. However, in order for this increase in the structure of production to take place in real life, there must be a prior decrease in the market rate of interest. But it is exactly this particular reason that differentiates the second scenario from the first. In the short run, the market rate of interest does not drop when people hoard a part of the saved resources. This happens because the newly saved money does not reach the capital market and is thus not transformed into productive credit. Still, this does not mean that hoarding is neutral on the structure of production, as some economists appear to suggest (Rothbard, 2009 [1962], p. 776), for the reasons that I have previously suggested.
Let us go one step further with the analysis. In order to tackle the theoretical problems surrounding the concept of interest, economists (Mises, 1998 [1949], pp. 538–545) break down the market rate of interest in three main components: the natural rate of interest, an entrepreneurial component and a purchasing power component. In our particular case, we are not interested in the second component, the entrepreneurial one, so we will hold it under the ceteris paribus clause and further discus the remaining two elements. The natural rate of interest represents the interest rate that is achieved when a society reaches equilibriumEconomists have used a myriad of names to refer to the equilibrium rate of interest, including but not limited to: originary interest (Mises, 1998 [1949]), natural rate of interest (Wicksell, 1989) or pure rate of interest (Rothbard, 2009 [1962]). Regardless of the denomination, all terms refer to the same underlining phenomenon, i.e. the rate of interest which is formed after all the current tendencies have completely run their course and no further changes in market data occur. and it depends entirely on the social time preference.
However, there are situations when an underlining equilibrium tendency can be in the short run affected by disturbing causes, to use Blaug’s (1997, pp. 51–66) terminology. Some of the most important factors which can cause a divergence of the market rate of interest (MRI) from the pure rate of interest (PRI) in a monetary economy are variations in the relationship between the supply and demand for money. This is the reason why the market rate of interest contains a third element, a purchasing power component which adjusts the short and medium term interest rate to variations in the purchasing power of money. This third component is either a positive or a negative price premium: if all prices rise, it has a positive value, if all prices fall, its value will become negative. We will see further that this short theoretical discussion will help us answer our research question.
Scenario two is intended to present us with an example of a society in which there will be a short run discrepancy between the market rate of interest and the pure rate of interest. The former will remain basically the same in the short run, because the extra funds will not pour in directly on the credit market, while the latter will decrease because of the corresponding drop in the social time preference. However, as economists we know that such a situation cannot persist, given that the market has a natural tendency to eliminate such discrepancies. Ludwig von Mises (1998 [1949], pp. 538–539) is extremely eloquent on this particular subject in his economic treaty “Human Action”:
Changes in the money relation may under certain circumstances first affect the loan market rate of interest on loans, which we may call the gross money (or market) rate of interest. Can such changes in the gross money rate cause the net rate of interest included in it to deviate lastingly from the height which corresponds to the rate of originary interest, i.e., the difference between the valuation of present and future goods? Can events on the loan market partially or totally eliminate originary interest? No economist will hesitate to answer these questions in the negative.
This is the main reason I claimed that hoarding and investment necessarily have the same effect in the long run. The market mechanism has a driving force which assures that resources are allocated in an optimal fashion. No idle resources can exist in the long run. Every time someone decides to spend less money on consumption purposes, there is a corresponding change in the productive forces of society. For every penny saved, there will be, in the long run, an entrepreneur who will marginally alter the structure of production, in the sense of making it more roundabout, and thus, more productive.
But we still have not answered our question. As I mentioned before, scenario one and scenario two describe two slightly different paths towards the same equilibrium point. The social time preference is the same in both of them, i.e. they both represent societies in which people increase their savings from 20 percent to 40 percent of the total income. Then how do the saved resources in the form of hoarded cash manifest themselves on the market rate of interest? This is the point where the purchasing power component becomes an extremely useful tool in our analysis.
In scenario one, where all the people keep their saved money in banks, the market rate of interest falls almost immediately in accordance with the change in social time preference. However, in the second scenario, there will be a short run deviation between the MRI and the PRI. This deviation will be corrected through the purchasing power component. When people hoard money, the purchasing power of the monetary unit steadily increases and the price structure gradually changes. However, this is a complicated process through which every price in the economy must be altered, and the adjustment of the MRI through the purchasing power component will always lag behind the price movements. This process is described by Mises (1998 [1949], p. 545):
We have shown one reason why the price premium can at best practically deaden, but never eliminate entirely, the repercussions of cash-induced changes in the money relation upon the content of credit transactions. […] The price premium always lags behind the changes in purchasing power because what generates it is not the change in the supply of money […], but the—necessarily later occurring—effects of these changes upon the price structure.
Thus, although monetary hoarding is in the long run nothing more than a particular case of capital accumulation, it does generate in the short run something which can be called a “time-efficiency” problem. This is the case because the market rate of interest cannot instantaneously adapt itself to the new situation, and it is exactly this indicator that enters in the entrepreneur’s decision making process. If people increase their monetary holdings for a significant period of time, all prices must gradually adapt before the market interest rate can be adjusted through the purchasing power component.
On the other hand, if we recall scenario one, in which all people directly invested (in our particular example all savings were kept in time deposits), the situation was much simpler in the sense that the market rate of interest adapted almost instantaneously and entrepreneurs could reap directly the benefits of increased capital accumulation. This is the reason for which I claim that although both hoarding and investment are growth promoting tools, the former does necessary bring about short term vagaries in the money relation which relatively delay economic growth.
THE BENEFITS OF AN ORGANIZED MARKETI consider that the main thesis of the present paper is a rather intuitive one. The theoretical apparatus employed had the sole purpose of elaborating a formal argument in favor of showing that hoarding is a particular form of capital accumulation in the long run. However, monetary hoarding does appear to create a time lag in the short run as opposed to direct investment of the saved resources, lag which is caused by the necessary adjustments of the market rate of interest to the variation in the purchasing power of the monetary unit.
In the present section I will attempt to give further reasons why saving via banksOf course, I am referring here to a non-inflationary banking system. If the banks use their fractional reserve privileges to create an artificial credit expansion, the above mentioned speed benefits will unequivocally be overcompensated by the negative consequences of the boom-bust cycle. For a detailed analysis of the negative effects of the business cycle, see the Mises-Hayek theory of economic crises (Mises, 1998 [1949]; Hayek, 2008 [1931]). can offer additional benefits by accelerating economic growth. The previous and rather straightforward argument which I provided was that when all the saved resources go into the banking system, the market rate of interest will adjust almost immediately. Entrepreneurs can benefit in this way from the smaller interest rate faster, which enables them to lengthen the structure of production and accordingly increase future economic growth. The adjustment process will be more intricate if people decide to hoard the same amount of money. In this case, only after all the price movements come to a halt (i.e. after all the prices become fully adjusted to the new purchasing power) can the market rate of inters drop, based on the negative purchasing power premium. If this line or argumentation has not yet fully convinced the reader, let us briefly try an additional approach.
Banks can do a better job in terms of speed of adjustment because the banking system is an example of an organized market. Organized markets generally tend to perform better than non-organized ones because they can decrease transaction costs.
This happens since banks are a specialized kind of intermediary. They are wholesalers, i.e., they collect money from numerous scattered individuals and they generally lend to a small number of businessmen. It is a known fact that intermediaries play a beneficial role for society, in the sense that they quickly diminish price gaps, pushing the market towards equilibrium. In a world based on the international division of labor, specialized producers should be more efficient than non-specialized ones. Our analysis here is nothing more than a particular case of Adam Smith’s (2007 [1776]) theory of specialization.
It is not the goal of the present paper to elaborate on the theory of the organized market, nor the theory of the wholesaler. However, I do consider that both of them are prima facie arguments that add to my previous demonstration, and that they are extremely interesting topics for further research.
CONCLUSIONSWe have shown in the present paper that hoarding is a particular form of capital accumulation, which permits entrepreneurs to lengthen the structure of production and increase future economic growth. However, I argue that hoarding necessarily implies a longer period of time between the moment when resources are saved and the moment when the new consumer goods are brought to the market (i.e. economic growth), as opposed to the case in which saved resources would be invested through the banking system (or any other type of direct investment).
The reason for which this happens lies within the specific features of the monetary economy. When people hoard cash, the only way in which entrepreneurs can employ the newly saved productive forces is through an increase in the purchasing power of the monetary unit. But this implies a gradual change in virtually all the prices in an economy, a process which is necessarily time consuming.
On the other hand, by using the banking system to save money, financial intermediaries can almost immediately adapt the market rate of interest and supply businessmen with the necessary resources to lengthen the structure of production. In this way, the previously discussed time lag is reduced and economic growth will be somewhat faster because the market rate of interest can adjust before the whole price structure. The fact that banks are also producers of specialized services and that the financial market is an organized market are supplementary arguments that add to the present demonstration. They both represent eventual directions for further research.
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Rothbard, Murray N. 1962. Man, Economy and State with Power and Market. 2nd ed. Auburn: Ala.: Ludwig von Mises Institute, 2009.
Schumpeter, Joseph A. 1934. Theory of Economic Development. Cambridge: Harvard University Press.
Smith, Adam. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. 4th ed.. Amsterdam: Metalibri, 2007.
Strigl, Richard von. 1934. Capital and Production. Vienna: Julius Springer.
Wicksell, Knut. 1989. Interest and Prices. New York: Sentry Press.
Longaberger can't sell its basket-shaped headquarters. As Peter Klein explains, resources in a modern economy are complex and specific — which is why we need free markets.
Peter Klein is the Mises Institute's Carl Menger Research Fellow.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 121–123
Dr. Howden (2015) has done me the honor of reviewing my recent book "Finance behind the Veil of Money" (Braun, 2014) in this journal. Many of the points he raises are very helpful to the potential reader. He is probably correct in stating that the book is not an easy read. Its origin as a doctoral thesis explains why no theoretical obstacles were avoided, even those that might be cumbersome for the general reader. When Dr. Howden takes issue with my analyses of the opportunity cost concept and the time preference theory of interest, he also touches points that are of interest to potential readers. In both cases, I elaborate on minority positions within the Austrian School—I follow Dr. Reisman on opportunity cost and Dr. Hülsmann on interest theory. I expected that my discussion of these topics would arouse opposition, or better, I had the desire that it would because, in my opinion, they are yet to be satisfactorily resolved.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 124–128
What is the relationship between opportunity cost, choice and action? In my review of Eduard Braun's Finance behind the Veil of Money (2014), I took exception with his view that opportunity costs are not only unnecessary, but even detrimental to understanding decision making.
The most substantial difference between our views comes from Braun’s treatment of the relationship between opportunity cost and choice.
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015): 456–486
ABSTRACT: This paper analyzes a recently reconstructed proto-chapter of Rothbard’s Man, Economy, and State (2009 [1962]) tentatively titled “Chapter 5: Producer’s Activity” (Rothbard, 2015 [1953]). In it, Rothbard used many concepts of standard neoclassical microeconomic analysis that he would later criticize, such as perfectly competitive markets and the isolated firm. This paper juxtaposes the proto-chapter with Rothbard’s finished work and argues that after grappling with the problems of Marshallian partial equilibrium production theory, Rothbard substituted it with an Austrian general equilibrium analysis. This distinctive approach did not construct production theory from the vantage point of an isolated price taking firm, but rather viewed the overall economy as a temporal and dynamic production structure with the capitalist-entrepreneur occupying the central role. This Austrian production theory has important consequences for understanding the efficiency of markets, the formation of output and input prices, and the profit-maximizing output level of an isolated firm.
KEYWORDS: Rothbard, production theory, perfect competition, profit maximizationJEL CLASSIFICATION: B25, B53, D21, D41, L12, L21
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015): 487–561
Editor's ForewordThis present work is an unpublished chapter of Murray N. Rothbard's Man, Economy, and State (hereafter MES) (2009 [1962]). Titled "Chapter 5: Producer's Activity," it was meant to be the fifth chapter of the book and the first on production theory. In it, Rothbard discussed the optimal production and investment decision of the producer, and used familiar analytical tools such as perfect competition, the isoquant-isocost framework, and the competitive versus monopoly price distinction. It was written when Rothbard still planned to write a textbook of Ludwig von Mises’s Human Action (1999 [1949]) before deciding to write a full blown treatise. Rothbard’s decision to do so was heavily influenced by his concurrent decision to abandon the chapter and rewrite his production theory, as he thought that the new material he would have to present and argue for would be unsuitable for an introductory textbook. In particular, the above mentioned analytical tools were all subject to trenchant criticism by Rothbard in his final production theory.
The chapter is meant to serve as both a compendium for Newman (2015), which is the concurrent paper written by the present author that discusses the evolution of Rothbard’s thought on production theory and its implications for modern theory, and as a source for scholars interested in Rothbard’s thought, Austrian economics, and historians of production theory to use for their own research projects.
The chapter was found and reorganized by the present writer at the Rothbard archives at the Ludwig von Mises Institute in Auburn, Alabama. Over the years, Rothbard had saved many of his draft pages for MES on various topics, including those that would eventually be put in the book and those that would not. Rothbard did not neatly organize his draft pages, so many of the pages that could be found in the archive boxes and were right next to each other could concern completely different topics. Fortunately, Rothbard did number his pages, so the present writer was able to reconstruct the chapter by sifting through the archive boxes and linking up pages based on their number and whether the sentences which ran from one page to the next corresponded with each other. The document that follows pieces together the missing chapter as much of what was possible from the available surviving resources.
The chapter is in a rough stage, as Rothbard appears to have written only one draft before deciding to revise his production theory and remove the chapter from his planned work. However, it was written very clearly and is easy to understand, so in terms of editing the paragraphs for the most part I have only had to make a few grammatical and stylistic changes regarding his numerical examples. In some cases, exclusively in the last section, I had to add a few words and sentences in order to clarify Rothbard’s argument. The largest of such additions occur towards the end of the chapter, where several of Rothbard’s draft pages could not be found. Consequently, I had to fill in with some summary transitional sentences and in one case a paragraph of what I believe Rothbard discussed in these pages, based on what Rothbard referred to later in the chapter. All additions I have made are in brackets [ ], and the observant reader will see that I have faithfully written what can be inferred from the rest of the chapter and in a style consistent with it. In addition, I have provided information in footnotes (prefaced with Editor’s footnote) about various references Rothbard makes to either previously written or planned chapters of MES.
I have also had to make some minor changes to the structure of the chapter. The three sections I could find were sections 1, 2, and 4, as there was a missing third section of the chapter that I could not find. Furthermore, Section 4 included all of the material that is now Section 3, which made it considerably large and unwieldy. Therefore, I have split up Section 4 into two based on respective topics and given Section 3 an appropriate title so that there are four well organized parts that smoothly flow from one to another.
In the first section, titled “The Demand for a Firm’s Product,” Rothbard concentrates on the production function of an individual producer for a given good. With fixed prices for inputs, Rothbard investigates the optimal production choices in situations where the firm either has or does not have an influence on the output price. In Section 2, “Competitive Price and Monopoly Price,” Rothbard introduces the terms perfect competition, competitive price and monopoly price, and defines a monopolist as someone who receives a grant of state privilege. In Section 3, titled by the present author “The Product and Outlay Schedules of the Firm,” Rothbard returns to the firm’s production decisions and analyzes factor ratios and production coefficients. Rothbard derives constant cost (isocost) and constant product (isoquant) schedules as well as rates of constant outlay and constant product substitution. Rothbard shows that the cost minimizing level of output is when these two rates are equal. In a subsection he presents a mathematical and graphical formulation of the above theories and briefly mentions the relation of them to the determination of factor pricing. Rothbard finishes up the chapter with Section 4, titled “The Output and Investment Decisions of the Producer,” by constructing “The Law of Investment Decision” using the concepts of rates of net income, marginal, and average rates of return. Rothbard argues that the investor will not produce at the outlay where either his profit amount or percentage rate of return is maximized, but rather up to the last outlay where the average and marginal rates of return are greater than or equal to his average and marginal rates of time preference. This theory may be useful for those scholars interested in an Austrian “Theory of Investment” as it is a portfolio theory of how the capitalist-entrepreneur allocates his money across various enterprises. This is linked with a brief criticism of firm analysis, which undoubtedly influenced him to drop the chapter and revise his production theory.
In conclusion, this chapter will be a fertile source for both historians of thought and contemporary theorists interested in Austrian economics and production theory. —P.N.
Section 1: The Demand for a Firm's ProductWe have seen that the money prices of goods on the market are set at the intersection of the demand and supply curves. Setting aside the relatively simple problem of the market for old stock, the market price and quantity exchanged are determined by the intersection of the market supply curves of the producers, and the demand curve. We have seen above that the stock thrown on the market in any given period is largely determined by previous anticipations of market conditions in this period. This notion has been presented in terms of the “final supply curve” of producers. In other words, if the selling price of a certain line of washing machines is expected to be 20 ounces of gold next September, how many washing machines will Smith begin to invest in now so that the final product will emerge next September? We have described this final supply in terms of the present price calling forth a present investment for a future production; strictly, of course, it is the expected future price that calls forth investment now for future production. All present production is necessarily the result of such previous anticipation.Editor’s footnote: Rothbard’s reference to his earlier presentation of the “final supply curve” is absent from MES. Rothbard’s discussion of supply and demand for an already produced stock of goods and his introductory analysis of entrepre-neurship and production can be found in Rothbard (1962, 153–161, 249–257). See below (pp. 557–59) for Rothbard’s further discussion of final supply curve.
Thus, all producers’ activity—the central nexus of the economy—is based on certain anticipations of future selling prices. We have analyzed above the determinants of market price for consumer goods, durable and nondurable, and now we must analyze the “final supply curve,” and the process of producers’ activity. Consumers’ goods, the end of human activity, must be produced by producers, and the overwhelming number of exchangeable goods must be produced through the monetary exchange process outlined in Chapter III.Editor’s footnote: See Rothbard (1962, pp. 187–231). Therefore, analysis of producer activity is vital; not only will it provide the final clue to the analysis of consumer goods’ prices—through discussing the determination of the size of the stock thrown on the market—it is also the key to the analysis of the determination of the money prices of factors of production. All other goods but consumer goods are factors, and all of these are demanded and bought solely by producers. It is producers that purchase with money, capital goods, land, and labor, and it is producers that use other factors to produce the capital goods. It is only through a more detailed analysis of producer activity, therefore, that the prices of factors can be explained.
To analyze the actions of a producer let us take a hypothetical case, Mr. Jones. Jones, like all others, must decide on the allocation of his money assets to investment expenditures, consumption expenditures, and to his cash balance. Let us postpone discussion of changes in cash balance to a later chapter on the demand for money and its utility.Editor’s footnote: See Rothbard (1962, pp. 755–874). Jones must allocate his expenses between consumption and investment expenditure. The motive that impels him to spend money on present consumption is the gratification of his desires through present consumption. What is the motive that impels him to save a certain amount of money by restricting his possible consumption, and invest that money in expenditure on various factors of production? This motive must be the expectation of greater money income in the future. We have already seen that every man prefers a satisfaction of a desire earlier than later, and therefore that a given amount of present money is always preferred to the same amount of money in the future.Editor’s footnote: See Rothbard (1962, p. 219). At any given point, he will have a certain rate of time preference, a rate by which he will prefer present money to the present prospect of money at some date in the future.“In every case the choice made is, at the moment when made, a present choice. We have no future desires though we may have a present forecast of a future desire. ‘Future desires’ means desires that will be present at some future time. Present desires are all those desires now being weighed in choice. Present desires may be either desires for present uses or for future uses (either in the same or in different goods). A present desire for future uses is but the anticipation of a future desire, though the two may be of unequal magnitude. It appears therefore that all time-choices are, in the last analysis, reducible to choices between present desires for psychic incomes occurring at different time-periods” Fetter (1915, p. 247). See also Fetter (1915, p. 239). We have seen that the more he allocates to investment, the greater will be the marginal utility forgone of present consumption, and the less will be the marginal utility of each additional future ounce of money income.Editor’s footnote: See Rothbard (1962, p. 220).
“Investment opportunities” for a greater supply of future consumer goods are always open to man, because investment in capital goods adds to the capital structure, and increases future product of consumer goods. On the other hand, man must satisfy his present needs first. Thus, men must always balance their prospect of future gain as against their rate of time preference for present as against future satisfactions. The primary activity in deciding whether or not to be a producer is the weighing of the anticipated future gain against the person’s rate of time preference. In the words of Professor Fetter, “The different time-periods, present and future, and their different economic situations are bought into comparison… by conscious choice between the thing actually present and the future good more or less clearly pictured in the imagination.”Fetter (1915, 240).
We must postpone detailed consideration of time preference and its effects to later chapters of this work.Editor’s footnote: See Rothbard (1962, pp. 367–451). Here it suffices to point out that each individual has his own rate of time preference, expressed as a percentage premium of present over future goods, and that the more he saves at any time, the greater his subjective premium will tend to be.
Let us suppose now that Jones is considering whether or not to invest 1000 ounces of gold, or spend this money in consumption. Let us say his rate of time preference for these 1000 ounces is 6% per annum. In other words, if he anticipates a return on this investment of 6% or less for the following year (assuming for simplicity that only one year is taken into account), he will not make the investment. Thus, in deciding on productive investment or not, his minimum return for the year will be an anticipated 1060 ounces. If he anticipates this or less, “it will not pay for him” to make the investment.Editor’s footnote: See the editor’s footnote 49 below on p. 552.
Now Jones surveys the prevailing conditions, and estimates that he has available four different lines of investment. For the sake of simplicity, we will now assume that all of these lines are in the production of consumer goods (since we have not yet explained the determination of any capital goods prices), and we will also assume that the period of production for each of these processes is exactly one year. This period of production, as explained in Chapter I, is the length of time from the beginning of the action—the investment—to the reaping of the final product. Editor’s footnote: See Rothbard (1962, pp. 13–17). It should be clear that it is a simple task to make the necessary adjustments in calculation if one or other of the processes takes more or less time to complete. The four lines of investment open to Jones he estimates will net him, in the year to be considered, net money returns of 10%, 8%, 7%, and 5% respectively.It is of course likely that Jones will weigh his decision on the basis of expect returns over a much longer period, say a decade, in which these returns may be considered to take place for a ten year period. We can adjust his calculations to cover any desired time period. In other words, with an investment in factors of 1000 ounces now and in the near future, Jones will be able to reap the following returns for lines of investment A, B, C, and D:
Table 1It is clear that Jones will not invest in line D in any case, since his rate of time preference is 6%, and he would prefer to spend his 1000 oz. on consumption now rather than make the investment. If all of his prospects were like D or worse, he would make no investment at all. In this case, it is clear that he will invest the 1000 oz. in line A, where the greatest percentage net money return is to be found. Here, we must remember the qualification that he will only choose such a course if other psychic factors are neutral. Thus, if he has a special fondness for the production of Good B, or a special hostility toward the production of Good A, the 8% money return may be worth more to him on his value scale than the 10% return to be made in Good A. Noting this qualification, however, it will be convenient for us to set it aside, and assume that psychic factors are neutral in our example, in which case the investor will always choose the greatest prospects for money return.
We must now investigate the line of production more closely. Suppose that we confine our attention to the line of production that produces Good A. Jones is eager to maximize the percentage return from his investment. What are the factors that will determine the size of his return? These factors are: a) the money prices of the factors purchased b) the selling price of his product c) the physical productivity of the factors in their transformation into the product. It is obvious that, other things being equal, the lower the prices he must pay for the factors, the greater will be his return; the higher the price of his product, the greater his return; and the greater his physical productivity the greater his return. Let us assume for the moment that the prices of the factors are given. Jones also discovers that there is available to him a range of technical possibilities in the production of the particular good. For the sake of simplicity, let us suppose that only two factors, X and Y, are required in the production of Good A. The money price of X and the money price of Y are fixed on the market—say it is 4 ounces per unit of X, and 10 ounces per unit of Y. Jones knows (or believes) that there are several possible proportions of X and Y that he can buy with his 1000 ounces in order to produce Good A. These may be the following:
Table 2With prices at 4 and 10, these combinations will all add up to expenditures of 1000 ounces. In the first combination, Jones spends 160 ounces on X and 840 on Y; in the second, he spends 200 ounces on X and 800 ounces on Y, etc. Now the question arises: which combination does Jones choose to adopt? First, this depends on the physical productivity of each combination. This physical productivity is the effect of the production recipe, a recipe which is known to the producer in making his decision. The relationship between physical input and product is sometimes known as the “production function.”See Boulding (1941, pp. 456–457) and Stigler (1946, p. 109ff). Let us say that the above combinations of input would yield the following products:
Table 3It would certainly seem that Jones will pick that combination which will yield him the maximum physical output. In this case, it would be Combination 3, by which we can produce 110 units from 1000 ounces’ worth of factors. There is one qualification to this course of action, however, and that would be if his increase in units produced would so lower the market price of the product as to decrease his gross revenue from the sale of the produced stock. In other words, suppose as Case (a), that the price of his product will be 10 ounces per unit, and that he correctly estimates it as such. Furthermore, suppose that regardless which production process he chooses, the market price will continue to be 10 ounces. In other words, whether he chooses to produce 100 or 110 or 96, etc. units, the market supply curve will not be affected sufficiently to lower the price. In this case, the gross revenue from the various combinations will be as follows:
Table 4: Case (a)Jones will choose Combination 3, yielding the largest gross revenue and hence the largest net revenue with a given investment (1000 oz.) and the largest percentage net revenue on the investment. It is evident that, regardless of the number of alternative combinations available, where the price is constant, the combination chosen will be the one that maximizes the physical product from a given amount of money invested in factors.
Now suppose Case (b) where Jones’ production is important enough in the market supply of his product so that a change from one combination to another does affect the market price at which the product will be sold.Here it must be noted that the constancy of price assumed in Case (a) did not necessarily follow for all possible decisions of Jones. Thus, if he decided not to produce the good at all, the price might well be affected, and be, say 12 ounces instead of the 10 ounces if he did go into production. But the constancy of price is only assumed for the relevant range of choice—in this case between the three different combinations. Case (a) only needed to assume that, between a product of 96 and 110 units, market supply would not be affected enough to change the price. Within the range of choice of combinations, a larger output will increase the market supply curve enough to lower the price of the product. It is evident that this is the usual rule on the market. Strictly, indeed, even in Case (a) there must have been some effect on the market supply curve from the change in output, however small, and this minute change will tend to affect the price. In Case (a), however, the change was too small to alter the point of intersection. In Case (b), the price is affected by the change in quantity, but not so much as to lower the gross revenue with an increased output. Thus, a typical situation might be:
Table 5: Case (b1)In this case, the increase in product and supply of the producer lowered the market price, but not in any case enough to lower revenue. Strictly, this condition only need prevail, in Case (b), at and above the point of maximum output. Thus, it would have been possible for the price, at a supply of 96 units, to have been 11 oz. per unit, and the gross revenue therefore to have been 1056 ounces.
In this situation:
Table 6: Case (b2)Here, it is true that as the supply increases from 96 to 100 units, the configuration of the demand curve and the market price is such that the revenue is lowered. However, the important consideration is that the point of maximum output is also the point of maximum revenue. Should Jones shift to another than the maximum combination in order to restrict the product, the higher price will not be sufficient to compensate for the loss of revenue. In both Case (b1) and Case (b2), the producer will choose the point of maximum output, which will also be the point of maximum revenue.
This data can be translated into terms of the demand curve to the individual producer. The individual producer, after all, is not concerned with what the market demand curve will turn out to be—he is concerned what the price will be for his particular product. He must ask himself the question: if I produce so many units, what will the selling price be; if I produce so many more units, what will be the effect on the selling price? In other words, he in effect is estimating what price the buyers will pay for different possible supplies of his particular product. This analysis applies whether or not the producer is one of hundreds producing the same product, or whether he is the only one producing that good. In any case, he must estimate at what price he will be able to sell his product to the buyers.
For Cases (b1) above, the demand curve to the individual producer can be constructed as follows:
Figure 1: Case (b1)When the supply of Jones is 96, the market price will be 10.5—in other words, consumers will be prepared to demand 96 of Jones’ units at a price of 10.5. This gives Jones one of the points, 1, on the demand curve for Jones’ product. The price and supply at 10.4 and 100 respectively, and the various other items on the schedule, yield the other points on this demand curve (such as 2 and 3). These points are drawn together in one line for convenience. The schedule above also tells Jones how much of his product will be demanded at any particular price. Thus, it is clear that the producer knows that if he produces 96 units, they will be sold for 10.5, and 100 units will be sold for 10.4, etc. He also knows that, regardless of the size of his stock, if he sets the price for his product at 10.5 he will be able to sell only 96 units; if he sets the price at 10.4 he will be able to sell 100 units, etc. Thus, the supply and estimated market price yield him an estimate of a true demand curve for his individual product. Not only will he know that a supply of 110 units will provide him with the maximum revenue, he will also know that, once the 110 units are produced, it will not pay for him to destroy or withhold some units in order to raise the price on the remainder. Thus, with this type of demand curve for his own individual product, it is to his interest to produce his maximum physical product, and not to deliberately restrict or withhold his product to obtain a higher price. Even if he can obtain a higher price, restriction will not compensate him in revenue for the lesser quantity sold.
This property of the demand curve for the individual producer, determining whether decreased production will raise or lower revenue, is called its elasticity. We remember from Chapter II that a demand curve is termed “elastic” over any given range if the total outlay of the sale will be greater at a lower than at a higher price.Editor’s footnote: See Rothbard (1962, pp. 126–130). In the money economy, this means that a demand curve is elastic between a range of two prices if the amount of money spent at the lower price is greater than the amount of money spent at the higher price. In the case of the demand curve to the individual producer, the money outlay by the consumers constitutes his gross money revenue at that price. Thus, in Case (b1), the gross revenue obtained by the producer at a price of 10.5 and supply of 96 is 1008 oz.; at a price of 10.4 and supply of 100 units is 1040 oz., etc. What we are concerned with in this problem is the elasticity of the demand curve for the individual producer at and above the point of maximum output. We compare the revenue at that point with the revenue at possible lower outputs. In the case of (b1), the gross revenue at the point of maximum output—the price of 10.0—is greater than any revenue that could be obtained from restricting Jones’ production to sell at a higher price. Thus, Jones will sell at a point of maximum output when the demand curve for his particular output is elastic at and above that point.
What of Case (b2)? Here, the demand curve for Jones’ product is inelastic, if we compare the price of 10.4 and supply of 100, and the price of 11.0 and the supply of 96. Between these two points on the curve, the demand is inelastic, and it would be more profitable for Jones to restrict his production from 100 to 96 in order to take advantage of the greater money revenue. However, this is irrelevant for Jones’ action, because the demand curve is still elastic relative to the point of maximum output. The point of maximum output yields the point of maximum revenue, and hence with respect to this point, the demand curve for Jones’ product is elastic throughout its range. The choice will still be Combination 3, the supply of Jones will still be 110 units, and the market price will still be 10.0.
If Jones were in the situation of Case (a), the analysis would be even simpler. It is obvious that if the price were 10 regardless of Jones’ product in the relevant range, the demand curve for his product is completely elastic, and it would always pay for him to be at his most productive, and produce the maximum physical output with a given monetary investment on factors. In this case, too, the producer strives for maximum physical productivity, and maximum output coincides with maximum revenue.
Another conceivable case is Case (c), where the demand curve for the individual producer is inelastic at the point of maximum output. Suppose, for example, that the following conditions obtained:
Table 7: Case (c)Or, diagramming this in the form of the individual curve:
Figure 2: Case (c)With this sort of demand curve facing him, it pays the producer best to supply to the market 100 units instead of the 110 units which he could supply. With a price of 11.5 per unit instead of 10.0, the result is a larger gross revenue of 1150, and a net revenue of 150 instead of 100.
Jones can restrict his production in either of two ways, and it does not matter which course he takes. He may either use the less productive combination of factors, Combination 2 instead of Combination 3, thus reducing his physical productivity; or, he may produce the maximum amount (Combination 3) and destroy the difference (the 10 units). Economically, it doesn’t matter which course he takes, since the result is to supply less for the market than he could have done with the purchased factors.
We see that when a demand curve confronting the individual producer is inelastic as in Case (c), there are two major points of differentiation from the Cases (a, b1, and b2), where this curve is elastic. First, in the other cases, physical productivity (output on a given investment in factors) is at a maximum, and all of this output is supplied on the market. In Case (c), there is a restriction of productivity by the producer to obtain greater revenue. Secondly, the final market price is always lower in the other cases, other things being equal. The effect of the action in Case (c) is always to raise the price to the buyer. The effect of the restrictive action is always to raise the price of the individual firm’s product higher than it would have been at the point of maximum supply and output.
Section 2: Competitive Price and Monopoly PriceWhen the market price of a firm’s product is arrived at as in Cases (a) and (b) above, this is termed the competitive price; when it is arrived at as in Case (c), through the restriction of production and supply, the resulting price is termed the monopoly price.On competitive price and monopoly price, see Fetter (1915, pp. 77–84, 381–385); Mises (1949, pp. 273–279, 354–376), Mises (1951 [1922], pp. 385–392), Menger (1950 [1871], pp. 207–225) and Wieser (1927 [1914], pp. 204, 211–212). The monopoly price can only be attained in the case of a demand curve inelastic to the producer, and is the result of a restrictive cut back from maximum productivity; it is always higher than the competitive price would have been. How much higher the monopoly price is, how much production is restricted, depends of course on the conditions of each particular case. Evidently, the more inelastic the demand curve for the individual producer, the higher, relatively, will be the monopoly price.See Brown (1908, pp. 626–629).,Editor’s footnote: Rothbard slightly modifies his definitions of monopoly and competitive price below (pp. 538–39).
Many writers have assumed that “competitive price” only refers to such conditions as Case (a), where the action of the individual producer has no effect on price. Such a rare condition is dubbed “perfect” or “pure” competition. More common situations like Case (b), where the action of the individual producer does affect the price, are termed, invidiously, “monopolistic” or “imperfect” competition, and it is assumed that this “monopolistic competitive” price is higher, and the quantity less, than would have obtained under “pure” competition.For example, see Chamberlain (1942). Recently, however, Professor Chamberlin has repudiated the implications drawn by his followers that the “pure compe-tition” situation is the ideal; indeed, he implies quite the reverse. Chamberlin (1950, pp. 85–92). We have seen that this contention is completely fallacious. If the demand curve for the individual producer is elastic at the competitive price, so that this point yields maximum revenue, the product will sell at the competitive price regardless of the fact that the action of the individual producer may have a strong influence on the market price. Thus, we see that there is not a large range of possible prices with the competitive price at the bottom, and monopoly price at the top, and a variety of “monopolistically competitive” prices that could be set in between. There is only, the competitive price and the monopoly price.
Whichever price is set, whether competitive or monopoly price, the determination of the price takes place in the way we have analyzed above-via the supply and demand schedules. The difference comes through the determination of the quantity of stock produced. Under competitive price the producer estimates what his selling price will be, or rather, what price he will be able to sell his stock for, and produces the maximum stock that he can from his investment. But if the demand curve to the producer is inelastic at that price, he can restrict his production somewhat, produce less stock, and increase his monetary revenue. The market price which will obtain as a result of such restriction is the monopoly price.
The extra revenue which the producer obtains from the monopoly price as compared to his revenue at the competitive price is a monopoly gain, and this concept, along with further details of the monopoly question, will be studied further in a later section.Editor’s footnote: This later section, whether or not it was intended to be included in the current chapter or a later one, was not found by the editor in the Rothbard archives. See Rothbard (1962, pp. 677–680) for his mature theory of monopoly gains on the free market. It is important to note that here he no longer uses the competitive versus monopoly price distinction.
It is most unfortunate that traditional terminology in economics makes it necessary to use such terms as “competitive price” and “monopoly price.” The terms are highly misleading and can lead to serious errors in analysis, and they are highly charged emotionally—they are “loaded terms” to most people. “Competition” is usually regarded as fine and praiseworthy while “monopoly” as somehow sinister and tyrannical. There was good reason for the sinister attachments to the word “monopoly” in the public mind. The original meaning of monopoly was a grant of special privilege by the State to a person or group of persons to produce a good to the exclusion of other producers. As the great jurist Lord Coke defined monopoly:
A monopoly is an institution or allowance by the king, by his grant, commission, or otherwise… to any person or persons, bodies politic or corporate, for the sole buying, selling, making, working, or using of anything, whereby any person or persons, bodies politic or corporate, are sought to be restrained of any freedom or liberty that they had before, or hindered in their lawful trade.See Ely (1917, pp. 190–191). The famous Blackstone gave almost the same definition, and called monopoly a “license or privilege allowed by the king.”
The original meaning of monopoly therefore was a grant or exclusive trade in some area, conferred by the State to the hindering of the “lawful trade” of other would be traders, or “competitors,” in the same field. Such monopoly grants were historically important in the Western world, and it is not surprising that, with the growth of the spirit of liberty and of the libertarian movement, monopolies became more and more odious.The battle of the equal-liberty movement against monopoly has had a long history in England. In 1603, the British courts decided, with respect to one of Queen Elizabeth’s numerous grants of privilege: “That it is a monopoly and against the common law. All trades… are profitable for the Commonwealth, and therefore the grant to have the sole making of them is against the common law and the benefit and liberty of the subject.” In 1624, Parliament declared that “all monopolies are altogether contrary to the laws of this realm and are and shall be void.” In the American states, the Declaration of Rights of the Maryland Constitution asserted: “monopolies are odious, contrary to the spirit of a free government and the principles of commerce” Ely (1917, pp. 191–192). See Walker (1911, pp. 483–484).,Editor’s footnote: In this footnote Rothbard refers the reader to later chapters on the hampered market on various monopoly grants. Rothbard originally wrote multiple chapters on the hampered market before the publisher required that he cut the length of the book down and remove controversial parts of the manu-script. Rothbard then had to write a summary chapter of his analysis (Rothbard, 1962, pp. 875–1041). Rothbard’s multiple chapters on government intervention were eventually published as Rothbard (2009 [1970]). See Rothbard (1970, pp. 1089–1144) for his analysis of various grants of monopolistic privilege. Rothbard also mentioned in this footnote that copyrights and patents would be discussed below, see Rothbard (1962, pp. 745–754) for his analysis on patents and copyrights.
Many present day writers have changed the original meaning of the word “monopoly,” and the result is an unwarranted transference of this acquired hostility toward entirely different conditions. Some define “monopoly” as any producer who is alone in the production and sale of any particular product, or “monopolistic” as the exertion of any perceptible influence over the market price. These conditions are far removed from privileged grants of monopoly. On such definitions, any individual producer of a good that the consumers regard as unique, and differentiate from other goods, is a “monopolist.” Ford has a monopoly over the sale of Ford cars; John Williams, lawyer, has a monopoly over the sale of the legal services of John Williams, etc. In this interpretation, every seller of an individualized commodity is a “monopolist.”
Labels for concepts are basically immaterial, the main requirement being that the original meaning continue in force to avoid confusion and error. In view of its historic origins, and emotional connotations, such a use of the term “monopolist” is highly inexpedient, and should be rejected. Similarly, to classify trademarks and brand names for individual products as grants of monopoly is an illegitimate use of the term. For the government to protect any individual in the use of his own trademark is identical with protection against Jack Smith calling himself “John Williams” and selling his own legal services in the guise of forgery. In other words, it is equivalent to the governmental function of defending an individual’s freely obtained property against violence and fraudulent theft. Editor’s footnote: See Rothbard (1962, pp. 162–169, 176–185). Each individual, in a free economy, has the right to his own self, to his own name, and to the exclusive use of his own property. He is no more a “monopolist” over his own name, than he is over his own will or his own property. The governmental function of defense of person and property, so vital to the existence of a free economy and a voluntary society, necessarily involves the defense of each person’s particular name or trademark against the fraud of forgery. It is absurd to use the term “monopoly” or “monopolistic” with respect to the consumers’ differentiation of various individual’s products and services. If the consumers consider Williams’ and Smith’s legal services as different in quality and therefore as different goods, then they are different goods. To allow Smith to pass himself off as Williams, because of the latter’s greater reputation for quality, is to permit violation of each person’s ownership over his name and product.
To define “monopolist” as the exclusive seller of any given product is thus highly inexpedient. We shall employ the original definition of monopoly as a grant of special privilege by the State, confining a field of trade of produce to one individual or group, to the exclusion of others who would be eligible to enter such production in a purely free economy.That such was the original definition of monopoly in economics as well as law is demonstrated by the definition of the economist Arthur Latham Perry: “A monopoly, as the derivation of the word implies, is a restriction imposed by a government upon the sale of certain services” (Perry, 1892, p. 190). Still earlier, Adam Smith discussed monopoly in similar terms, and pointed out how monopolists may use the government privileges to restrict sales and raise selling prices; “Such enhancements of the market price may last as long as the regulations of police which give occasion to them” (Smith, 1937 [1776], p. 62). We shall define that voluntary society where there are no grants of monopoly privilege as a society of free competition, i.e., one where anyone may enter any field of production that he desired (so long as he does not usurp the name of another individual). His ability to do so in any case depends of course on the capital he can invest or borrow, and on his entrepreneurial ability in forecasting future conditions, but this of course is his own responsibility. He is free to compete, not only when he has the ability to do so, but generally when there are no coercive restrictions preventing him from doing so.
It should be clear by this time that there is a great distinction between the concept of “monopoly” and of “monopoly price,” and hence the misfortune of the same word applying to different concepts. The two are entirely different. The monopolist, in our sense, may or may not be able to achieve a monopoly price. The demand curve for his product may be elastic, or there may not be even any consumer demand for his product at all, in which case he could make no net return in producing the good. Thus, the State may grant Hiram Jones an exclusive monopoly privilege for the manufacture of kerosene lamps, but if so few people wish to buy these lamps as to make the production unprofitable, the monopolist is not able to achieve a monopoly price or a monopoly gain. On the other hand, the production may be profitable, but the demand curve elastic, so that the monopolist does not restrict production and sells at what would have been the competitive price. Similarly, the “monopolist” in the faulty sense of a single seller of any product, may not be able to achieve a monopoly price for his sale. A lawyer will probably not be able to gain more revenue by restricting his hours of legal service in order to raise the market price; a producer of a particular brand of breakfast cereal may not be able to make gains by restricting his production in order to raise the price and earn a monopoly gain.
Thus it is perfectly possible for a “monopolist,” either in the sense of a privileged seller or as the sole seller of an individualized commodity, not to be in the position of charging a monopoly price for his product. The result depends on the demand curve for his individual product. On the other hand, it is possible to be able to charge a monopoly price without being a “monopolist” in either of the two senses. Thus, let us suppose that there are several sellers of the same product, and that therefore there is no monopoly. For each of the producers, the demand curve for his individual product is elastic at the competitive price, and therefore there is no way to achieve an extra monopoly gain by restricting production and raising price. On the other hand, the demand curve for the product as a whole, the total market demand curve, might be decidedly inelastic at the market price. In such a case, there might well be a tendency for the various producers to get together and decide production and price policy as if they were one firm only. If they could make such an agreement, they could act as one firm, and the market demand curve would then be identical with the demand curve for that “firm,” and the inelasticity would permit a general restriction of production and a rise to a monopoly price. Such an agreement by many producers to act as one firm in the market is known as a cartel. A cartel arrangement can permit numerous firms to act as “monopolists” in the sense of sellers of an individualized commodity.
There are many stumbling blocks in the paths of firms attempting to form such a cartel, however. Although the demand for the whole product may be inelastic, the demand for each firm will be elastic. Therefore, each firm will agree that the total product and sale should be restricted in order to raise the price, but each producer will be reluctant to restrict his own product and sales. For if the other firms restrict their sales, each firm can gain considerably by expanding his own and taking advantage of the higher price. Hence, it is necessary for each cartel member to agree on a certain quota of the aggregate product and sales, and restrict himself to that quota. It is quite clear that the difficulties to the establishment, and the maintenance, of such a cartel are well-nigh insuperable. In the first place, there is likely to be a great deal of bickering about the assignment of quotas since each firm will try to acquire a larger quota. Whichever basis quotas are assigned are arbitrary, and will always be subject to challenge. As Professor Benham states:
Firms which have produced a relatively large share of output in the past will demand the same share in the future. Firms which are expanding—owing, for example, to an unusually efficient management—will demand a larger share than they obtained in the past. Firms with a greater “capacity” for producing, as measured by the size of their… plant will demand a correspondingly greater share” (Benham, 1941, p. 232).
Particularly likely to be restive under a cartel system are the more efficient producers, those who are making larger profits, and who are eager to expand their business. These firms will be eager to take advantage of the elastic demand curve to their own sales, and to test their own mettle against the less efficient firms protected by the assured cartel’s quota. It is obvious that the cartel, increasingly as it persists, tends to protect the sales and earnings of the inefficient as compared to the more efficient competitors.
As Benham puts it:
The successful maintenance of a combination, once it is formed, is threatened both from within and without. Conditions will change as time goes on, and will make it difficult for the combination to retain the adherence or “loyalty” of some of its members. Some firms will find that consumers demand more of their particular products than before and will resent having to pass on orders (in excess of their quota) to be executed by other members of the combination. Again, some firms will outstrip others in taking advantage of the progress of technical knowledge, and will conclude that they have more to gain by expanding their sales at lower prices than by continuing their membership of the combination. If the demand for the products of the industry falls considerably, the proportion of “unused capacity” will increase, and this will strengthen the desire of some firms to break away and make fuller use of their plants, thus increasing their receipts, by selling at lower prices.Benham (1941, p. 233). On the rapid breakup of even a relatively successful cartel, see Fairchild et al. (1926, pp. 54–55). Also see Molinari (1904, pp. 192–195), Fay (1923, p. 41) and Fay (1912).
The ever present temptation to each producer, particularly a venturesome and efficient one, is to defy the cartel, either secretly or openly, and expand his own sales. The great instability of the cartel stems from the fact that once the firm steps out of line, the others must do so as well. For with A, B, C, etc. restricting their output to maintain the monopoly price, if competitor D expands his output, and cuts the price slightly, he tends to take a great deal of business away from the other producers. Even if price is not affected a great deal, D’s expansion earns revenues while the others must limit theirs.Menger (1950, pp. 222–225). The result is a speedy breakup of the cartel and a return to competitive pricing and output conditions.
Just as great a menace to the existence of a cartel is the threat of outside competition from newcomers. As a matter of fact, the greater the success of the cartel in maintaining its internal cohesion, and earning monopoly gains which are apportioned to the members, the greater will be the temptation for new firms to enter the field. These new firms, unhampered by cartel agreements, can expand their production and sales to take business away from the cartel, and may cut the price of the product as well. This factor is a powerful one in causing the dissolution of the cartel agreements. As a result of these factors, it is not an exaggeration to state that almost no cartel agreement, unaided by special privileges from governments, has been able to survive more than a very short period of time.In many cases, fear of possible outside competition prevents any formation of a cartel, even when other conditions seem favorable. This is known as the influence of potential competition on would be cartelists. The type of State privilege is varied, and will be dealt with in the chapters on State intervention and the Hampered Market.Editor’s footnote: See footnote 22. One such measure in compulsory cartelization, another is the imposition of artificial restrictions in the freedom of entry of potential competitors into the field.
Another important factor tending to prevent the rise of cartels is that, in a free economy, an agreement to form a cartel is not enforceable in the courts. In other words, if Jones signs an agreement to join a cartel and only process 10% of the output of certain other firms, he may violate the agreement at any time without suffering governmental penalties, such as payment of damages of compulsion to abide by the contract. This is due to the particular scope which governmental enforcement of contracts has in a free economy. It was seen in Chapter II that the governmental agency, in a voluntary society, enforces contracts, not simply because they are contracts or promises per se, but because they represent unfinished exchanges of property.
Suppose, however, that a monopoly price has been established on the free market, either by an individual firm or by a remarkably stable cartel. Are the consequences necessarily sinister, as has often been assumed? In the first place, it must be realized again that the term “monopoly price,” used in contrast to “competitive price” is really a misnomer, although the terms must be used for traditional reasons. The monopoly seller or sellers are not immune from, or beyond the pale, of competition. Quite the contrary. The terminology is the result of an old neoclassical preoccupation with single “industries.” Every monopoly seller competes with every other seller for the money of the consumer. Every consumer allocates his money expenditure among all the available uses, and therefore this fundamental competition obtains between all sellers of all the goods and services. Producers compete for wide groups of laborers of various types, of lands and capital goods. Thus, Ford does not only compete with General Motors; it competes with the sellers of washing machines, of television sets, of houses, of caviar, of concert music, etc. Everyone on the free market is a mutual competitor. Thus the monopoly seller who obtains a monopoly price is not beyond competition. He does not dictate to the consumer or anyone else.
But even if the monopoly seller is subject to competition, isn’t the consumer worse off when a monopoly price and restricted production obtains? Can we not say that there is a loss of consumer welfare in a monopoly price situation?Editor’s footnote: See Rothbard (1962, pp. 79–94). Isn’t this an important exception of the harmony of interests that prevails on the voluntary market? To answer these questions, let us recall the exchange situations detailed in Chapter II. Jackson and Smith are in isolated exchange, the former has a horse and the latter has fish, and they bargain to make an exchange. Let’s say the agreed upon terms of exchange are 90 barrels of fish for the horse. Now, critics could charge that Jackson is worse off than he would have been if the price had been set at 95 or higher, while Smith is worse off than he would have been if the agreed price were less than 90. Such charges however miss the point of the analysis. The point is that both voluntarily agreed on the price, that both believed that there were no better alternatives available. The same is true for every price in every exchange, regardless of the number of exchanges. The purchase or the sale of the unit of the good at the agreed upon price is considered the best possible alternative action by each party. Thus each is the best off, has the highest welfare, that he can obtain, consistent with the maximum welfare of everyone else. Smith could force Jackson at the point of a weapon to make the exchange for 80 or 70 or 60 or no fish at all. But in that case it is obvious that the use of coercion has made Jackson worse off, and that Jackson is being exploited by Smith. Furthermore, this action brings up all the problems of violence and an exploitative society, which have been mentioned previously and will be discussed fully in later parts of this book.Editor’s footnote: See footnote 22. Within the framework of a voluntary society, the market price is the best price that either the seller or the buyer can get, and therefore comparing the welfare of either one with some impossible ideal is vain. In the same way, buyers and sellers on the market are “included” or “excluded” from exchange by their own voluntary action in accordance with their value scales.
But what of the case of a monopoly price? When it is set in the framework of the free market, again all parties to the exchange benefit. A coerced lower price or greater product could only exploit the sellers for the immediate benefit of the buyers. Monopoly pricing, on the other hand, is not the exploitation of the consumers, because the payment is voluntary. This conclusion is confirmed by a closer look at the inelastic demand curve, which must obtain in all cases of monopoly price. Thus, suppose that a firm’s maximum productivity would yield a product of 100 units at the competitive price of 10 ounces. Its inelastic demand curve is such that a stock of 50 units raises the market price to 30 ounces, the monopoly price. In the former case, the firm’s revenue is 1000 ounces from its investment; in the latter case, it is 1500 ounces. This means that consumers have voluntarily paid more money for the product in the monopoly price situation. How can it be deduced from this that the consumers are worse off under a monopoly price? After all, the inelasticity of the demand curve is not fixed in Heaven; it is the result of the voluntary action of the consumers in paying more money for the product at a monopoly price. If the consumers really felt that they were worse off than they could be because of the monopoly price, they could, individually or jointly, boycott the product and refuse to buy at the higher price. Such action, would, of course, render the demand curve for the good elastic, and force the firm or the cartel to increase its output and lower the price to the competitive one. The money withheld in the boycott could either be added to cash balances, spent on the products of competitors, or used to invest in a competitor to a cartel. There is therefore never any need to worry about the situation of the consumers in a free market. The shape of their demand curve, and therefore the final market price, is purely the result of their own voluntary action.
It should be clear from the above discussion that there is nothing particularly reprehensible, or frustrating of consumer freedom, in the establishment of a “monopoly price” or in a cartel action. A cartel action, if it is a voluntary one, cannot injure freedom of competition or, if is profitable, cannot injure consumers. On the contrary, they are, as are all other actions on the free market, perfectly consonant with a free society, with individual self-sovereignty, and the earning of money through serving consumers.
As Benjamin R. Tucker brilliantly concluded in dealing with the problem of cartels and competition:
That the right to cooperate is as unquestionable as the right to compete; the right to compete involves the right to refrain from competition; cooperation is often a method of competition, and competition is always, in the larger view, a method of cooperation… each is a legitimate, orderly, non-invasive exercise of the individual will under the social law of equal liberty….
Viewed in the light of these irrefutable propositions, the trust, then, like every other industrial combination endeavoring to do collectively nothing but what each member of the combination might fully endeavor to do individually, is, per se, an unimpeachable institution. To assail or control or deny this form of cooperation on the ground that it is itself a denial of competition is an absurdity. It is an absurdity, because it proves too much. The trust is a denial of competition in no other sense than that in which competition itself is a denial of competition. (Italics ours.) The trust denies competition only by producing and selling more cheaply than those outside of the trust can produce and sell; but in that sense every successful individual competitor also denies competition.... The fact is that there is one denial of competition which is the right of all, and that there is another denial of competition which is the right of none. All of us, whether out of a trust or in it, have a right to deny competition by competing, but none of us, whether in a trust or out of it, have a right to deny competition by arbitrary decree, by interference with voluntary effort, by forcible suppression of initiative.See Tucker (1926, pp. 248–257). For a defense of voluntary combinations from a juristic point of view, see Cooley (1878, pp. 270–271). Also see Flint (1902) and Croly (1909, pp. 359–365) for the economic defenses.
This is not to say, of course, that joint co-operation or combination is necessarily “better than” competition among firms. We simply conclude that the relative extent of areas within or between firms on the free market will be precisely that proportion most conducive to the well-being of consumers and producers alike. This is the same as saying that the size of a firm will tend to be established at the level most serviceable to the consumers.Does our discussion imply, as Dorfman (1949, p. 247) has charged, that “whatever is, is right”? We cannot enter into a discussion of the relation of economics to ethics at this point, but we can state briefly that our answer, pertaining to the free market, is a qualified Yes. Specifically, our statement would be: Given the ends on the value scales of individuals, as revealed by their real actions, the maximum satisfaction of those ends for every person is achieved only on the free market. Whether individuals have the “proper” ends or not is another question entirely and cannot be decided by economics.
Section 3: The Product and Outlay Schedules of the FirmLet us now return to the activity of the firm and its production function. We will assume now that the firm is competitive, and produces for a competitive price, so that its situation either fits Cases (a) or (b) above. In the production schedule drawn up for Jones shown in Table 3, the ratios between the quantities of the factors differ for the various technical alternatives available. Thus, 50X combined with 80Y produces 100 units of product, and 60X combined with 76Y produces 110 units. The ratios between the quantities of factors: 50/80, 60/76, etc. may vary considerably. The list of technological alternatives varies according to the specific “engineering” data of the product in question. In very rare cases, there might be cases where only one ratio, or one set of “production coefficients,” is permissible. In such cases, for example, the product could only be produced with a combination of 5X to 8Y, in that ratio. In almost all cases, however, it is possible to vary the ratios of the factors. Thus, some might assume that the factor ratios in a firm producing, say, chemical dyes are inalterably fixed by the chemical formula of the dyes. This is a complete misconception of the problem, however. The point is that the variations can take place among the number of workers, the number of vats, the amount of land, management, etc., that will be used. The greater the development of the economy, the advance of technological knowledge, and the amount and variety of factors, the greater the opportunity for variability of factor ratios. It is doubtful, indeed, if there are any instances of production where the factor ratios are absolutely fixed.See Stigler (1946, pp. 111–112) and Weiler (1952, p. 147ff).
In Jones’ case, given the factor prices, and the production functions available, it is clear that he will choose the combination 60X plus 76Y in order to attain the maximum output, and hence maximum revenue, from the original investment. In order to analyze more fully the problem of production combinations, the firms’ production, and factor prices, we will assume a far greater range of production alternatives by extending Table 3. Suppose, for example, that with the price of Factor X at 4 oz. per unit, and the price of Factor Y at 10 oz. per unit, 1000 oz. will purchase the following alternative combinations of factors yielding the listed quantities of product:
Table 8These are the technological alternatives that can be accomplished with 1000 ounces’ worth of factors. The maximum productivity is still at 60X plus 76Y, and this will still be chosen.
Now, simply from the given factor prices, we can deduce the rate of outlay substitution, i.e., the rate at which one factor must be subtracted to compensate for the addition of another factor, so as to have a constant outlay (in this case, 1000 ounces). In the present case, 2 less units of Y have to be compensated by 5 additional units of X in order to arrive at the “constant outlay combination” of 1000 ounces. For example, starting from the first line, we know that 40 times 4 equals 160; 84 times 100 equals 840, and the sum equals 1000. If we add 5 units of X and subtract 2 units of Y to move to the second line, we know that 45 times 4 equals 180, 82 units of Y times 10 will give 820, to sum to 1000. It will be seen below algebraically below that the rate of outlay substitution of one factor for another is equal to the ratio of the prices of the two factors. Therefore, the rate of substitution of factor X for factor Y is 2/5, while the ratio of the money price of Y to the money price of Y is 4/10, or 2/5. This ratio of 2/5 obtains regardless of what constant outlay is in view; whether it is 500 ounces or 700 or 1800 ounces.
As yet, we have not progressed far beyond the conclusion that Jones will produce at the (60X, 76Y) combination. However, this line of approach permits further insight into the activity of the firm, and the interplay of technological and financial factors. Let us now shift the focus of attention, and consider this type of question: assuming for the moment that Jones wishes to produce say, 105 units, what are the alternative combinations of factors which can produce them? The answer is a purely technological one, and in accordance with the technological knowledge available, Jones can draw up a list of alternative physical combinations that would yield this result. So far, in this sort of problem, no financial or monetary considerations have yet entered. We already know that 105 units can be produced by the combinations: (55X and 78Y), and (70X and 72Y). Let us say that the following are the combinations of the two factors that will yield 105 units of product:
Table 9It is obvious, that in investigating any constant product combinations, an addition in the amount of one factor must be offset by a decrease in the quantity of the other, for the final product to be the same.It is obvious that, for each of these combinations, more of both factors will produce at least as much as, and probably more than, the particular product. Thus, if (40X; 100Y) can produce 105 units of product, so can (45X; 105Y). This follows from the nature of scarce goods and scarce factors. The use of the latter combination to produce 105 units, however, would clearly be senseless. The latter, obviously more expensive combination, would either produce more and the surplus thrown away—which would be a ridiculous procedure; or else would produce just as much, in which case the factors would still be wasted and needless money expended. In describing constant outlay combinations, therefore, we assume that those combinations which are obviously more expensive for each product—using more of both factors—will be discarded at once. The only question then comes from the partial substitutability of one factor for another. This can be deduced from the mere fact of these factors as instruments of production. It is also deducible from the very fact of the existence of factors. As more and more of one factor is added, and another factor is diminished, the added quantities must compensate less and less for losses in the other factor. Conversely, the more a factor is diminished, the greater will be the need to compensate by adding to another factor, to produce the same product. This is called the imperfect substitutability of factors. This imperfect substitutability is deducible from the very existence of human action. The very fact that consumer goods are scarce implies that factors of production are scarce, and the very fact that there are factors implies that there is more than one factor, since if there were only one factor it would be a consumer good and not a producers’ good. The very fact that there is more than one factor, in turn, implies that the different factors are not perfectly substitutable for each other; otherwise, they would not be separate factors at all. The common example of such imperfect substitutability is that if labor were perfectly substitutable for land on a farm, constant production could be insured with a constantly diminishing area simply by adding to the number of workers, so that 100,000 workers in the space of a thimbleful of land could produce as much wheat as 100 workers on a hundred acres of land. The imperfect substitutability, however, applies to all factors of production in all cases, and not just to labor and land.
We may define the marginal rate of production substitution of one factor for another as the ratio of the amount of the second factor that can be diminished as a result of an increase in the first factor in order to yield a constant product. It is clear that the marginal rate is diminishing as the factor continues to be added. When the combinations change from (40X; 100Y) to (45X; 90Y), the marginal rate of substitution of X for Y is 10/5, equal to 2; but later on in the proceedings, when the combination changes from (65X; 73Y) to (70X; 72Y) the marginal rate of substitution is 1/5. What the actual rates are depend on the specific technological data, but economics does tell us that the marginal rates of product substitution diminish.
Suppose that Jones decided to produce 105 units of product; he could affect the production in each of the above different ways. Which alternative would he choose? Obviously he could choose that alternative that involved the least expense in money, and that would depend on the prices of the factors. Technologically, he would have no way to choose between the various combinations, because technologically all of them are equally effective. It is only the existence of factor money prices that permits the producer to choose among these combinations. With the original factor prices of 4 ounces of gold per unit for X, and 10 ounces for Y, the necessary money expenses he would incur for the production of 105 units of product would be as follows:
Table 10In this particular example, Jones will choose either (60X, 75Y) or (65X, 73Y) either of which minimizes his required money outlay at 990 ounces. Given the amount of production at 105 units, the minimum outlay combination of factors will be the one chosen.
Some writers discuss the activity of the firm as if this were the most appropriate manner of analysis, as if a quantity of product is arbitrarily set, and the producer looks for the minimum outlay combination of factors to produce it. In reality, however, it is clear that the beginning point is the decision to invest a certain amount of money in factors, and the attempt to choose a combination so as to maximize the productivity of the factors, as we have seen above. The present analysis is subsidiary and supplementary to the previous one, but it is useful to revealing the relationship between technological and monetary elements.
Reverting back to the 1000 ounces’ worth of combinations depicted in Table 8 we saw that Jones chose that combination which maximized production for 1000 ounces, at 110 units of product (60X and 76Y). We shall now demonstrate that this combination is also the minimum outlay combination of all the factor combinations that could produce 110 units of product. The demonstration of this truth is simple. In the first place, we may rule out those combinations which require less of each factor, such as (55X; 74Y). We have seen above that obviously wasteful combinations are discarded immediately; therefore, if (60X; 76Y) are required to produce 110 units, there could not be another constant product combination with less of each factor that could also produce 110 units. This follows from the very nature of scarce goods and scarce factors. Therefore, the possible combination which might be able to produce 110 units for less outlay would have to be a constant product combination schedule such as listed above in Table 10 for 105 units, with more of one factor compensating for the subtraction of another. Now suppose that this supposed minimum outlay combination for 110 units has a quantity of X of more than 60, and a quantity of X of less than 76. But to be cheaper, the combination would have to have less of one factor—given the other—than the combination on the 1000-ounce constant outlay schedule. But for each addition of X (X is assumed for convenience to only change in blocks of 5 units, but this does not alter the fundamental result), the constant outlay combination produces less units of product: 107, 105, 100, etc. In order to be cheaper for any given X, the units of Y would have to be even less; and it is manifestly impossible for such a combination to produce as much as these amounts, let alone 110 units. Symmetrically, the same is true for combinations with less X and more Y. For constant outlay, each of the possible alternative combinations produces less than 110 units; to be cheaper than each of these, any other combination could only produce still less, and could not produce 110 units.
It is therefore universally true that the maximum product combination for any given outlay of money is also the minimum outlay combination for that particular physical product.
Thus, we see that, on the free market, each firm, in maximizing the product that can be produced from any given outlay, is also engaged in reducing the money outlay required for each product. Given the prices of the factors, there is only one way to increase his money income from the investment: to find a factor combination that will be the most productive of physical product, and that, in consequence, will be the cheapest method of producing that amount. This analysis enables us to see clearly the different roles played in production by technological and by economic considerations. Technological considerations yield knowledge of the various series of constant product schedules that would be available. At any given product that could possibly be considered, the prospective producer could command a series of tabulations that would yield him the production functions and combinations that could produce it. This would be the contribution of technology. But this knowledge by itself would tell the entrepreneur next to nothing about the crucial questions in the whole problem of producers’ activity: should he enter the business at all? How much should he invest? Which of the alternative constant product combinations should he choose? The answers to these vital questions can only be provided by economic, by financial, as opposed to technologic, considerations. Specifically, it is the establishment of money on the market which enables the businessman to make these decisions in a rational and intelligible manner. The prospective producer will invest in that line of business, in that particular firm, which will maximize his expected money income, over any period of time that he chooses. This rule, as we have explained before, is modified when psychic nonmonetary matters intervene, thus obeying the general, universal rule that in all action the actor maximizes his expected psychic income. Setting aside cases of conflict between money and psychic income, which have already been noted, investors drive to maximize their money income. They will enter that line of business which promises the greatest return on their investment, they will invest in accordance with their expected return balanced by their time preference, and they will produce that combination which requires the least monetary expenditure for the particular product. And to accomplish this they will sell their products for as much as they can—which we have seen will quickly tend to be the competitive market price; will try to buy their factors for as little as they can—which we will see below will be the competitive price; and will try to increase the physical productivity which can be obtained from any given set of factors, i.e., increase their productive efficiency to the utmost. But it is clear that none of these decisions could be made if the investor did not have the various price data and estimates to guide him in his choices. And it is only because the money commodity has become the general medium of exchange that such markets, and such price and income comparisons and estimates, are possible.The absurdity of the “technocratic fallacy” here becomes obvious. The technocratic charge is that business conducts “production for profit” instead of “production for use,” and that the latter would prevail if engineers were granted dictatorial control over the productive system. It is clear from the discussion that technology cannot solve the production problem, and that therefore “production for (money) profit” is the only possible method of production beyond the very primitive level. Technology by itself could neither provide a guide to “maximizing production” nor to determining what should be produced. And it is also evident that business on the market takes account of the technological factor as much as is necessarily possible. It should also be clear that production for profit is necessarily production for “use.” There is no reason to produce any good except to supply the demand for its use by consumers, whether the consumer is other persons or the producer himself (in the more primitive production situations). All production is for use. And these price and income calculations and estimates are most emphatically money estimates; they can in no way be reduced to, or considered equivalent to, barter.
We have already demonstrated that the maximum product combination for any given outlay of money is also the minimum outlay combination for that particular physical product. It is therefore also true that every minimum outlay combination is the maximum product for that outlay. Let us then take the case of an investor with 990 ounces of gold to invest. His maximum product combination will produce 105 units, at either the combination (65X; 73Y) or (70X; 72Y), which are also the minimum outlay combinations for 105 units. We may see above the behavior of the rate of product substitution as the number of units of factors change; the rate of product substitution of X for Y changes from 2, to 6/5, to 3/5, etc. We notice that the minimum outlay combination is reached at the approximate point where the rate of product substitution is equal to 2/5; i.e. is equal to the rate of outlay substitution, which, given the prices, is constant throughout at 2/5. If the rate of product substitution is appreciably less than or more than the rate of outlay substitution, it will pay for the producer to shift to other alternatives until the two rates are approximately equal.
Thus, there is a tendency for the firm to produce at such a rate and such a way that the rate of product substitution between factors is equal to the rate of outlay substitution between them. And, since as we have seen, the rate of outlay substitution always equals the ratio of the prices of the factors, the firm will always tend to produce so that the rate of product substitution between the factors equals the ratio of their money prices.Editor’s footnote: See below (pp. 535–37) for Rothbard’s analysis when more than 2 factors are involved.
In the particular case of Jones, he will tend to produce in such a way that the rate of substitution between the two factors is 2/5.
Actually, this analysis does not help us in the specific determination of the productive combination that will be chosen: this will always be given by the requirement of maximum product per outlay (which will be the minimum outlay for that product). On the contrary, the two ratios will not by means always be equal, because the range of production alternatives available may not be sufficient. If there are only a few production alternatives, then there cannot be the small steps which are necessary to allow equality of rates, or meaningful discussion of such rates. Thus, if only two combinations can produce 105 units of product: namely, (45X; 90Y), and (65X; 73Y), Jones will choose the minimum outlay combination, but the “rate of product substitution” between such distant combinations will be 17/20. However, the rate will still be the nearest approach possible to 2/5, and in that sense we may still say that the tendency will be to approach that rate. The value of the concepts of rate of substitution will fully emerge as essential to an analysis of the prices of factors of production, and, specifically, the demand schedules for the producers for these factors.
The Product and Outlay Schedules of the Firm-Mathematical AnalysisAt this point it is now time to turn to an algebraic and geometric presentation of the above analysis for two factors.
The definition of a constant outlay schedule is that the total sum of money expended be constant, whatever that sum may be. In other words, for two factors, the sum of the amount of money spent on factor X plus the sum of the amount spent on factor Y is always equal. The amount of money spent on each factor, in turn, is always equal to the price of that factor times the total quantity of the factor that is purchased. Thus, if the price is 10 ounces per unit, and 5 units are bought, the total sum of money expended is 50 ounces. Therefore, for a constant outlay schedule, if px is the money-price of factor X; py is the money-price of factor Y, a is the number of units of X bought at any given point; b is the number of units of Y bought at any given point; and k is any constant sum of money outlay; then:
This equation defines any given point on any constant outlay curve for two factors. Now, suppose that we wish to move from this point to any other point on the constant outlay curve. The amount of X then becomes a+m, while the amount of Y, which diminishes in compensation, becomes b-n. At this point then:
Now, we may multiply out in equation (2), and substitute from equation (1). Then:
This gives us proof of the statement in the text that the rate of outlay substitution between two factors is equal to the ratio of the prices of the factors. As X increases, the ratio of the decline in Y due to the increase in X needed to maintain the same total cost is equal to the ratio of the prices of X to Y.
Returning to equation (1), let us solve for b, the quantity of Y at any given point:
Now, let us solve equation (1) for those points where a is equal to zero, i.e., there are zero quantities of X. Then:
This value of b, at the point where a equals zero, may be termed b0. Now, we may substitute (5) into (4), and the equation becomes:
Now, we can see that equation (6) is directly applicable to the case of Jones’ 1000 ounces. b refers to the values of Y at each point, and therefore may be written as Y. Similarly, a refers to the values of X and can be written as X. The ratio of px/py is equal to 4/10 or 2/5. b0 is the value of Y when X is zero; it is equal to the constant outlay (1000) divided by the price of Y (10)—this equals 100.
Therefore, for Jones’ condition of 1000 ounces and the given prices of the factors:
This is Jones’ constant outlay curve for 1000 ounces.
All constant outlay curves for two factors have the shape of a
straight line. The slope of the line is negative, and is the ratio of the prices of the two factors, which is also equal to the rate of outlay substitution between them. When X is zero (even though such a choice will never arise in practice), Y is equal to the constant outlay sum divided by the price of X; and when Y is zero, it is easily seen that the value of X is the constant outlay divided by the price of Y.
This algebraic analysis enables us to establish a whole series of constant outlay curves for different values of k for different constant outlays. Whatever the constant outlay, the curve can be determined: it again will be of the same slope as the other curves, while the difference will be in its position. Thus, say the constant outlay is 800 ounces of gold. In this equation, when X is zero, Y will be equal to 800/10, or 80. When Y is zero, X will be equal to 800/4, or 200. And the constant outlay curve for 800 will connect the two points.
In this way, we can establish a whole family of constant outlay curves. All that is needed is the knowledge of the prices of the two factors, which are assumed to be given; and then for each possible constant outlay, the combinations of the factors can be determined. Some of the members of the family of constant outlay curves in Jones’ case are as follows:
Figure 3Now, it is important to realize that the prices of the factors are the sole determinants of the family of constant outlay curves. These prices are always approaching uniformity on the market. Therefore, the constant outlay curves are not only applicable to Jones; the very same ones are applicable to all producers who use these two factors. Thus, the given set of constant outlay curves and the given rates of outlay substitution are the same for all the firms producing with these factors, not just for one firm alone. At any one time, then, the family of constant outlay curves for any two factors is the same for all producers on the market. This family of constant outlay curves is a series of regular, similarly sloped lines, easily determined by anyone once the prices are given, and the same for all producers.
The production function, on the other hand, is not a given data to all producers. The production function is the estimate of the maximum quantity that could be produced from each combination of factors. Although this is technological rather than catallactic knowledge, it by no means follows that it is “given” to all prospective producers. This knowledge is not simply of engineering formulae; it involves numerous minute details of individual skills, correctness of estimates, judgment of materials and location, etc.On the vital importance of knowledge of “particular circumstances of time and place” see Hayek (1945, pp. 77–91). It is far more likely that each individual’s production function differs than that it is the same, even with the same product and the same factors. As we will see below, this likelihood is made a certainty when there are many more than 2 factors of production, and, when, as is almost always the case, some of these factors are unique (specific), in some ways to the individual firm. Production functions, therefore, are irregular, and differ from one producer to another. Furthermore, they are not “objectively” given; they are only estimates in men’s minds.
What is the shape of the production function? Some might be of fixed proportions, i.e. only one combination of factors can produce each possible quantity of output. We have seen in the text that this is practically never the case, but if it were, a diagram would be as follows: the quantity of one factor on the horizontal axis (say X), and the quantity of the other factor on the vertical axis (say Y):
Figure 4The numbers designate the quantity of output yielded at the various points. These quantities can be of any amount, but they must increase as the quantities of X and Y increase, by the nature of production.
With the existence of varying proportions of factors, so that there are alternative factor combinations for each quantity of product, we can draw up constant product schedules, and therefore constant product curves. If we assume that there are many possible combi-nations for each possible product, then we may ask the question: suppose for example that 1 unit of X and 10 units of Y combine to produce 10 units of product:
Figure 5At this combination (1X; 10Y) there is very little of X and a great deal of Y. Now suppose that X is increased to 2; what will be the loss in Y to compensate and maintain production at 10 units? We cannot know the answer except for the concrete case, but it is clear that since the two factors are imperfect substitutes for each other by their very nature, where the quantity of X is low a slight addition of it will compensate for a big loss in Y to maintain constant production. Let us say that the constant production combination is (2X; 6Y). In the diagram we may connect the two points for the sake of convenience. Now, what if X is increased to 3 units? Since X has been increased and Y has diminished, it will now take a lesser loss of Y to compensate for an increase of X. Thus, the point (3X; 4Y) might be on the constant product curve. Between the first and second points, the loss of Y was 4 and the gain of X was 1 unit; the ratio of the two is 4/1, or 4. From the second to the third point, Y lost 2 and X gained 1; the ratio was 2. This ratio is the marginal rate of product substitution between the factors, or the rate of substitution of X for Y. It is evident that as X increases, this rate diminishes. As X increases and Y diminishes, more and more gain of X is needed to substitute for less and less loss of Y. Thus, the succeeding points on the constant product curve above may be (4X; 3Y), (7X; 1.5Y), with marginal rates of substitution at those points 1 and .5 respectively.
We have arrived at one constant product curve. At each constant product, it is evident that there will be a similar shape, in that the marginal rate of substitution diminishes throughout. However, it is obvious from the nature of production that the larger product calls forth a larger quantity of both factors at each point. Thus, suppose that we are interested in a constant product curve at 20 units. Suppose X is 1 unit; it is obvious that Y will have to be more than 10 in order to produce these 20 units. What amount this will be we do not know; we only know it will be greater. Let us suppose that the point will be (1X; 15Y). We can now draw in a set of succeeding points, assuming only a diminishing marginal rate of substitution. It is clear that all these points will be above, or to the right of, the corresponding points on the lower constant product line.
Thus, we see that there is a family of curves for each constant product. The higher products are above (to the right of) the lower ones. The property of diminishing rates of marginal substitution make these curves tend to be convex to the origin. As the product gets lower and lower, the curves get closer to the origin, finally reaching that point itself at zero product; since zero quantities of factors yields zero product. On the other hand, the curves never cross the X or Y axes. Since both factors are assumed to be necessary ones for the production of the product, and hence the imperfect substitutability of the factors, no increase in the one factor, however great, can compensate for the loss of the whole supply of the other. A common classical example is the case of a wheat farm where no amount of labor, however great, can produce wheat when there is no land available; on the other hand, no amount of acreage can produce wheat without any labor. The point applies, however, to all types of production.
The point has come when this information can be consolidated. For any process of production using two factors, there are two families of curves: constant outlay curves, and constant product curves. Constant outlay curves hold for all producers who use the two factors, since they depend solely on the market prices of the factors. Constant product curves are estimates by the enterprising producers, and will differ from firm to firm. While the former are regular straight lines determined by the ratio of prices and total outlay in view, the latter are irregularly spaced, their only condition being the diminishing rate of substitution between the factors. The two families of curves will be somewhat as follows:
Figure 6As we have seen in the text, at any given outlay, the actor will produce at the maximum product. What does this mean in graphic terms? Let us take, as in the figure below, a typical constant outlay line, and start at the top.
Figure 7This diagram has seven constant product curves, marked 1 to 7, in ascending order of the size of the product. As the constant outlay curve begins at the top it intersects constant product curve 1 at point A. At point A, that combination of factors X and Y yield a total product of order 1. Proceeding further along the constant outlay line, (further in the sense of increasing X and decreasing Y), we intersect point B, at which point X the factors will produce products of size 2. So as we proceed along the constant outlay line, we arrive at higher and higher products—at curves further and further to the right. Finally, we arrive at the point with the highest size product, and the point of production that will be chosen with this outlay. This is point E of size 5, the point of tangency between the constant outlay line and the highest constant product curve obtainable with that outlay. Beyond this point, the constant outlay line again intersects the lower-sized product curves.
For any constant outlay line then, the entrepreneur will strive to act so that his combination of factors will be at a point tangent to the constant product curve. Of course, the entrepreneur in practice does not need to know about such tangencies and curves; he is only concerned with maximizing his output for the given outlay. But we have seen that mathematically this is implied by such maximum output. It must be cautioned that in practice, the constant production curves are a series of dots, of discrete points, rather than continuous lines. A continuous curved line implies that the distance between the points of decision by the actor are infinitely small; actually, this can never be the case—human action of necessity deals with discrete objects and distances. However, in the realistic case, the choice of the maximum product is the closest approximation to such tangency that could be, or should be, achieved.
It is clear that this elaborate analysis of families of curves and tangencies is of no particular aid in this problem; however, it provides analytic tools that will be handy in later analyses of the pricing of factors of production.Editor’s footnote: This analysis of factor pricing was planned to be in a later section, however it was never written because Rothbard changed his mind on the usefulness of using this approach. See Newman (2015) for more information. For one thing, we know geometrically that the marginal rate of product substitution, which is always diminishing, is equal to the slope of the constant product curve, when the latter is a continuous curve. At a point such as E, of tangency with the constant outlay line, elementary geometry tells us that the slopes of the curve and the line are equal. The slope of the line equals the marginal rate of outlay substitution, which is constant throughout and equal to the ratio of the factor prices, and therefore, at the point of tangency, the marginal rate of outlay substitution equals the marginal rate of production substitution. Under real conditions, this is only an approximation rather than an actual fact, but this proves the assertion in the text that the producer sets his production so that these two marginal rates tend to be equal. And this means, furthermore that, for each producer’s decision, the marginal rate of product substitution between the two factors tends to equal the ratio of their prices.
This equality is only an approximation, since for the universal case of more or less discrete points; the point of decision will only be the nearest approach to such equality. However, because of the divisibility of money, the constant outlay curve tends to be (although never will be) a continuous line, while the more advanced the production structure and the more complex the alternative combinations, the nearer will the constant production schedules approach being continuous curves. The more highly developed the market economy, therefore, the greater will be the tendency to approach equality between the ratio of the prices of factors and the marginal rates of product substitution between them.
At each possible constant outlay line, therefore, the producer will pick his preferred combination of factors at the point of maximum output, or approximate tangency to a constant product curve. The higher the amount of money to be spent, and therefore the higher the constant outlay line, the higher and the further to the right will be the constant product curve, and the various points of tangency. Thus, a typical family of constant product and outlay curves may have points of tangency as follows.
Figure 8In this figure, we depict constant product curves, P1, P2, ….P7, and constant outlay lines, O1, O2, … O7. They have points of tangency at A, B, C, D, E, F, and G. The zero point is also a point of tangency, at zero input of factors. The points of tangency enable to producer to determine his maximum product outlay curve. For at any given outlay, the tangency points will yield the size of the maximum constant product curve. Thus, O1 will be tangent to P1 at point A. The same is true to every other alternative. Thus, the decision points A, B, C, etc., reveal to the producer: 1) the maximum product for each outlay, and 2) the best combination of factors for this production.
Section 4: The Output and Investment Decision of the ProducerWe must now return to Jones and his outlay of 1000 ounces. We have already seen that, given an investment of 1000 ounces, Jones will select one combination which will yield him a maximum product. Out of a group of alternative combinations, he will select the best combination. We could diagram this situation as follows:
Figure 9This diagram shows that, at an outlay of 1000 ounces of money, different alternative combinations could yield various amounts of product, namely 110, 107, 105, 100, 97, and 96, as listed in Table 8 above. The highest production, or the top dot on the line, will be the one that is chosen, and the combination of factors will be picked accordingly. This dot is crossed to represent the product of the combination that will be chosen. The same sort of process will be undertaken regardless of the amount that the producer has to invest. Thus, if he has 990 ounces to invest, he will choose the combination yielding him the maximum product, at 105 units. At each possible investment of money outlay, the producer will choose that factor combination which yields him the maximum product. Thus, the diagram of such a situation will be as follows:
Figure 10For each straight line, the top crossed dot will be selected. Thus, we see a series of possible vertical straight lines, representing the constant outlay, with units of product on the vertical axis, and money outlay on the horizontal axis. Each vertical straight line is a constant outlay line, and the crossed top dot is the maximum product that would be selected in each case. The crossed dots can be joined for convenience to give us a connected line of potential products for each money outlay:
Figure 11Each producer will try to determine the various points on this product outlay curve. As we have seen, he estimates the various alternative factor combinations for producing each particular quantity of product, and using these and the prices of the factors, the producer will be able to judge his constant outlay combinations, and which combination will yield him the maximum product for each outlay. This will give him the series of crossed top dots for each outlay, and yield him the above diagram, which represents the maximum product schedule for each outlay.
What can economics say about the shape of this important curve? In the first place, it is obvious that a greater outlay can never produce a lower maximum product. We have seen above that the 1000 ounces will yield a maximum product of 110 units. A greater outlay, say 1050 ounces, cannot produce a maximum product of less than 110 units. This is obvious from the very nature of production and of factors. At the very least, the 110 units could be produced, even if the excess factors purchased with the other 50 ounces cannot be used. Thus, the maximum product schedule always slopes upward or remains horizontal when the money outlay increases. It never slopes downward.
Another characteristic of the maximum product outlay curve is an obvious one: it must pass through the zero point, since no expenditures will obviously result in no production. A typical product outlay curve might therefore look like this:
Figure 12We notice that we may conveniently omit the crossed dots from the final connected line. From the line, we may read off the maximum product which would be yielded by the expenditure of any given outlay.
Without discussing at this moment when the curve is likely to be horizontal, it is obvious that no producer knowing the situation will pick any outlay along the horizontal except the cheapest: i.e., the point on the extreme left of each horizontal line. Thus, if 1000 ounces of outlay will produce 110 units maximum and 1050 ounces of outlay will also produce 110 units maximum, it is clear that there will be no hesitation in choosing the 1000 ounces, and not the more expensive outlays. Any other decision would be a pure waste of money by the producer. Therefore, without yet fully answering how much money will the producer decide to invest, we can immediately answer that he will never decide to invest that amount which lies along a horizontal line. Thus, if 1000 ounces will produce 110 units, and all greater expenditures up to 1100 ounces will only produce 110 units (with expenditures of over 1100 ounces yielding more units), we can be sure that Jones will not decide to invest a sum of between 1001 and 1100 ounces. He will either invest more or less. In Figure 12 above, we cross the horizontal lines with vertical marks to designate those sums that are ruled out from the producer’s decision.
So far, from Figure 10 we know two definite points on Jones’ maximum product outlay curve: 1000 ounces netting him 110 units of product and therefore 1100 ounces of money revenue; 990 ounces netting him 105 units of product and therefore 1050 units of revenue (selling prices are assumed to be 10 ounces per unit). In the former case, he makes a net money income of 100 ounces, equaling 10% of his outlay; in the latter case, he makes 60 ounces net, equaling about 6% of his outlay. Now, we must directly pursue the question of how much Jones, or any other producer, will decide to invest in any particular line of production, and how much he will decide to produce. It is clear that the determining influences are the expected net income, its amount and its percentage. Their exact nature, however, must wait on a more elaborate explanation of the relation between outlay, product, and revenue, in table and figure.
Before finally analyzing which point on the maximum product outlay curve will be chosen, it is necessary to extend the analysis to remove the restrictive assumption of 2 factors. What will be the situation with n number of factors? This is a vital consideration, since it is very rare to find an actual case where only two factors are used to produce any given product.
If there are n number of factors, with market prices assumes to be given, the producer’s investment decision turns out to be almost identical with the case of two factors. The situation may not be diagrammed as in the case of two factors, but the greater mathematical difficulties in the description of the case of n factors does not by any means signify difficulty for the producer. The producer is, again, confronted with a complex of technological alternatives, for producing various amounts of output. Now, the production functions will be combinations of various quantities of factors X, Y, Z, etc. Once again, a constant outlay will enable a certain set of factors to be chosen, in accordance with their market prices. The producer may draw up the list of alternative factor combinations and corresponding outputs, plus a list of factor combinations that can possibly be bought at each given outlay. And, once again, the producer will choose the maximum product combination for each outlay. The fact that there are now many factors does not change the desire of the producer to maximize his product for each possible outlay. The shape of the maximum product curve does not change; it is still true that a greater outlay cannot yield a lower product, and that those greater outlays which will not increase product will not be chosen. It is evident that the analysis based on the maximum product curve is not changed by permitting any number of factors.
What of the interrelationships between the factors and the factor combinations that will be chosen as points on the maximum product curve? Here, it is clear that the situation, with n factors, is more complicated. It is, however, essentially the same, and does not materially alter the analysis. It is still true that we can represent the producer as adjusting, and substituting, all of his factors for each other. Each factor is an imperfect substitute for each other factor, the degrees of imperfection varying with the data of each concrete case. There can be no perfect substitutes for different factors, and there are few or no cases of absolute fixed proportions between all factors, so that, within limits, more of one factor can be substituted for less of the others. The marginal rate of substitution between any two factors diminishes as one factor increases. The rate of outlay substitution between any two factors is equal to the ratio of their prices and the producer will still tend to approximately equalize the rate of outlay substitution and the rate of product substitution between any two factors. Even if ten factors are involved, if, for any two factors, for example, the rate of product substitution is greater than the rate of outlay substitution between them, it will pay the producer to keep substituting, say X for Z, until the rates are approximately equal. For this is equivalent to saying that substituting more X for less Z at constant outlay will yield a greater total product. Conversely, if the rate of product substitution is less than the rate of outlay substitution, it will pay to use less of X and more of Z until the rates are equal.
Therefore, for a case of n factors, the producer will always tend to produce at the point where the marginal rate of substitution for any two factors is equal to the ratio of their prices. There is a simultaneous balancing and adjusting in order to find the maximum product for each outlay. It must be emphasized that there is still one maximum product for each outlay, that there is still an array of different products for the alternative combinations at each outlay. Out of this array, the producer selects the maximum product combination; the number of factors involved does not change this.
Now let us turn to the final production decision of the producer who has arrived at his maximum product schedule. How much does he decide to invest and to produce? For convenience, let us take the case of another producer, Smith, [who can invest in a different firm that produces Product P]. In addition to his maximum product outlay schedule, he estimates his future selling price, and this enables him to estimate his revenue outlay schedule. Thus, assume that his maximum product outlay schedule is as follows (assuming, for convenience, steps of 10 ounces of money outlay):
Table 11This product outlay schedule is shown below in Figure 13.
Now Smith estimates the future selling price of his product. It is quite possible that, as Smith’s prospective product decreases, his selling price will rise. This estimate depends on his idea of the market demand schedule for his individual product.
At this point we must broaden slightly our application of the concept of monopoly and competitive price. A monopoly price situation will occur not only if less produced from a given money investment yields a greater profit, but also if a lower money outlay, and its lower product, yields a greater profit because of the higher selling price. It is clear, however, that this does not materially change our analysis of competitive and monopoly price. In the previous section we assumed a given investment and a lower than maximum product; here, a lower outlay can also yield the same goal of a lower product, and without the waste of the former. This, then, is the actual case. If the demand for the firm’s product is inelastic, so that a lower product, thrown as stock on the market, will so raise the price that money revenue is increased, the firm acts as a “monopolist” to cut back production and outlay to the lower figure. Thus, suppose that at a money outlay of 60 ounces, and at a maximum product of 50 units, as in Table 11, the price of the product per unit is 2 ounces. The money revenue, then, will be 100 ounces, for a net income of 40 ounces. If the demand schedule for the firm’s product is inelastic above this range, then, for example, a sale of 10 units will raise the price to 20 ounces, and a total revenue of 200 ounces. Now obviously, Smith will not invest 60 ounces, produce 50 units, and then throw 40 of these units away in order to acquire 200 ounces. We assumed this above, because we were dealing with the assumption that money outlay is fixed at a certain amount. Obviously, he will rather choose the minimum money outlay required to produce 10 units, i.e. 20 ounces. There will therefore be no need for him to throw away 40 units, and he will save 40 ounces which he would have needlessly expended.
There is therefore no change in our analysis of the demand curve for the firm, and its relation to the incidence of monopoly price. This curve depends only on the quantity sold, and bears no relation to how this quantity is produced. The change in our analysis of the monopolist is, that even he will choose the maximum product for the money outlay that he spends. Even the monopolist will choose a point on his maximum product outlay schedule, and therefore even he strives to gain further profits producing whatever units he makes as efficiently and as productively as possible. If his demand curve is inelastic, he will simply reduce his money outlay from the amount that he would have invested under a competitive price. The reduction of his outlay will reduce his product to the most profitable amount.
On the other hand, there is no reason to restrict the definition of competitive price to a situation where the amount the firm produces has absolutely no effect on the price. It is clear that a change in the amount a firm produces always does change the market stock of the product, and therefore tends to affect the price. It may well be, of course, that, within the relevant range; the action of the firm is not large enough in relation to the product as a whole, to change the market price. There is no need, however, to restrict the discussion of competition to this limited case. The only criterion is that the demand curve is not such as to raise revenue for a restriction of output to a price above the competitive one.
The following is a tabulation of Smith’s productive situation, [and the firm producing P that he can invest in], with the above total outlay and total product schedules, plus an expected selling price schedule for each quantity produced and sold of P. The selling price declines as the stock increases, but are not such as to yield a monopoly price situation (i.e. an increased total product for the firm does not lower its gross revenue). From these three columns we can deduce three others, which are also presented: expected total money revenue (which equals expected selling price times product); net money income (which equals money revenue minus money outlay); and percentage net money income (which equals net money income as a percentage of money outlay). These three schedules are derived from the primary three:
Table 12Figure 13Figure 14Figures 13 and 14 illustrate Table 12. In Figure 13, total units of product are plotted on the vertical axis, as against corresponding money outlay on the horizontal axis. The figure reveals the amount of maximum total product that could and would be produced at different amounts of monetary outlay. The result is the product outlay curve, which is read vertically. There is a dotted line bypassing the point at the money outlay of 80, because here the product curve is horizontal, and no producer would consider such a waste of his resources as to produce at such a point.
In Figure 14, the product schedule is multiplied by the expected selling price at each quantity of product, to yield the expected total revenue for each point of outlay. This yields the total revenue schedule of Column 4. In this figure, money revenue is plotted on the vertical axis, and money outlay on the horizontal axis, the result yielding a revenue outlay curve, which expresses the expected revenues for each amount of invested money outlay.
It is clear that there is a direct resemblance between the shape of the revenue and product curves, since the former is derived from the latter. At a 45 degree angle between the two axes, there is a diagonal straight line. Since the units on each axis of Figure 14 are exactly the same (money in gold ounces), with the same distances, such a 45 degree line can also (vertically) represent money outlay on the diagram. Thus, let us take a money outlay of 60 ounces. This is given by the distance 0A on the horizontal axis. However, if we read vertically upwards from point A, we find that the distance between A and the intersection point B on the money outlay line is also precisely 60 ounces. Therefore, AB, and other such vertical distances, may be read as equaling money outlay on the chart.
This device makes figure reading a very easy task. At the outlay of 60 ounces, the money outlay equals AB. What is the money revenue? This can be read off from the revenue curve, and will equal AC, or 75 ounces. This permits a clear portrayal of net income, which will be the difference, or the vertical line BC.
Similarly, the expected net income can be read at any desired point. It becomes evident, for example, that there is a negative money income at such outlays as 10 ounces, 30 ounces, or 100 ounces.
Such a chart also permits the facile portrayal of the expected percentage net income, or rate of net income. This will equal the net income divided by the money outlay. On the figure, for example, it will be the ratio of BC divided by AB, or alternatively, BC divided by DB.
Now, armed with this portrayal of the alternatives and their expected consequences, what amount [of P] will Smith decide to produce [in this firm]? It is obvious that this problem is a central one in the analysis of productive activity on the market. For the question is applicable to all producers, whatever the product or whoever the individual involved.
Smith has a list of alternative courses of action from an investment of 0 to 100 ounces. It is clear that he will not decide on 80 ounces, since this will be a wasteful act with 70 ounces able to produce the same number of units. It is also clear that he will not choose to invest: 10 ounces, 30 ounces, or 90 ounces, since he will suffer monetary loss from such investments. He will not invest 20 ounces, where there would be no income from his investment. Which alternative will he choose of the ones remaining?
Most writers on this important subject have gone astray in their answers to this question. They look at the schedules and simply assume that every producer is interested in “maximum money profits,” or, in better terminology, “maximum net income.” Almost invariably, they would conclude in Smith’s case that Smith would choose a money outlay of 60, and the expected money revenue of 75, since this yields the highest expected net income, i.e. 15 ounces. This is greater than any of the other alternatives. At first sight, this assumption seems plausible. Further analysis, however, reveals the unsoundness of such a simple assumption. It is true that if Smith invests 60 ounces, he expects a return of 75, and a net income of 15. Yet compare this with the alternative of investing 50 ounces and obtaining a net income of 14. In the former case, his percentage net income, [or rate of net income], is 25%, while in the latter case it is greater, 28%. Isn’t it plausible that Smith could invest 50 ounces at 28%, and then find a better and more rewarding way of investing the remaining 10 ounces? If we look at the marginal rate of net income, it becomes clear that, on the added 10 ounces of outlay, Smith is only making an extra 1 ounce in net income, a percentage net income of only 10% on these last 10 ounces. If, as seems plausible, Smith can find a greater rate of net income on these 10 ounces, it is clear that he will only invest 50 ounces in this product, and will invest the other 10 ounces elsewhere.
How many ounces [in this firm for Product P] then, will Smith invest? Will he invest 60 ounces to earn a net income of 15, and a rate of net income of 25%; or will he invest 50 ounces to earn a net income of 14, and a rate of 28%?
It is clear from out discussion that, in fact, there is no precise theory of the determination of the investment in, and output of, the firm. There is no theory of investment or output of the firm, because on firm cannot be considered in isolation from the other firms in the economy. Whether or not Smith will invest 50 ounces or 60 ounces in this firm depends, for example, on whether he will be able to invest the remaining 10 ounces elsewhere to yield more than 1 ounce of net income. The prospective investor considers, in various possible firms, the net returns that he will earn from various amounts of outlay in various possible firms. He must consider which alternative will be more remunerative: to invest 50 ounces here and 10 ounces elsewhere, or 60 ounces here. His marginal rate of return on the last 10 ounces is 10%; if he can earn 15% or 1.5 ounces elsewhere, he will invest them there, and invest only 50 ounces in this firm. Furthermore, the investor might invest nothing at all in this firm, for he might be able to earn a 30% return for 60 ounces in some other firm, producing some other product. It is impossible, therefore, to consider a firm in isolation, and attempt to determine how much will be invested in it, or how much it will produce.
Each investor, in a free economy, can range among a myriad of possible enterprises and invest in them. Indeed, by means of the device, to be examined more fully below, of parceling out parts of ownership of a firm’s assets to different investors in various shares, each individual can invest a few ounces of money in one firm, a few in another, and several in a third, the investors hiring managers to supervise the actual production.Editor’s footnote: See Rothbard (1962, pp. 426–435). In all of his actions, psychic factors being equal, he will attempt to maximize the rate of net income from each unit of money that he invests, thereby maximizing his total net income from his entire investment in all branches. To pursue this approach will lead us to a theory of the savings and investment of the investor, rather than of the output of the firm, and thence to the theory of the savings and investment of all the investors, indeed all the individuals, in the economy. This will be inextricably connected with the problem of time preference, which we have already seen in Chapter I to play a determining role in the decision of the individual as to how much he will save and invest compared to the amount he will consume.40 This will be discussed in a later chapter.Editor's footnote: See Rothbard (1962, pp. 367–451).
It is evident that, in the pursuit of the maximum possible rates of net return, the investors will invest each sum of money, large of small, in that firm or in those firms where the rate of net return, for each size of money invested, will be at its maximum. Investors will spurn 2% return projects to invest in expected 20% return projects.
At this point we must make a crucial distinction in our analysis of investment and production—the distinction between the investor or investors considering investment in new firms, and those contemplating the extension or continuance of investment in old firms. New firms are those which are starting from the beginning. If Smith is a new investor, he will decide as follows: [with a given 60 ounces to invest], he will invest 50 ounces so as to produce 40 units [in this firm for Product P], and earn an expected 28% net income [and invest 10 ounces elsewhere to try to earn more than a 10% marginal rate of net income]. However, if he cannot earn [more than] 10%, or 1 ounce, on 10 ounces elsewhere [in another firm], he will invest 60 ounces to produce 50 units [of Product P], and earn 25% on the investment.
It is clear that there prevails on the market a tendency toward equalization of expected net income rates on new firm investments. Suppose that in one firm or product, the rate of net return is expected to be unusually high compared to other investments, say 28%. It is clear that the new investors will flock to invest in this firm, or in competing firms producing the same product. If the data on the market remain the same, then this flood of investments will tend to lower the price of the product, and raise the price of the factors, particularly those specific to that product, until the expected rate of return will be drastically lowered. Furthermore, in unusually unprofitable firms, such as those earning 2%, the old investors, given enough time, will allow their capital goods to wear out, and shift their investments to the more profitable investments. Suppose we postulate, then, an evenly rotating economy, such that the data never change, i.e. on each day consumer demand, saving and investment, tastes and resources and technological knowledge, will be the same. In this case, given enough time, the rate of net return will be equalized in every firm and every branch of production. This will be an economy of certainty-since there will be no uncertainty of future price, demand, or supply. In this case, the expected rate of return will invariably be the realized rate of return, and this will be equalized for every firm and investment. This rate of return is called the pure rate of interest. What rate will it be, and how will it be determined, we must leave to further chapters.Editor’s footnote: See Rothbard (1962, pp. 367–451). In the evenly rotating economy, then, every firm will earn the same net return, say 5%. Since there is no uncertainty, every firm will be built and arranged to produce at its optimal level.
[Returning to the individual investor, Smith, in the above example we assumed that he was going to invest 60 ounces in one or more firms. But how does Smith choose the amount of money that he is going to invest at all? We have shown above that we cannot simply concentrate on maximum net income on an investment, but must also pay attention to its rate of net income.] Can we then say that Smith will invest that sum which will yield him the largest percentage, or rate of net income? No, we cannot simply make such a plausible statement either. Suppose, for example, we consider the investment of 40 ounces, yielding a percentage net income of 19%. An additional investment of 10 ounces would yield an additional net income of 14 minus 7.6 ounces, which equals 6.4 ounces, [for a rate of net income of 28% on his 50 ounces]. This is a return of 6.4 ounces on an outlay of 10 ounces, a marginal rate of return, or marginal rate of net income, of 64%. Yet, circumstances are conceivable when Smith would not make the additional investment. We must never forget, as we pointed out in Chapter III above,Editor’s footnote: See Rothbard (1962, p. 220). that every individual is always engaged in balancing his various consumption, and his various investment expenditures, and additions or subtractions from his cash balances. Suppose, now, that Smith has a money stock of 200 ounces, which he is in the process of allocating. It is entirely possible that, while he may choose to invest 40 ounces in factors of production yielding him a 19% net income, even so high an additional return of 64% on the next 10 ounces will not induce him to restrict his consumption further. In such a case, Smith prefers present consumption spending with these 10 ounces to the 64% rate of income; therefore, his marginal rate of time preference for these 10 ounces is higher than 64%, and he does not make the investment. His investment in the product will then be 40 ounces and his level of output will be 28, producing an expected revenue of 47.6, a percentage of 19%.
In every case, therefore, the amount of money investment by the producer, and consequently the amount of product made, depends on the interrelationship between the expected rate of net income and the individual’s rate of time preference.
This interrelationship, specifically, is most important in its marginal aspects. The reader is referred again to Chapter I, the basic foundation for the later analysis.Editor’s footnote: See Rothbard (1962, pp. 1-77). There we saw how man allocates his stock of goods in accordance with their marginal utility in the various uses.Editor’s footnote: See Rothbard (1962, pp. 21-33). We also saw how man allocates his labor in accordance with the marginal utility of the expected products in the various uses, and with the marginal disutility of the foregone leisure.Editor’s footnote: See Rothbard (1962, pp. 42-47). This is particularly relevant. We recall that each man allocates his labor in units, say hours, to that particular use which provides the greatest value of marginal product on his value scale.
This analysis, in its essence, is applicable to the present problem. Smith is choosing, not between the utility of labor and its product versus leisure forgone, but between the utility of an expected future net money income, and between the disutility of present consumer goods forgone, by investing in factors of production. Again, his decision in every case is marginal, i.e. he deals with divisible units of a good. In this case, he is dealing with units of a money commodity used to purchase factors. He knows, or believes that he knows, the various technological alternatives by means of which certain quantities of factors will yield him certain quantities of product, and from this he estimates the expected money revenue that will accrue from the sale.
Thus, let us consider an expansion of Smith’s choices [for the firm producing Product P] as shown in Table 12 above:
Table 13Money outlay and expected net money income are taken from Table 12. The other columns require extended explanation. The purpose of the added columns is to better analyze Smith’s final investment decision in production. Column 7 sets forth the addition in net money income which will be yielded by an addition to Smith’s monetary investment in factors. This is the marginal net income expected from his various decisions. However, an investment of 10 ounces will immediately be rejected by Smith; the net income itself is negative. Similarly, an investment of 20 ounces, or 30 ounces, will be rejected for the same reasons. The first possible investment is that of 40 ounces; there is no choice for Smith between 0 and 40. Therefore, the space above that in Column 7 is left blank. Marginal decisions, and their features, refer only to actual choices confronting the actor. The differential in which we are interested in is the differential that is significant to the human actor, and not the convenience of algebraic manipulation. Therefore, for example, the marginal net income at an outlay of 40 ounces is not the difference between 7.6 and –7.6, equaling 15.2, since there is no possibility that Smith would ever consider an outlay of 30 ounces, yielding a negative return. The margin is not between 0 and 10, 10 and 20, etc., but between 0 and 40 only. The marginal net income at 40 then, equals 7.6 minus 0, which equals 7.6. From then on, the margin occurs every 10 ounces, for that is the decision unit, so to speak. Smith estimates that the next 10 ounces of investment will increase his net income from 7.6 ounces to 14 ounces—giving him a marginal net income by these 10 ounces of 6.4. From 50 to 60, the 10 new ounces only increase the net income from 14 to 15 ounces, a marginal net income of 1 ounce. After this point, the net income declines; therefore, the marginal net income is negative. Thus, after 60 ounces, an additional 10 ounces will lower the net income to 13; thus its marginal net income is minus 2 ounces.
Immediately, we have learned something more about Smith’s eventual investment production decision. It is obvious that no one will knowingly invest additional money the marginal net income of which is negative. Smith will not invest 10 more ounces in order to see his net income dwindle by 2. Therefore, in our example, all points above 60 are eliminated from Smith’s final decision. This leaves us with three possible points of decision: 40, 50, and 60 ounces. Now, we may compute the rate of marginal net income for each of these amounts. This is equal to the marginal net income at each outlay divided by the marginal outlay listed in Column 8. The marginal outlay is the additional amount of money which each given amount of outlay represents in Smith’s decisions. Thus, Smith may either invest nothing or 40 ounces, the next step. His marginal outlay for an investment of 40 ounces, is 40 ounces. His marginal outlay at an outlay of 50 ounces is equal to 10 ounces, or the differential between 50 and 40—the two successive points of decisions. The marginal outlay at 60 is also 10 ounces. After that, there is no need to apply the concept, because these decisions have been ruled out. Column 9 lists the rate of marginal net income, and this gives the percentage of net income which each additional investment of units of money will earn. At 40, an addition of 40 ounces earns 7.6 ounces net; this is a percentage return of 19%. At 50, an addition of 10 ounces earns 6.4 more ounces of revenue-a marginal percentage return of 64%. At 60, the additional 10 ounces earns only one more ounce in revenue-a marginal rate of 10%.In Smith’s particular case, marginal net income is only negative in the early and later stages. In some cases, there may well be points where the marginal net income is negative in between points where it is positive. In such cases, the point of negative marginal income is skipped over, and marginal outlay is assumed to be the difference between the two nearest points of positive marginal outlay. Thus, Jones’ schedule of outlay and expected net income may be as follows:
The alternatives that remain for Smith’s consideration are condensed in Table 14 below taken from Tables 12 and 13:
Table 14To summarize how we obtained these columns: from techno-logical knowledge, Smith could calculate the maximum physical product that could be obtained from each combination of factors, and this with the prices of factors, which we have taken as given, determine the maximum total product schedule for each possible alternative outlay of money investment. Horizontal spaces in the schedule were eliminated, i.e. where the marginal product is zero for each increase in outlay (it can never be negative). For each possible product, Smith estimates the selling price for which he could sell the product, and this times the quantity produced yields him the revenue schedule for each outlay. The net income is then easily calculated, and points where this absolute net money income is expected to be zero or negative are immediately eliminated from consideration. The rate of net income is the percentage that the net income bears to the money outlay at each point. Marginal Net Income, then, can be calculated: at each step this is the additional net income earned from the additional dollars invested. Marginal outlay can usually be taken at equal steps for each alternative, but this must change when the net income turns out to be zero or negative in certain cases, in which cases the marginal outlay considered by the actor must be greater in order to skip these points. Those points where marginal net income is negative are then eliminated from consideration, since it would be obvious folly to invest additional funds where only losses would be earned. The two key concepts now are the rate of net income (which is equal to net income divided by outlay) and the rate of marginal net income, which equals marginal net income divided by marginal outlay. These are listed in Columns 6 and 9 respectively.
Before continuing to discuss the decision between the remaining alternatives, we might well consider the question: is there a fixed relationship between the average rate of net income, which shows us the percentage return from the total investment, and the rate of marginal net income, which gives us the percentage return on each successive dose of monetary investment? The answer is definitively yes; in fact, at any point, the rate of net income is equal to the weighted average of the rates of marginal net income at that and preceding points, the weights being the size of the marginal outlay at each point. Thus, at an outlay of 50, the rate of net income is 28. This is equal to the average of the rates of marginal net income at that and preceding points, namely 64 and 19. However, it is not simply 64 plus 19 divided by 2 ((64+19)/2=41.5). This would be an unweighted average of the two numbers. Each number is multiplied by the marginal outlay at that point, and the sums are divided by the sums of the marginal outlays, which is total outlay at the final point. Thus, 19 times 40 plus 64 times 10 is divided by 40 plus 10 (((1940)+(6410))/((40+10))=1400/50=28). Or, at the money outlay of 60, the rate of net income equals 40 times 19, plus 64 times 10, plus 10 times 10, divided by 40 plus 10 plus 10 ((4019)+(6410)+(10*10))/((40+10+10))=1500/60=25).
Furthermore, at the first feasible marginal step, whatever it may be (in this case it is from 0 to 40 ounces), the rate of net income equals the rate of marginal net income, the net income equals the marginal net income, and the total outlay equals the marginal outlay. This is because the starting point is always zero—no investment—and the total of something after the first step is the same as the difference between the step and zero.
Thus, we see that the average rate of return is the weighted average of the preceding marginal rates of return, and that at the first step, the two rates of return are equal. This indicates another important truth: that the average rate at any point is equal to the marginal rate, if the distance between that point and zero is taken as the unit. Thus, if Smith is considering the investment of 60 ounces, his expected average rate of net income is equal to the marginal rate of net income, if the “margin” is taken as a unit of 60 ounces. Thus, the decision on an investment of sum of money is a “marginal” one in two senses: a) in the sense of the last small unit of money and its return, and b) in the sense of the return to a marginal unit taken as the size of the sum itself. Both sizes of marginal chunks are discrete steps, and both are taken into consideration by the actor.This statement will be surprising only to those who have been misled by the use of the differential calculus in economics. In calculus, the steps between points are treated as infinitely small, and therefore the marginal is thought to be the infinitesimal. In that case, “small” sized units will be recognized as approxi-mations to some “ideal” marginal unit, but a “big” unit will not be thought of as marginal. Actually, the size of a marginal unit can be any amount, depending on the decision to be made. There is nothing ideal about infinitesimally small units, and they are not relevant to the real world of human action in any case, since action always deals with discrete steps.
[Now we must return to the important concept of the rate of time preference and integrate our analysis of the rate of net income.] Any man, in deciding upon the allocating of any given sum of money between consumption and investment purposes, estimates the expected yield of net money income to be derived from his investment (modified where necessary by other psychic considerations) and compares it with his minimum required monetary return from that sum of money, taking into consideration his total stock, and his value scale. This minimum rate of return is his rate of time preference: any investment which he expects will yield him a lesser return will not be made. [Thus Smith and his investment decisions in the firm producing Product P, as shown in Table 14, are compared with his rate of time preference.] This rate of time preference is set by his relative valuations of present and future satisfaction; it is his “minimum supply price”—the lowest “price” at which he will part with his present money in order to invest in a prospect of a higher income at some time in the future. As an individual allocates more money to investment and less to consumption at any time, his marginal rate of time preference increases, until it finally becomes prohibitively high for any investment. This fact is set by man’s necessity to consume in any given present, before making investments for the future. The entire schedule of a man’s time preference rate, therefore, increases as the invested outlay increases, finally nearing verticality. [It can be calculated in marginal and averages form like net income.] If the rate of net income from the investment outlay is greater than the rate of time preference, he will make the investment; if not, he will abstain from the investment.
The investor Smith, in sum, does not simply try to maximize his expected net money income. He, like every actor in every situation and every choice, tries to maximize his psychic revenue and attain a psychic profit. He cannot only consider money income from the investment. He must weigh this against his psychic time preference rates. His maximization of psychic revenue, therefore, impels his investing so long as the rate of average and marginal net income exceeds his average and marginal rates of time preference.Editor’s footnote: Strictly speaking, it must be greater than or equal to. An investor would still invest if the rate of return is equal to the rate of time preference, since his rate of time preference is the minimum he would need to earn in order to forgo the present money and invest. In the Evenly Rotating Economy, each investor only earns the interest rate, which is the societal rate of time preference. [Investment decisions in a firm, then, will always be where the average and marginal rates of net income are greater than or equal to the average and marginal rates of the investor’s time preference. More precisely, Smith’s investment decision in the firm producing P, will be at the last marginal outlay where this occurs. In general, then, investment in a firm will be pushed to the last marginal outlay where expected average and marginal rates of net income are greater than or equal to the average and marginal rates of time preference for the investor. We may call this the Law of Investment Decision.]
There is an important modification in this analysis of Smith that must be made, before our investigations into his output and investment decisions can be completed. In this example, we have assumed that the investor Smith faces only one alternative: either invest in the given line of production or don’t invest at all. In actual life, as we know, the investor has open to him a choice in the investment of money in many lines of production or many firms. [As explained earlier, the production and investment of a firm cannot be considered in isolation.] Smith must not only choose whether to invest or to consume (or add to cash balance), he must decide between several alternative lines of production. How then must our law be changed to indicate the determination of his total investment, and of the investment in each line of production? In the first place, it is clear that Smith is primarily interested in maximizing his psychic revenue from the total of the investments in his portfolio. His interest is not in firm A or B or C, but in his income from all of these investments as a whole. Therefore, he weighs his average and marginal rates of time preference against the gross revenue that can be achieved from all of his investments at the given outlay. Thus, at any total outlay, say 120 ounces, he determines what distribution of money among the alternative investments will yield him the maximum total gross revenue, and hence the maximum net income, and maximum rate of net income for the given outlay. At each point of outlay he decided on the distribution that will accord him the maximum gross revenue, and therefore he is able to deduce the maximum average and marginal rates of net income for each outlay. He invests his money up till the largest amount at which the maximum average and marginal rates of net income are larger than his average and marginal rate of time preference, respectively. At this amount, he distributes his outlay among the various enterprises in accordance with the “maximum revenue distribution” at that outlay.
In the final form of the Law of Investment Decision, then, there is not the previous direct and complete link between investment outlay of the individual producer and the output of the individual product-as there is when the individual producer invests in only one line of production. It is still true that the actor invests in production—in general up to the last point that his expected average and marginal rates of net income exceed his average and marginal rates of time preference. Since this is true for each man, it is clear that the production of all goods in the society at any period is completely determined by these factors. It is still true for each individual product that the amount invested is such that the average and marginal net income rates at that point are greater than the time preference rates at that point. In this sense, the law still holds. However, no longer does the investor push his investment in each particular firm to the last point before his time preference rates outstrip his income rates. He does not do so, because now he wishes to distribute his money outlays among several lines of production, in order to increase his revenue.
We must now return to our original question. How is the Smith, or in general, any investor’s outlay in any given line of production, and therefore the output for that particular product, determined? To find the answer, we must look at a hypothetical illustration. Suppose now, that Smith has to consider, not only the product that we have explored in detail above, but also several other lines of production. Alongside the hypothetical money outlays, Smith lists, for each line of production, the expected net income from each outlay. Thus, let us say that he decided among firms producing products P, Q, and R, recalling that our illustration above consisted of product P. Then we might have the following schedules:
Table 15These net income schedules reveal what net income Smith expects to enjoy when investing a certain outlay in any given line of production. But these schedules permit combination into one maximum net income schedule, which will determine the investment distribution that will yield the largest net revenue for each given outlay. Thus, suppose Smith is considering an outlay of 50 ounces. He might invest them all in the firm producing P, in which case his net income will be 14 ounces. If he invests them all in the firm producing Q, his net income will be 18 ounces; in the firm producing R, his net income would be 15 ounces. Clearly, if he can only invest in one firm or in the other, then he will choose firm producing Q. But, since he can distribute his investments, he also considers the various investment combinations adding up to 50 ounces which involve two or more firms. Thus 40 in producing P and 10 in producing Q will yield 7.6 plus 2, a net income of 9.6. Mentally considering the various combinations, it becomes clear that prospectively the best is (30Q plus 20R) which yields a net income of 13 plus 8, or 21 net ounces. At each hypothetical outlay, the investor picks what appears to be that combination that will yield the highest net income. The following is Smith’s maximum net income schedule with each money outlay, with the investment distribution in parentheses:
Table 16The best combination for any outlay is that one for which the sum of the net incomes from each line of production is the highest. An equivalent property of this condition is that the weighted average of the rates of net income from each line of production be the highest (where the weights are the money outlay in each line). Thus, take the problem of the best investment of 50 ounces. 50 ounces all in producing Q would yield 18 ounces income, or a 36% return. This is higher than an investment of 50 ounces producing P or R. But an investment of 30 ounces in B yields 13 ounces income, or 43%. An investment of 20 ounces in R yields a return of 8 ounces income, or 40%. A weighted average of these two yields by the respective outlays is: 30 times 43, plus 20 times 40, divided by 50. This equals 42%, the weighted average, which also equals the rate of maximum net income (amount of maximum net income divided by money outlay). Thus, the best distribution can be determined from schedules of rates of net income for each of the various outlays in the various lines of production. In this case, the distribution is not confined to producing just Q, even though producing Q is more profitable than either of the others at any given total investment.
From the maximum net income schedule, there can be deduced schedules of rates of maximum net income, marginal outlay, marginal maximum net income, rates of marginal maximum net income, etc. Thus:
Table 17Smith, or any investor, then proceeds analogously with the case of one product, investing money outlay (in the best distributions) up to the largest amount that his rate of marginal maximum net income is greater than [or equal to] his marginal rate of time preference, and his average rate of maximum net income is also greater than [or equal to] his average rate of time preference. Here again, average rate at any point is equivalent to the marginal rate (of maximum net income) at that point, with the size of the point itself considered as the unit.
We at last come to the end of the tortuous road of analysis of the determination of investor’s decisions and of the amount of investment in any one productive firm. An investor will continue to invest rather than not so long as his expected average and marginal rates of return are greater than his average and marginal rates of time preference; and he will make his investment in that productive enterprise or combination of productive enterprises that will yield him the greatest possible net income, or rate of net income, for any hypothetical outlay. If we may eliminate the distinction between average and marginal by varying the size of the marginal chunk, then we may simply say that each unit of money outlay will be spent in the way that promises to yield the actor the greatest utility: in spending on consumer goods, if the rate of time preference for this amount is greater; or in spending on factors of production in that line or lines and in that firm or firm, where the rate of net return promises to be the greatest.
We have thus analyzed the principles according to which a man allocates his stock of money in accordance with expected greatest utility: the allocation of money units between investment in general and present consumption, and the decision between investment in various different firms and lines of production. The quest is for psychic profit, and the course of action that will yield the greatest utility—in the usual case, this line of investment will be the one that is expected to yield the greatest net return from the outlay. Exceptions are cases where other psychic factors, such as particular like for, or dislike for, the production process or the product itself, alters the decision from a pure consideration of monetary return. Otherwise, a man invests in those enterprises which he expects will yield the highest rates of return.
We have thus seen what determines the amount of stock of any good that will be produced in any particular period—it will be the amount that the producer had invested in a previous period in order to aim at such production. The amount of previous investment depends on the producer’s anticipated net monetary return. It is clear that an increase in anticipated rate of net income in any line of production will tend to increase the investor’s outlay in that product, and that on the other hand a decrease in the anticipated return will tend to diminish his investment in that process. If we interpret the concept of “increase in rate of net income,” as meaning an increase in the entire rate of net income schedule, so that at each outlay of product, net income is expected to increase, it is obvious that the rate of net income schedule will intersect the investor’s time preference rate schedule at a further point, so that an increase in the expected net income schedule will increase the amount of investment outlay in that product, and contrary for the decrease. Furthermore, an increase in expected return for producing P will tend to shift more of the investment outlay to this firm from competing firms Q, R, etc., and the contrary will occur with a decrease in expected revenue.
As a matter of fact, changes in anticipated rate of net income are most likely to take place throughout the entire range of the schedule. The factors that can change the rate of return are: a) expected future selling price, b) the prices of the factors, and c) the producers’ production function-the physical efficiency in converting quantities of factors into quantities of product. It is evident that, with factor prices here assumed to be given, and known, the producer’s anticipations of future income are governed by his anticipations of selling price and of his production function. It is clear that a rise in expected selling price for any good, will ceteris paribus, increase the amount of investment outlay in its production; and that an increase in physical productivity for any good will ceteris paribus, increase the amount of investment outlay. Conversely, decreases in expected selling price, and/or decreases in physical productivity will, ceteris paribus, diminish the investment in that product.
We have learned, therefore, that consumers’ goods prices are determined by consumers demand schedule and by the stock produced and sold; that the sales of produced stock depend on anticipated future price; that the amount of stock produced depends on previous investment in production; that the previous investment in production depending on the net money income that the investor anticipated receiving, and the amount of investment will be up to the last amount at which the anticipated rate of return exceeds the rate of time preference; that the anticipated rate of return depends on: expected future selling price, and production technique (given factor prices). In the last analysis, then, consumers’ goods prices depend on: consumers’ demand schedules, and general time preferences, producers’ anticipations of prices, and productive techniques.
Many questions remain to be answered. Among them is the discussion in Chapter IV on the final supply curve of the producers as compared to the stock on the market.Editor’s footnote: See footnote 1. The “final supply curve” is the amount that will be called forth in supply in the future by certain prices. The discussion in Chapter IV implicitly assumed that the present ruling prices would be the ones that would be anticipated in the future. Thus, the figure below:
Figure 15Editor’s footnote: Although not discussed in terms of “final supply curve,” a similar diagram can be found in Rothbard (2008 [1983], p. 27), which was not present in MES.Implicitly assumes that the present prices of P1 is assumed to be the future price, and will call for the equivalent amount onthe SF curve, which will tend to lower the final market price to P2. However, we may alter this restriction, and make the necessary mental allowances for any anticipated change in price. The main point of the diagram still obtains—that the present market price is not necessarily the “final” one toward which the market forces are tending. The question then remains: what principles determine the “final” equilibrium market prices? Even though this price is never attained in practice, it is important because it is the point (though always shifting) toward which prices tend to move. And a final selling price, given the productive technique, and given factor prices tend to set net entrepreneurial income. On what basis does entrepreneurial net income, the driving force in the money economy, tend to be determined? This problem, along with a discussion of time preference, must be taken up in subsequent chapters.Editor’s footnote: See Rothbard (1962, pp. 367–451, 509–555).
Now entrepreneurship classes are all the rage. While in real life government strangles businesses large and small everyday, the academic community has finally woken up to what creates wealth—entrepreneurial activity. This is a positive sign. And again it is an advancement for Austrian economics, as it has been the Austrian school that has focused on the role of the entrepreneur in the market process, while other schools of thought haven’t recognized the role of entrepreneurs at all.
Foss and Klein recognize entrepreneurship as judgmental decision making under uncertainty. They show how judgement is the driving force of the market economy and that to understand the performance of a firm, its managers, and organization, the acumen of entrepreneurs and managers must be analyzed and dissected.
Robert Bradley, a leading free market energy economist, has in collaboration with Richard Fulmer put together an outstanding book that covers the huge subject of energy, beginning with answers to the most fundamental questions (What is energy? Where does energy come from?) and proceeding to current policy applications (Are we running out of oil? Is the globe warming?). It is ideal for students and classroom use. But it is also the best book for anyone who wants to think and talk intelligently about this huge topic.
Alarmists about energy have published book after book predicting an energy crisis. We shall soon run out of oil, they claim, and this will plunge the world’s economy in crisis. As if this were not enough, man-made global warming threatens to bring about catastrophic changes.
Bradley decisively refutes these doomsayers. Oil and other fossil fuels, he shows, are abundant. Increased exploration and new techniques for extraction have produced an ample supply of oil. We face no crisis, and there is no good reason to look to solar and wind power as replacements for oil. These have long ago been rejected as inefficient by the market.
Global warming proponents also take an unduly pessimistic view. If the globe is in fact warming, the changes that ensue are likely to be on the whole beneficial.
Our real problems with energy stem not from the free market, but from ill-advised government programs, such as price control and restrictions on resource extraction.
Twelve-term Texas Congressman, Presidential candidate, and #1 New York Times bestselling author Ron Paul returns with a highly provocative treatise about how we need to fundamentally change the way we think about America's broken education system in order to fix it.
Whether or not you have children, you know that education is vital to the prosperity and future of our society. Yet our current system simply doesn't work. Parents feel increasingly powerless, and nearly half of Americans give our schools a grade of "C". Now, in his new book, Ron Paul attacks the problem head-on and provides a focused solution that centers on strong support for home schooling and the application of free market principles to the American education system. Examining the history of education in this country, Dr. Paul identifies where we've gone wrong, what we can do about it, and how we can change the way we think about education in order to provide a brighter future for Americans.
The modern age of economic intervention began under the pretense of helping workers. Professor Sennholz demolishes the entire edifice that gave rise to this movement.
We were told that workers must be organized into unions. They must have job protection. Their safety must be guaranteed by legislation. There must be a minimum wage. People under the age of 15 must never engage in remunerative work, for that would be exploitation. And workers need retirement income. If unemployment rises, nothing short of full scale central planning is required!
So on it goes, except for one inconvenient fact: the age of intervention accomplished precisely the opposite of its stated goals for workers. The unemployment of the 20th century was government created. And today, workers are taxed, regulated, and regimented to their own detriment.
Here is the uncompromising case against the entire interventionist regime erected on behalf of workers. No one does a better job in showing how the state has harmed the very group that it claimed to be backing.
Sennholz refutes dozens of theoretical fallacies and exposes the bad policies that flow from them. His focus on current trends like "mandated benefits" explains how they have so drastically increased labor costs. He also deals with the feminist arguments against the free market, and makes a strong case for the benefits of the underground economy. A principled and readable work that unfies theoretical rigor and a passion for liberty.
Quarterly Journal of Austrian Economics 18, no. 3 (Fall 2015)In the introduction to this collection, Guinevere Nell applauds Austrian scholars for their noteworthy contributions to economics. However, in her view, contemporary Austrians are too often motivated—and constrained—by the search for free-market conclusions, leading them to neglect both the problems of unregulated markets and the promise of alternative forms of organization. To remedy this myopia, Nell’s book attempts to apply Austrian theory outside “free market boundaries.”
Quarterly Journal of Austrian Economics 18, no. 3 (Fall 2015)ABSTRACT: Austrian economists since the time of Böhm-Bawerk have argued that lowered interest rates lead, in general, to longer production processes. Recently Hülsmann (2011) and Fillieule (2007) have challenged this argument and demonstrated with mathematical precision that lowered interest rates shorten production processes. This paper argues that it may be misleading to search for a direct causal effect of interest rates on the length of production because another, related factor affects it more directly. We name this factor intertemporal labor intensity, since it has to do with the moment of hiring labor. We discuss the relationship between savings and the interest rate, and modify a textbook depiction of the structure of production by changing interest rates. After explaining the concept of intertemporal labor intensity, the paper discusses a crucial assumption of Hülsmann (2011) and Fillieule (2007) on the ratio of labor to capital.
KEYWORDS: capital theory, interest, production structure, Böhm-BawerkJEL CLASSIFICATION: B13, B53, D24, E43
Elections took place across the country this past Tuesday with some interesting results. Voters in Ohio decided they hated monopolies more than they liked marijuana, while residents in Houston voted down the left’s latest egalitarian menace. While there is never a reason to trust the empty promises of pandering politicians, elections can occasionally offer insight into who is winning the battle for ideas. So there may be reason for optimism when you see Hawaiians’ discussing secession or the fact that there is global momentum in the fight against prohibition. While central planners struggle — both in the US and abroad — to maintain the status quo, bad government will never be able to repeal good economics.
The question then turns to how to we advance the cause of Austrian economics, peace, and freedom? That is the topic of this weekends’ Mises Circle in Phoenix, Arizona. One of our speakers, Dr. William Boyes, joined Jeff Deist this week to offer a preview of his talk. The founder of Arizona State University’s Center for Economic Liberty and a successful author of economics textbooks, Dr. Boyes discusses how to advance liberty and capitalism in the face of a statist educational system. One option — our new Online Mises Boot Camp!
In case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Activists Seek to Impoverish Thai Villagers to Save Monkeys from "Slavery" by David AdamsFor WHO, Red Meat Is a Red Herring by Yuri N. MaltsevThe Fed Desperately Tries to Maintain the Status Quo by Ronald-Peter StöferleHow Beijing and the West Work Together to Manipulate the Global Currency War by Brendan BrownWhy We Need Private Property to Deal with Scarce Resources by Patrick Barron"Social Expenditures" In the US Are Higher Than All Other OECD Countries, Except France by Ryan McMakenZwolinski and Woods on the Basic Income Guarantee by David GordonPot Battle in Ohio by Mark ThorntonPoverty Does Not Cause Obesity by Ryan McMakenWill Regulation Destroy a Revolution in Physics? by Matt McCaffreyMy Irish Eyes Are Smiling by Mark ThorntonA Practical Guide to Hawaiian Secession by Ryan McMakenMexico, Canada, and Ten American States Look Toward Marijuana Legalization by Ryan McMakenYellen on Negative Interest Rates by Jonathan Newman
Scarcity of resources exists in many forms and is the problem in economics. If resources were not scarce, there would be no need to economize. The existence of scarcity is true of all resources (such as time, human energy, and natural resources). However, it is not necessarily intuitive that allowing scarce resources to be owned privately is the solution to this problem.
Consequently, socialism appears attractive to many and they turn to having all resources owned collectively for the “common good.” Unfortunately, a society which spurns private property — and hands resources over to government planners instead — often learns the terrible lessons of central planning and the tragedy of the commons (i.e., commonly held resources will be plundered to extinction).
If society spurns allowing private ownership of resources, it must find some other means to prevent the tragedy of the commons and to allocate goods. Historically, the means chosen is the use of force and central planning. Throughout history, most of mankind has been divided into a hierarchical system of masters and slaves with some gradations between the two extremes. The masters (pharaohs, emperors, kings, sultans, warlords, etc.) devised complex rules-based systems for resource distribution that were decided by a small number of people and not by markets. And ultimately, these plans depended upon pure terror for enforcement. But this so-called solution to the problem of scarcity — restricting the people’s liberty through the use of force — does not work.
Problem 1: We Can’t Economize Without Effectively Ordering Our Preferences FirstThe gradual growth in the understanding of what we now regard as basic economics eventually ended thousands of years of subsistence existence for the masses in the West. Modern economics explained that without private ownership of resources, there was no mechanism for observing or acting on ordinal preferences in which persons prioritize desires from highest to lowest. Without a way to allocate goods according to ordinal preferences, there is no rational means to economize for the betterment of society.
In other words, without markets and prices, there is no way to know what people really want or need, so the masters never really knew what to order the slaves to produce, what technical means to use, what alternative materials to use, the quality desired, or how much to produce. Thus, the commissars of the Soviet Union ordered the production of inefficiently produced, shoddy goods. The Soviet empire collapsed, despite the fact that Russia is blessed with vast natural resources and an industrious population.
Problem 2: Few Raw Materials Are Ready to ConsumeA second fatal problem with common/government ownership of resources is that few readily available, consumable resources actually exist. There are no resources on the planet that do not require at least a minimum of effort to transform into a consumable product. Even edible berries growing in the wild must be harvested, meaning that someone must transport himself to the berries’ location and pull them from the bush at just the proper time. The cost of doing so is the value one places on forfeiting his leisure. Of course, other natural resources require much more effort to convert to consumable products, passing through many stages of production.
For example, timber and minerals must be extracted, harvested, etc. and then molded into something that can be consumed. Consider a hiker lost in the wild. It matters not at all to him that great stands of timber lie within easy reach or that valuable minerals lie under foot. These natural resources require great effort over very long time periods to be converted into something consumable, as is the case with converting timber into a shelter or crude oil into gasoline. A lost hiker does not have the knowledge, time, or previously produced means to convert these basic resources into consumable products to ensure his survival. All this is far beyond anyone's autarkic abilities.
Now let us assume that someone did harvest trees by felling them, transporting them to a lumber mill, milling them, storing them in a ventilated and dry place for many months before kiln-drying them (all processes that are required to turn trees into useable lumber), advertising their availability to contractors, keeping sales records, sending out bills, and collecting the bills, only to have a socialist call him a plunderer and confiscate his lumber for free distribution to whomever the masters deemed to be politically advantageous to their continued privileged position. No one other than the favored cronies of government would ever harvest another tree. In other words, production of usable lumber would be monopolized, and as with all cases of monopolies, prices would increase and quality would decline. Moreover, with no voluntary market at work in timber and forest land, there would be no means of knowing if these resources were being used in a way valued by those who valued them most.
At the same time, the central planners could not let just anyone harvest the trees or access the land. If the trees had no owners, great forests would be denuded in short order because there would be no social mechanism to prevent what would amount to a tragedy of the commons by order of the state.
Problem 3: We Need Private Property to Build CapitalWithout the ability to profit from privately owned property, there would be no incentive to provide or withhold capital for any endeavor. Also, a system of private ownership is necessary to determine if that capital is being used in a way the consumers value. The consequences of ignoring this fact of economic science is most evident today in China's ghost cities, where resources, both natural and human, have been expended for no observable benefit except to advance the careers of politicians who can claim to have met the requirements of the latest Five Year Plan. Timber and other resources were provided to build ghost cities, not because the owners of the resources sought to be economical with their resources, but because government edicts required that timber, concrete, gasoline, and more be used to produce what are now empty cities.
The opposite case of resource waste comes from special interest groups who capture the political apparatus of the state and prohibit exploitation of resources by private individuals. In the name of protecting Mother Gaia from being plundered, modern environmentalists have convinced the political class that most progress is unsustainable, dangerous to our health, or any number of other specious claims. Society is prevented from benefiting from their conversion to consumable products. The poor suffer the most from these policies as the prices of raw materials — and thus finished consumer goods — are driven up.
Private ownership insures that valuable resources will never be plundered to extinction, because their value will have been capitalized. Instead, private owners will seek to make resources as widely available as possible without endangering the long-term prospects for future harvesting of resources. The process of determining a resource’s capitalized value is impossible absent free-market capitalism with strict defenses of property rights.
Despite both the theoretical and empirical evidence to the contrary, socialists tell us the opposite; i.e., that state ownership of all resources will prevent their plunder and ensure prosperity for all. As Ludwig von Mises explained, though, socialism is not an alternative economic system of production. It is a system of consumption only, and a system of economic ignorance and economic plunder.
Interviewed by host Paul Molloy, Mark Thornton discusses a recent Mises Daily article on the consequences of setting a minimum salary of $70,000.
They also examine the negative impact of the minimum wage, and how fair wages are determined by the market.
You can read the Mises Daily article they review by clicking here.
Orders for US non-military capital goods excluding aircraft rose by 0.6 percent in August after a 0.2 percent decline in July to stand at $73.2 billion. Observe that after closing at $48 billion in May 2009, capital goods orders have been trending up.
Most commentators regard this strengthening as evidence that companies are investing both in the replacement of existing capital goods and in new capital goods in order to expand their growth.
Responding to Markets or the Central Bank?There is no doubt that an increase in the quality and the quantity of tools and machinery (i.e., capital goods) is the key for the expansion of goods and services. But is it always good for economic growth? Is it always good for the wealth-generation process?
Consider the case when the central bank is engaging in loose monetary policy (i.e., monetary pumping and an artificial lowering of the interest rate structure). Such types of policy set the platform for various non-productive or bubble activities.
In order to survive, these activities require real funding, which is diverted to them by means of loose monetary policy. (Once loose monetary policy is set in motion this allows the emergence of various bubble activities).
Various individuals that are employed in these activities are the early recipients of money; they can now divert to themselves various goods and services from the pool of real wealth.
These individuals are now engaging in the exchange of nothing for something. (Individuals that are engaging in bubble activities don’t produce meaningful real wealth. However, by means of the pumped money, they do take a slice from the pool of real wealth. Again, note that these individuals are contributing nothing to this pool).
Now bubble activities, like any non-bubble activity, also require tools and machinery (i.e., capital goods). So various capital goods generated for these activities are in fact a waste of real wealth. This is because the tools and machinery that are generated here are going to be employed in the production of goods and services — that without the monetary pumping of the central bank — would never emerge. In other words, the wrong infrastructure has emerged.
These activities do not add to the pool of real wealth, they are in fact draining it. (This amounts to economic impoverishment). The more aggressive the central bank’s loose monetary stance is, the more drainage of real wealth takes place and the less real wealth left at the disposal of true wealth generators. If such policy persists for too long, this could slow or even shrink the pool of real wealth and set in motion a severe economic crisis.
Strength in Capital Goods Purchases Really Point to a BubbleWe suggest that the strong bounce in capital goods orders since May 2009 is on account of an extremely loose monetary stance by the Fed. Note that the wild fluctuations in our monetary measure AMS after a time lag followed by sharp swings in capital goods orders.
An increase in the growth momentum of money is followed by the increase in capital goods orders to support the increase in various bubble activities. Conversely, a decline in the growth momentum of money supply followed by a decline in capital goods orders.
We suggest that a down-trend in the growth momentum of the money supply since October 2011 is currently on the verge of asserting its dominance. This means that various bubble activities are likely to come under pressure. Slower monetary growth is going to slow down the diversion of real wealth to them from wealth generating activities.
Consequently capital goods orders are going to come under pressure in the months ahead. The build-up of a wrong infrastructure is going to slow down — and fewer pyramids will be built.
Image source: iStockphoto
Featuring Thomas DiLorenzo, Doug French, Bob Higgs, Yuri Maltsev and Bob Murphy at the Mises Circle in Indianapolis: "Agricultural Subsidies: Down on the D.C. Farm," on 14 May 2011. Sponsored by Weaver Popcorn Company.
In this course, Robert Murphy, author of the study guide to Murray Rothbard's masterpiece, Man, Economy, and State, will guide you through the chapters in which the market economy can finally be seen as an integrated system. This course is a perfect follow-up to Professor Murphy's course "Praxeology Through Price Theory", but is also superb for anyone who is already familiar with Austrian methodology and price theory. Enroll, now: http://academy.mises.org/courses/production/
Interviewed by Freedom Works host Paul Molloy, Mark Thornton discusses how sports stadiums are largely funded by the taxpayer, and how major sports leagues are — or aren't — taxed.
This article is also available as an Audio Mises DailyMinimum wage doesn’t apply to everyone.
When Congress first established minimum wage in the Fair Labor Standards Act of 1938, it left a loophole for businesses that employ people with disabilities.
The Secretary, to the extent necessary to prevent curtailment of opportunities for employment, shall by regulation or order provide for the employment, under special certificates, of individuals ... whose earning or productive capacity is impaired by age, physical or mental deficiency, or injury, at wages which are lower than the minimum wage.
These special certificates are known today as 14(c) permits, and thousands of employers have one. Some studies claim that more than 300,000 Americans work for subminimum wage under the auspices of such permits.
This isn’t well known. Advocates of minimum wage often base their support for the measure on ethical grounds, claiming that all workers deserve a degree of compensation regardless of their productivity. Such was the reasoning of Seattle Mayor Ed Murray, who raised his city’s minimum wage last week to the unprecedented level of $15 per hour under the guise of “equal access and opportunity for all.”
Yet minimum wage advocates rarely address the issue of minimum wage exemptions. If minimum wage is supposed to help those who otherwise would not earn a “living wage,” why exempt people with disabilities — often the least productive of us all?
Ironically, Congress presumes the answer to this question is in the minimum wage legislation itself, undermining its logic in the process.
When Congress passed the 14(c) exemption along with minimum wage in 1938, they did so, as quoted above, “to prevent curtailment of opportunities for employment” of people with disabilities. The authors of the bill understood that minimum wage leads to unemployment for those “whose earning or productive capacity is impaired.” So in order to avoid the negative publicity associated with putting people with disabilities out of work, they exempted such people from minimum wage.
But this begs a question. If people with disabilities are exempt from minimum wage because their earning capacity is impaired and finding employment might otherwise be impossible, why don’t people without disabilities whose earning capacity is equally low also qualify for an exemption?
Admittedly, this question is opposite of that asked by most people who are aware of the 14(c) exemption. Where the exemption is known, it’s often derided as an act of discrimination against people with disabilities — not everyone else.
But as economists have shown, minimum wage doesn’t help the lower class. It prohibits employers from hiring anyone whose earning or productive capacity is below the enforced minimum hourly wage, creating permanent unemployment among the least productive people. As economist Murray Rothbard noted, “laws that prohibit employment at any wage that is relevant to the market must result in outlawing employment and hence causing unemployment.”
So by exempting people with disabilities from minimum wage, Congress actually discriminates against the non-disabled — those who cannot work under the auspices of a 14(c) permit — and favors people with disabilities.
But of course, if Congress intends minimum wage law to be effective toward its end of ensuring no one works for less than the specified hourly wage, this couldn’t be otherwise. If everyone were exempted who could not find work at the going minimum wage, minimum wage would be pointless and ineffective. On the other hand, if no one were exempted and everyone subject to the same minimum wage law regardless of physical condition, people with disabilities would be hard pressed to find work and many of them would sadly become unemployable.
It’s a sticky situation. By continuing to exempt people with disabilities from minimum wage, Congress reveals its implicit awareness of minimum wage’s negative effects on the least productive people. Yet to end all exemptions means to disadvantage people with disabilities in the workplace who already have a hard enough time finding work. Finally, to repeal minimum wage altogether and allow everyone to negotiate wages freely would mean to admit a seventy-five-year long mistake that harmed thousands, if not millions, of unskilled laborers over the past half-century who found themselves unemployed at some time or another.
The 14(c) exemption for people with disabilities reveals the brokenness of minimum wage law. It makes the policy all the more heinous, as lawmakers insist on enforcing, and even strengthening, such laws while exhibiting their full awareness of how it harms the least productive people. Nevertheless, ending the 14(c) exemption will do more harm than good. Instead, the exemption should apply to everyone — with or without a disability — who cannot find work in the current minimum wage environment. Only then will Congress, to use its own words, “prevent the curtailment of opportunities for employment” for everyone who wants to work.
Image source: iStockphoto
This article is also available as an Audio Mises DailyIn Alabama last week, an estimated 900 union reps, politicians, local business owners, and their families rallied to raise awareness of supposed steel import dumping and how it threatens their way of life. They have a point. When a competitor enters a market selling a homogeneous product and can undercut the price of the established producers, those producers’ livelihoods are threatened.
Thank goodness this is the case. In a free market economy, the threatened firms often respond by searching for ways to increase efficiencies, attempting to access lower cost inputs, and improving on economies of scale and scope. In the long run, those firms that continually adjust to serve the consumer better than others survive for another day, while those that don’t tend to fail and are soon forgotten.
When this process is played out across the entire economy, more goods and services are produced than would have otherwise, prices fall (resulting in a corresponding increase in purchasing power), and we become richer. That this process was relatively unhampered in the United States in the nineteenth century explains why the Industrial Revolution occurred here and why, over time, Americans grew in prosperity and their economy became the envy of the world.
Although one can go back to the Washington administration of 1789 for examples of government intervening in the market order, it was not until the Progressive Era that these interventions became institutionalized as official functions of government, and soon cartels and crony firms began to characterize and (increasingly) define the US economy. In the steel industry in particular, this has proved to be quite nefarious. Let’s count some of the ways.
First, there are the unions. Steel was one of the first industries to be unionized. This in itself is not necessarily pernicious, but it became so once extra-market power, yielded by the coercive state, was used to anoint union workers over others. These workers became more resistant to change and less productive as it became increasingly difficult if not impossible to fire them. A primary reason why steel producing states became known as the Rust Belt is because while union productivity relatively declined and union wages relatively rose, capital and labor found itself more productive in other states. Both escaped the Rust Belt for better opportunities elsewhere.
Although opulent labor unions have spent tens of millions of dollars to force unionization on right-to-work states, ostensibly out of concern for working conditions there, the actual purpose is to remove relative differences in the cost of capital and labor so as to remove the advantages these states enjoy. Their solution, when faced with the consequences that result when workers’ wages exceed their productivity, is to try to force the same wage-productivity outcome on potential competitors elsewhere.
Second, there are international trade effects. Although the American steel industry’s glory days occurred in the first few decades following World War II, it was not to last as steel production, often employing superior technology, took root overseas. Managers of less-protected industries would have had strong incentives to respond with similar investments out of concern for shrinking market share, but such incentives are diminished when managers can depend on the government to impose protective trade legislation. Why renovate factories to match South Korean steel efficiencies when lower priced Korean steel can be countered with tariffs and quotas?
Such is the moral hazard of protectionism. It removes healthy incentives for favored industries to improve over time.
Finally, there’s the role of prices. By forcing domestic steel prices higher than they otherwise would be, increased competition becomes inevitable as competitors react to heightened price signals the domestics themselves created. This “short-sightedness effect” plays out with short-run benefits to domestics but with long-run problems that often result in demands for new rounds of protection. It’s a costly cycle that harms consumers the longer it is allowed to exist.
Higher protected prices also have the effect of increasing the search for substitutes such that, today, many thousands of products have been developed to replace goods that used to incorporate steel. That’s great for those producers and the consumers they serve, but one wonders about the unseen goods not produced because resources were diverted to steel substitutes. Let’s just say they do not show up in GDP calculations.
Talk of such destruction was probably not a feature of last week’s steel rally in Alabama, where the federal flag flew freely and workers’ signs proclaimed, “Keep It Made In America” and “#SOSJobs.” Pat Summerlin, an electrician attending the rally, said protecting the industry was important since, after all, his plant and its workers support the community. “If I lose my job, that means I’m not spending money at your business. We’re all connected.”
Not if you balance increased spending of the well-connected with harmful and often unseen effects of protecting the domestic steel industry on everyone else. When you do, there is a net loss to society — a loss that reflects a profound and even steel-like ignorance of economics.
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This article is also available as an Audio Mises DailyMany Americans, perhaps a substantial majority, still believe that, irrespective of any problems they may have caused, labor unions are fundamentally an institution that exists in the vital self-interest of wage earners. Indeed, many believe that it is labor unions that stand between the average wage earner and a life of subsistence wages, exhausting hours of work, and horrific working conditions.
Labor unions and the general public almost totally ignore the essential role played by falling prices in achieving rising real wages. They see only the rise in money wages as worthy of consideration. Indeed, in our environment of chronic inflation, prices that actually do fall are relatively rare.
Nevertheless, the only thing that can explain a rise in real wages throughout the economic system is a fall in prices relative to wages. And the only thing that achieves this is an increase in production per worker. More production per worker — a higher productivity of labor — serves to increase the supply of goods and services produced relative to the supply of labor that produces them. In this way, it reduces prices relative to wages and thereby raises real wages and the general standard of living.
What raises money wages throughout the economic system is not what is responsible for the rise in real wages. Increases in money wages are essentially the result just of the increase in the quantity of money and resulting increase in the overall volume of spending in the economic system. In the absence of a rising productivity of labor, the increase in money and spending would operate to raise prices by as much or more than it raised wages. This outcome is prevented only by the fact that at the same time that the quantity of money and volume of spending are increasing, the output per worker is also increasing, with the result that prices rise by less than wages. A fall in prices is still present in the form of prices being lower than they would have been had only an increase in the quantity of money and volume of spending been operative.
With relatively minor exceptions, real wages throughout the economic system simply do not rise from the side of higher money wages. Essentially, they rise only from the side of a greater supply of goods and services relative to the supply of labor and thus from prices being lower relative to wages. The truth is that the means by which the standard of living of the individual wage earner and the individual businessman and capitalist is increased, and the means by which that of the average wage earner in the economic system is increased, are very different. For the individual, it is the earning of more money. For the average wage earner in the economic system, it is the payment of lower prices.
What this discussion shows is that the increase in money wages that labor unions seek is not at all the source of rising real wages and that the source of rising real wages is in fact a rising productivity of labor, which always operates from the side of falling prices, not rising money wages.
Indeed, the efforts of labor unions to raise money wages are profoundly opposed to the goal of raising real wages and the standard of living. When the unions seek to raise the standard of living of their members by means of raising their money wages, their policy inevitably comes down to an attempt to make the labor of their members artificially scarce. That is their only means of raising the wages of their members. The unions do not have much actual power over the demand for labor. But they often achieve considerable power over the supply of labor. And their actual technique for raising wages is to make the supply of labor, at least in the particular industry or occupation that a given union is concerned with, as scarce as possible.
Thus, whenever they can, unions attempt to gain control over entry into the labor market. They seek to impose apprenticeship programs, or to have licensing requirements imposed by the government. Such measures are for the purpose of holding down the supply of labor in the field and thereby enabling those fortunate enough to be admitted to it, to earn higher incomes. Even when the unions do not succeed in directly reducing the supply of labor, the imposition of their above-market wage demands still has the effect of reducing the number of jobs offered in the field and thus the supply of labor in the field that is able to find work.
The artificial wage increases imposed by the labor unions result in unemployment when above-market wages are imposed throughout the economic system. This situation exists when it is possible for unions to be formed easily. If, as in the present-day United States, all that is required is for a majority of workers in an establishment to decide that they wish to be represented by a union, then the wages imposed by the unions will be effective even in the nonunion fields.
Employers in the nonunion fields will feel compelled to offer their workers wages comparable to what the union workers are receiving — indeed, possibly even still higher wages — in order to ensure that they do not unionize.
Widespread wage increases closing large numbers of workers out of numerous occupations put extreme pressure on the wage rates of whatever areas of the economic system may still remain open. These limited areas could absorb the overflow of workers from other lines at low enough wage rates. But minimum-wage laws prevent wage rates in these remaining lines from going low enough to absorb these workers.
From the perspective of most of those lucky enough to keep their jobs, the most serious consequence of the unions is the holding down or outright reduction of the productivity of labor. With few exceptions, the labor unions openly combat the rise in the productivity of labor. They do so virtually as a matter of principle. They oppose the introduction of labor-saving machinery on the grounds that it causes unemployment. They oppose competition among workers. As Henry Hazlitt pointed out, they force employers to tolerate featherbedding practices, such as the classic requirement that firemen, whose function was to shovel coal on steam locomotives, be retained on diesel locomotives. They impose make-work schemes, such as requiring that pipe delivered to construction sites with screw thread already on it, have its ends cut off and new screw thread cut on the site. They impose narrow work classifications, and require that specialists be employed at a day’s pay to perform work that others could easily do — for example, requiring the employment of a plasterer to repair the incidental damage done to a wall by an electrician, which the electrician himself could easily repair.
To anyone who understands the role of the productivity of labor in raising real wages, it should be obvious that the unions’ policy of combating the rise in the productivity of labor renders them in fact a leading enemy of the rise in real wages. However radical this conclusion may seem, however much at odds it is with the prevailing view of the unions as the leading source of the rise in real wages over the last hundred and fifty years or more, the fact is that in combating the rise in the productivity of labor, the unions actively combat the rise in real wages!
Far from being responsible for improvements in the standard of living of the average worker, labor unions operate in more or less total ignorance of what actually raises the average worker’s standard of living. In consequence of their ignorance, they are responsible for artificial inequalities in wage rates, for unemployment, and for holding down real wages and the average worker’s standard of living. All of these destructive, antisocial consequences derive from the fact that while individuals increase the money they earn through increasing production and the overall supply of goods and services, thereby reducing prices and raising real wages throughout the economic system, labor unions increase the money paid to their members by exactly the opposite means. They reduce the supply and productivity of labor and so reduce the supply and raise the prices of the goods and services their members help to produce, thereby reducing real wages throughout the economic system.
This article is also available as an Audio Mises Daily
Apparently all it takes to get recognition these days from the National Bureau of Economic Research is to time yourself doing math problems.
In this new paper from the NBER, S. Boragan Aruoba and Jesús Fernández-Villaverde solve the familiar stochastic neoclassical growth model using various software, programming languages, and operating systems, in search of the fastest, most efficient way to do economics. Criticisms of the model aside, we see that contemporary mainstream economics is in a holding pattern. With no new math problems, the economists have resorted to timing their computers’ efforts to solve the existing math problems. This raises some very important questions: where is the “fresh” economics, and is faster production necessarily better?
From my seat in the research wing of the Mises Institute, I’m close to some interesting and — in terms of a connection to real, human market actors — relevant work in economics. Peter St. Onge, whose article you may have read a couple weeks ago, is working on a Mengerian approach to corporate strategy in product offerings, owing heavily to subjective utility and Austrian entrepreneurship theory. Audrey Redford is hard at work on a valuable extension of Mark Thornton’s Economics of Prohibition, specifically focusing on the history of the Harrison Narcotics Tax Act of 1914, using a Misesian framework to analyze prior state interventions. Dante Bayona just presented a very promising attempt to expand Roger Garrison’s capital-based macroeconomics to open economies and international trade, and is finishing a paper on Rothbard’s Aristotelian-minded praxeology.
The list of great research, just in this wing, continues, including Kyle Marchini’s work on private product certification, Jingjing Wang’s work on the history of thought on entrepreneurship, Matei Apavaloaei’s work on political entrepreneurship and protectionism, Ludvig Levasseur’s work on Kirznerian alertness, and Arkadiusz Sieron’s work on the Cantillon effects through a business cycle. And I haven’t even mentioned the great quantity and quality of work from the faculty at the end of the hall: Professors Klein, Salerno, and Thornton, who will all be teaching this week at Mises University.
Roundaboutness, Booms, and Production TimeAlthough prediction of future events is inherently problematic, especially concerning human action, I can confidently say that none of the economists in this office will ever patrol the halls with a stopwatch, timing our research production. This would be preposterous because we understand the “roundaboutness” of production is causally related to the value of the product — entrepreneurs will only choose longer production processes if they estimate consumer valuations of the product are still more than the costs of production which carry an extra premium for being expended in the present. Longer production (not-so-intuitively), means better, more-highly-valued products.
Note that this does not mean that longer production for the sake of longer production is valuable (a common misconception of Böhm-Bawerk’s theory), just that longer production is only employed when the estimations of the increase in value of the future product exceed the increase in the discount applied to the future product.
Artificial manipulation of interest rates throws all of this coordination of consumer and producer valuations of time, capital, and production into a mess. When longer production processes are made to look more profitable, and saving is made to look less profitable, a massive rerouting of capital occurs. Entrepreneurs, seeing the decreased opportunity cost of producing goods and services, divert capital into longer production processes, while consumers at the same time increase their expenditures on final goods and services. Given a scarce supply of capital, the capital market turns into a fierce game of Hungry Hungry Hippos, which drives up the prices for these factors and therefore the costs of production as a whole.
Boom Leads to Bust, Even in Higher EdConsumers have the final say in the matter, however. As the chief appropriators of funds, they assert their unchanged, real time preferences by not buying the final goods at the inflated prices — inflated because the entrepreneurs anticipated that the longer production processes (more waiting) were profitable! As soon as this unsustainable course is realized, including the realization that the initial reallocation of resources was based on incorrect and misinformed estimations of consumer demands, the market crashes: demand for the factors fall, including wages and total employment, consumers pay for the prior indulgence, and economic activity as a whole stagnates, mired in uncertainty and pessimism as capital and labor move back into valuable and sustainable lines of production.
Could this type of discoordination reach higher education and research institutions? Could the supercomputer designed to simulate the entire planet that’s sitting in some economics professor’s office be a malinvestment? Probably. The economics researcher with the utmost concern for a computer with all the bells and whistles reminds me of the new, less-than-creditworthy homeowner, with the utmost concern for a house with all the bells and whistles and the square footage of a medieval castle.
Aruoba and Fernandez-Villaverde’s paper is innocent enough — they’re just trying to introduce young graduate students to different computer programs and encourage proficiency in various programming languages. But their paper is as telling as it is innocent. Perhaps the academic economics community should stress realism over RAM, conceptual rigor over computer speed, and respect for the complex, dynamic intricacies of human action over complex math problems.
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Supporters of minimum wage hikes claim they have little or no effect on employment, the law of demand makes it clear the effects of price controls are very real, writes Josh Grossman. This audio Mises Daily is narrated by Keith Hocker.
An economy cannot be successfully planned with computers and technicians. Mises and Hayek proved this decades ago, writes Nicolás Cachanosky. This audio Mises Daily is narrated by Allan Davis.
Volume 4, No. 2 (Summer 2001)It is within the bowels of government where the real yes-men problem lies. Here, there is no automatic feedback mechanism of the market to rely upon, to quell any incipient tendencies in the direction of yes-manning. At best they are extraordinarily weak; at worst they are nonexistent. Thus, far from Prendergast being able to make her point that the yes man phenomenon is a market failure, the truth of the matter is that it is a government failure. If market firms rely upon or are involved in yesmanship, they lose money and tend to go bankrupt; if and to the extent that governments become embroiled in this economic virus, the forces for their dissolution are either very much attenuated, or totally absent.
Volume 16, No.4 (Winter 2013)ABSTRACT: The aim of this paper is twofold: to reformulate the concept of contestable markets in the context of property boundaries, and to recapitulate the characteristics of “sunk costs.” The first section outlines the idea of contestable markets developed in the 1980s and contrasts it with the perfect competition model. The second section explains the notion of sunk costs as entry barriers in the contestable markets framework. The third section summarizes the relation between costs and prices. The fourth section separates sunk costs from fixed costs and formulates main propositions on their nature. The fifth section deals with the contestable markets model, where sunk costs are perceived as an inefficient barrier to market entry. The sixth section modifies contestable markets theory in compliance with the “Austrian” theory of competition.
KEYWORDS: contestable markets, sunk costs, market competition, freedom of entry, price system, property rightsJEL CLASSIFICATION: D4, D21, D24, B53 1. CONTESTABLE MARKETS, COMPETITION AND PRIVATE PROPERTYThe neoclassical theory of prices developed in the beginning of 20th century is based on an unrealistic set of assumptions, which constitute the “perfect competition” model. The empirical significance of this model is questionable, since it seriously misrepresented the market process, and inspired ill-conceived policies aimed at promoting competitive enterprises. Fortunately the theory of competition has progressed in recent decades and moved away from perfect competition. One of the steps forward is a theory of “contestable markets.” The ambition of this theory was to abandon the abstract criteria of perfectly competitive markets and substitute them with the notion of perfectly contestable markets (Baumol, et al. 1983, p. 2). Although the latter model is not entirely accurate, it is still much closer to reality than the perfect competition model. One of the main advantages of the contestable markets school is its rejection of the primitive notion that any big company should be nationalized or subjected to extensive regulations (since it did not fulfill the ideal of perfect competition).Mateusz Machaj (m.machaj@prawo.uni.wroc.pl) is an assistant professor at the Institute of Economic Sciences, University of Wroclaw. The author would like to thank Dr. Joseph Salerno for his help and invaluable comments on the paper.
In developing the contestability approach, William Baumol and others stressed that there is no tradeoff between economies of scale and competitiveness of industries. Industries consisting of small number of highly centralized producers might be very competitive, even though they do not conform to the perfect competition ideal. Economies of scale do not cause uncompetitive results, if the threat of entry can function as if it were an economic watchdog. So, if one of the prevailing producers sells at a price above the market, new competitors are incentivized to enter the market and grasp the profit opportunity. Even industries with only one producer may be very competitive because of that possibility.
Any sector under consideration remains competitive as long as it stays contestable, i.e., there is the threat of entry by other companies. Perfect competition theory contends that a competitive environment requires the existence of many small companies and firms. Only then could one be sure that any individual firm has to act “efficiently” (otherwise it would lose its customers). The contestable markets theory takes a radically different view: a threat of entry will suffice to put pressure on producers to act competitively. As long as there are no barriers to entry, entrants are free to contest the market, forcing the industry to be competitive. No additional requirements are required.
At first this approach seems to be compatible with the legal approach of the older anti-monopolist school, which viewed monopoly as a form of governmental privilege granted to select companies (Rothbard, 2004, ch. 10). A privilege that prohibits other firms from entering the market, or as Baumol would probably say, prevents potential entrants from contesting the market. Although these two theories of competition share undeniable similarities, contestable markets theory—apart from being a promising step away from the neoclassical theory of competition—is still under its negative influence.
One of the commentators suggested that contestable markets theory leads to libertarian conclusions on the role of government (Shepard, 1984, p. 575). If contestability of markets has nothing to do with the size of firms or the number of competitors, and focuses only on the freedom to entry, there seems to be no role left for the government to “support” competition. Baumol reacted, however, with great reservations about this interpretation and commented on such “libertarian ideology”:
Contestability theory does not, and was not intended to, lend support to those who believe (or almost seem to believe) that the unrestrained market automatically solves all economic problems and virtually all regulation and antitrust activity constitutes a pointless and costly source of economic inefficiency. (Baumol and Willig, 1986, p. 9)Although, on the other hand, it has been stated in Baumol and Willig that “On balance, contestability analysis leans on the side of those who advocate extension of the domain of laissez faire” (Baumol et al. 1982, p. 476).
Even though it appears that the concept of contestable markets could be reconciled with the “Austrian” theory of competition, the main theorist of contestable markets argues the opposite. According to theorists of contestable markets, modern industries do require, in some cases, property redistributions via antitrust agencies (to sustain competition). We admit the difference between free market theory of competition and contestable markets, but we plan to argue the opposite—that carefully examined, contestable markets theory supports free market conclusions about the absence of rationale for antitrust policies. We have to see first how the theory of contestable markets criticized the perfect competition model and proposed the alternative. The foundation for this critique rests on a distinction between sunk and fixed costs.
- WHAT DOES IT MEAN THAT A MARKET IS CONTESTABLE?Let us examine a numerical example in order to demonstrate how contestable markets work competitively in the environment of economies of scale. For the purpose of simplicity, we select the following assumptions. We ignore the cost of capital and assume the normal rate of return to be zero. We divide costs into two separate categories: fixed and variable costs. Fixed costs are of course related to economies of scale.
Suppose the firm produces one widget per year for the price of 25 dollars. In order to create that product, it is necessary for the firm to buy materials and intermediate goods. Let us assume that materials, intermediate goods and other kinds of variable costs sum to 5 dollars per unit. Assume further the firm also uses one particular machine that wears out after five years. The amortization is not dependent on the amount of widgets produced; therefore, it should be treated as a fixed cost. The price for the machine is 100 dollars (amortization 20 dollars per annum). Here is a simple investment plan for each of five years:
One year:Fixed costs per year (amortization of the machine): 20 dollarsVariable costs (materials and intermediate goods): 5 dollarsPrice of the widget: 25 dollars
The machine is used up after five years. Total costs over a 5-year period and total revenues are equal to 125 dollars (we abstract from the return on capital). In this equilibrium state, all costs correspond perfectly to the price of the good.
One of the deductions built upon the perfect competition model is that fixed costs constitute a barrier to entry. Baumol and others persuasively argued, however, that the existence of fixed costs is not a true barrier to entry. The reason is that fixed costs are fixed in the sense that they do not vary with the amount of output. Even though they do not vary, they still can be avoided after the payment had been made. In the above example, the machine was bought for a 5 year period, and its costs would not vary with the output (after the purchase). Nonetheless, it would still be possible to sell it after one year of usage. In that scenario the fixed cost could be partially recovered or even completely avoided. With that kind of opportunity, markets with economies of scale can be highly contestable and truly competitive.
Imagine one exclusive producer and seller of widgets deciding to increase the price for widgets from 25 dollars to 50 dollars. This creates an enormous profit opportunity for other entrepreneurs. The essence of the contestable markets framework is that fixed costs need not be true barriers for entrepreneurs to enter the market and grab those opportunities. When the price is raised to 50 dollars per widget, the potential competitor is able to enter the sector and engage in a “hit and run” strategy in order to gain extra profits. His appearance starts the process of lowering those higher prices. The progression of rivalrous activity can be described similarly in the perfect competition scenario, yet there remains a question of fixed costs. The entrant’s strategy of price cuts might work in the first year. Let us suppose that after the initial year, the situation goes back to the competitive level of a zero rate of profit (a widget price of 25 dollars). After the success of hit and run policy, the entrant decides to leave the market. Fixed costs need not be a barrier provided that the entrant is able to liquidate the machine at a sufficient price.
In the example, to avoid the costs, he would need to sell the machine at a price that excludes the costs covered by revenues during the first year. Therefore he would need to sell it for 80 dollars. Under those circumstances, fixed costs would not be a problem for a competitive entrant. The potential entry allowed by that feature is a pillar of the contestable market. A competitive market does not require perfect competition and the existence of uncountable set of suppliers. The potential threat of entry might be adequate even with fixed costs, which could be recovered. A hit-and-run approach would successfully work for a short time. After the return to equilibrium, durable equipment could be sold, and venture capital would be free to leave the market without losses.
Fixed costs develop as a problem for the entrepreneurial project of a hit-and-run approach only if they cannot be liquidated, that is when they become sunk costs; costs that cannot be easily recovered (see for example Kessides, 1990). This is the example of a barrier to entry: a potential competitor might decide not to enter the market because of the expenses he needs to cover. This inquiry leads to a conclusion that markets with fixed costs are contestable, but markets with sunk costs are not. Examples of sunk costs “include many categories besides physical capital, such as research and development, advertising to establish brand loyalty, and training to create special workers’ skills” (Shepard, 1984, p. 580).
Notice the benefits of contestable markets theory over the perfect competition model. Baumol and others succeeded in abolishing most of the absurd assumptions of the latter. The perfect competition model stated four assumptions: an infinite number of producers and consumers, perfect information, homogeneity of all goods, and no barriers to entry and exit. Contestability theorists rejected the first three, and modified the fourth one—in the perfect competition model economics of scale are a barrier to entry. This should be considered as immense progress in the neoclassical theory of competition.However, Martin (2000, p. 9ff) points out that technicalities of contestability research very often implicitly use assumptions, which are quite similar to perfect competition suppositions. We do not deal with those possibly contradictory aspects, but focus on tenets of contestability research that appear to be breaking away from the perfect competition model.
Due to this advancement, the scope for an antitrust policy was narrowed. The perfect competition model provided almost a blank check for any type of “antitrust” intervention, since no sector was ever occupied by firms facing perfectly elastic demand curves. In the light of the contestability contribution, antitrust policy was supposed to focus on barriers to entry; with the key aspect of sunk costs that could restrain potential entrants.
It is worthwhile to see how contestability theorists explained that fixed costs are not barriers to entry. The explanation depends on how the word “barrier” is understood. In some sense, fixed costs can be considered as barriers to entry, since they do not allow several producers to enter the market. Had they not existed, perhaps more producers would be engaged in profitable production. In the same sense, other factors such as scarcity of capital goods, skills, and property can also be considered as barriers to entry (Carlton, 2004, p. 469).On 7 possible definitions of a barrier to entry proposed by different economists through the second part of the 20th century, see McAfee et al., 2004, p. 461–462. Yet even if fixed costs stop some particular producer from entering the market, it is not a problem. A more important consideration is whether this stopping is “inefficient” from the point of view of the market process. Baumol’s conclusion is that it is not; thus, following Weizäcker (1980), he defines “an entry barrier as any (unspecified) advantage over an entrant that an incumbent firm enjoys if that advantage produces welfare loss” (Baumol and Willig, 1981, p. 408). We could clarify that statement to fit the example above that was just discussed: fixed costs are “barriers” to entry, but they are economically efficient barriers to entry since they stop inefficient producers (producers with higher average costs) from entering the market.Naturally the other subject that could be discussed in this line of reasoning is the meaning of “efficiency” (“welfare loss” etc.). We intentionally avoid this discussion and accept a very loose, very broad and intuitive meaning of the word “efficiency,” which could be accepted by most economists. Efficiency is a feature of an economic system which systematically increases consumer possibilities for higher production, higher quality of products and lower prices. We do not adhere to the neoclassical concept of efficiency, welfare losses or any other form of utility calculations.This reformulation will be helpful for the analysis of Baumol’s own idea of barriers to entry.On the subject of contestability and its more specific problems consult Brätland (2004).
- THE NATURE OF COSTS AND PRICESThe mainstream approach is based on a division of “business costs” separated into two categories: fixed and variable. Variable costs are the ones that are “immediately adjustable with output.” Fixed costs, on the other hand, have to be paid no matter what the level of output is, so they are not adjustable and do not vary with the amount of goods produced. This sharp distinction, although illustrative, may not be a good portrayal of costs and may lead to serious misinterpretations concerning the nature of the market process.
Contrary to this approach of supposed dissimilarity, there are different stages of variability (Rothbard, 2004, p. 591). Some costs are more adaptable to the quantity of output produced, others less. When a producer of shoes rents a factory, the rent is much less variable than the shoelaces. There are, however, other instances of variability, for example the costs of hiring personnel. Contracts with the crew and management may be fixed to some extent, yet it is always possible to increase the number of employees or to hire existing ones for longer working hours. The same applies to phone bills or power bills, which are usually neither perfectly variable nor perfectly fixed. On the one hand, the entrepreneur has to pay the energy bill, and on the other hand he might decrease the usage of energy. Even rent is not absolutely fixed, since it is always possible to hire another extra factory (for the purpose of increased production)—or in the case of decreased output, hire a smaller and cheaper one.
There are few important consequences of the fact that there is no sharp real-world separation of variable and fixed. First of all, the distinction between more and less variable costs is loosely related to the concept of “long run” and “short run.” The typical method is to associate fixed costs with the long run. But this certainly should not be the case. Even in the long run, there are costs more fixed than others, that is, costs varying less with output. Although in the longer run it is much easier to make costs more flexible, the distinction still is between more and less variable costs. Costs vary more or less both in the long run and the short run.See the great and insightful article on this: Wang and Yang (2001).
Second of all, which concedes Baumol’s point, fixed costs are not unavoidable costs. Costs fixed more than others are costs that do not vary with the output. To assume that they are necessarily lost because they do not vary is a step too far. When a businessman is about to commit to a certain projects, his calculations include different degrees of variability. The money is being spent on all costs—both less and more variable. The money capital is “lost,” it is devoted to the production process and its “recovery” depends on entrepreneurial abilities. Variability is not important in such a consideration. Even after the payment of bills, it might still be possible to recover more variable and more fixed costs. For example when a particular factory has been closed, the already rented place for that business might be rented to somebody else. In that scenario, part of the cost would be recovered by reselling the services already purchased. The same is true with material and intermediate goods, which are more variable with the output.
This observation has consequences for the approach offered by neoclassical analysis.Therefore contrary to Weitzman’s claim (1983, p. 486) there can be fixed costs, which are neither sunk, nor variable. A typical textbook theory of pricing is incorrect in stating that the optimal choice for a firm is to equalize marginal costs with marginal revenues. This assumes that (more) fixed costs are not part of business calculations (once they have been made). The mainstream equates here erroneously fixed costs with costs that cannot be recovered. Some of the costs already suffered could be recovered and avoided—hence not only marginal costs are included in calculative considerations. Fixed costs (or fixed to a higher extent than the rest) also are part of the decision making of firms both in the long run and the short run. To profitably assess decisions in the market, businessmen need to compare monetary costs paid before the process of production and monetary revenues received for selling a product; therefore, price spreads are key.
We come here to the well-established theory of valuation and imputation. The imputation process is working backwards from prices of consumer goods to the higher order goods which produce them. All costs, no matter how they vary with the level of output, are linked to prices of final goods. The imputation process of assigning values to producer goods works independently of the distinction between “more fixed” and “more variable.” Every factor of production is supposed to contribute worthiness to the production of goods purchased by final consumers. If the factor does not contribute anything to creating a valuable consumer product, there is no reason for the entrepreneur to purchase it. Consequently, every single price of the factor of production relates to prices of possible consumer goods that might be created by it. This is despite variability of factors, because the only reason to pay for the factor is its possible contribution to increased consumer satisfaction.
Entrepreneurs pay not only for the direct use of a factor, but also indirectly for not using it in an alternate process. When a producer of hammers pays for the steel, he is “taking” the steel away from other producers. He covers the opportunity costs by paying the price for withdrawing the factors from alternative employments.See the illuminating treatment of this law of costs in one of the best expositions in Böhm-Bawerk (1962). We are focusing here on monetary calculation aspect and we abstract from subjective factors and subjective utility. The significant part of that process is the speculative valuation of factors and entrepreneurial judgment concerning their future usefulness. Naturally, true “equilibrium” opportunity costs cannot be known in advance to any observer. The usefulness of employed factors is always a matter of a guess performed by entrepreneurs (Mises, 1966, p. 396).
- THE NATURE OF SUNK COSTSThe only reason for entrepreneurs to pay for factors is their usefulness in production. The entrepreneur may make a mistake and purchase a factor which either does not contribute to production of consumer goods, or contributes to a lesser extent than expected. On the microeconomic level, this signifies disequilibrium between costs of factors and prices for finished products. Some of the costs should not have been paid for, since they did not contribute to consumer satisfaction. This disequilibrium state is referred to as sunk costs. These are costs of durable factors that have new market value, which is lower than the initial (discounted) outlay paid in a purchase. Sometimes economic authors call any type of costs paid in the past “sunk.” We object to this terminology, since those costs could simply be named as past costs.
Past costs may be recovered. Assume that the entrepreneur bought the machine for 100 units—100 units represent past cost. Now let us consider a few possibilities. Imagine that after a while a machine is worth 200 units on the market, or that its contribution to production of consumer goods is higher. Under the circumstances, past costs can be recovered, but they also might be turned into monetary profits. Consider another case—that market conditions changed in such a way that the entrepreneur cannot use profitably the machine in his line of production, but can sell the machine to another firm for the price of 100 units. In this situation, the past cost of the machine can be recovered and the money paid for it need not be lost or “sunk.” In fact money can be prevented from being wasted.
Let us consider a third case. Suppose the machine is less money-productive than the initial 100 units, and its market price falls significantly below 100 units. The difference between 100 units and the current value (or usefulness) of the machine embodies sunk costs. These costs cannot be avoided or recovered at the moment. The entrepreneur decided to spend the money in order to buy the machine, and now the cost is sunk; a machine becomes a part of inconvertible (or partially inconvertible) capital of the company.In some cases inconvertible capital can still be productively employed, but not be liquidated.
The analysis of sunk costs is confronted with a rudimentary question: why would any entrepreneur be willing to spend the money? If the current value of the machine is 30 units, why did anyone pay 100 units to own it? The obvious response is that a person who had bought the machine committed an error. This determines the first basic theorem on sunk costs: sunk costs are caused by an entrepreneurial error. If the entrepreneur had known in advance that the value of a machine was 30 units, then he would not have paid 100 units for it.“The larger the sunk costs, the higher the prior expectation of profitability must have been. One does not sink funds, unless one expects such expenditures to be justified” (Frank, 1988, p. 341). By making a conscious decision to do that, he would willingly consume his own capital, therefore 70 units would not denote sunk cost, but rather the price for a subjective pleasure of destroying his funds.
The presence of sunk costs results from uncertainty over the time horizon (because without passage of time under uncertainty there can be no error). This leads to the second theorem: sunk costs are a phenomenon recognizable ex post. It is not fully accurate to speak about sunk costs ex ante, that is before the decision is made (it is only possible to speculate about probable sunk costs which may appear in the future). If the entrepreneur needs to pay 100 units for the machine, he can either expect it to be worth the money, or not. If his assessment is that the cost is higher than potential revenues, he perceives a potential loss to suffer from the decision to buy. Therefore he decides to abstain from the purchase in order to avoid any losses associated with possible sunk costs.In the theory of competition, prices should not be treated as given. In the above example, the decision not to buy factors certainly influences valuations and puts downward pressure on prices.
Although the presence of sunk costs is only recognized ex post, we can still meaningfully speak about the ex ante possibility of sunk costs. This possibility depends on uncertainty and risks associated with production processes. Moreover, the price of a machine depends not only on the process in which it is being used, but also on other processes in which it could have been used alternatively. It is more obvious in cases of more homogeneous goods like raw materials, land, or other durables. In case of any sudden change in economic circumstances, it is easier to liquidate land than to sell a specific tool used in the factory. The possibility of suffering from sunk costs in the future is highly correlated to specificity of capital goods. This establishes the third theorem on sunk costs—the more nonspecific the factor of production, the lower the possibility it will be associated with sunk costs in the future.
Sunk costs are not fixed forever. Their presence is conditioned by unexpected changes in market prices. The reverse is also true: sunk costs may disappear in dynamic conditions (or decrease, or increase). The assessment of sunk costs is derived from a comparison of past prices with current prices. Current prices, contrary to past prices, are not fixed and can change. Since sunk costs are the difference between past and current prices, they can also change. If the machine was bought for a price of 100 units, and its current value is 30 units, then 70 units represent sunk costs. This cost is not fixed, however, because the current value may rise, which would decrease the sunk cost. In some cases, a significant increase in the current market value would eliminate sunk cost completely and turn losses into profits. We have reached the fourth theorem: sunk costs are not fixed once and for all.
Sunk costs are fundamentally linked with the passage of time. Any production project that takes a longer time is subjected to more instances of economic changes. Therefore, under longer processes, more durable goods can change their value more often than during shorter projects. This constitutes the fifth theorem on sunk costs—the longer the process of production in which the factor is involved, the more vulnerable the factor becomes to becoming a sunk cost in the future.
- SUNK COSTS AND EFFICIENCYContestability theorists challenged the neoclassical idea of treating economics of scale as barriers to entry, because in some circumstances fixed costs could be recovered. As we pointed out in the second section, the statement should be carefully clarified. Fixed costs and economics of scale can in fact stop some entrepreneurs from entering the market. These obstacles constitute “efficient” barriers. Apparently existing producers are so efficient that potential entrants are not in a position to outcompete them. In other words, the market cannot be easily contested, because it is already characterized by a competitive state of affairs. Contrary to perfect competition claims, fixed costs perform valuable economic functions (see on this Armentano, 1982, p. 37). Follow this line of reasoning in order to determine whether sunk costs constitute a socially wasteful barrier to entry. Sunk costs are barriers just as fixed costs are, since they stop some producers from entering the market. Nevertheless, more important questions are: why do those costs exist in the first place, what is their social and economic function, and do they constitute an economically inefficient barrier to entry?
As noted previously, we can either deliberate about sunk costs already suffered, or possible future sunk costs. Factual sunk costs denote past mistakes and induce entrepreneurs to revise their plans.“We now realize that in a world of dynamic change unused resources have two functions. Firstly, they act as shock absorbers when combinations disintegrate. Secondly, their existence provides an inducement to invest in those capital goods which are complementary to them” (Lachmann, 1947, p. 209). The existence of ex post sunk costs has the same social function as losses and bankruptcies. Sunk cost is not a problem; it is a signal to search for a solution. The problem was a mistaken initial decision, which led to spending the money. Sunk costs merely represent a necessary market correction of previous factor overvaluations. If the government decides to meddle with existing sunk costs, its actions are similar to interfering in losses. This hampers the profit and loss mechanism and restrains its efficiency.
Responsibility for economic mistakes is a pillar of competition. If uncertainty and risks are to be priced and valued accordingly, competitors in the market need to expect that the government will not bail them out. The main goal of entrepreneurs’ actions is the effective employment of factors. The capital value of assets stems from correct estimates of future prices and successful predictions of the future consumer market. Sunk costs as instances of error should be avoided by businessmen, since they indicate that there was some inefficient discrepancy between costs and prices. Actions to avoid sunk costs are to the benefit of consumers. If the government decides to intervene with sunk costs, consumer sovereignty is hampered, because instead of solely focusing on future consumer purchases, entrepreneurs also start to consider possible ways of receiving government’s help (rent-seeking behavior). Intervention in this field is similar to typical subsidies funded by public money.
When costs are sunk, they are sunk for a reason. Wasted inconvertible capital implies that factors have been misallocated. There are grounds for updating market values in order to reflect new economic conditions. Significant downward adjustments in prices result from specificity of factors. If the factor is more nonspecific, its value adjustment need not be major, or may not need to happen at all. When mistakes have already been committed, the existence of sunk costs is a natural and efficient consequence. Those costs embody a necessary correction that needs to take place in the market for more specific factors.“Every capital instrument is designed for a purpose. Where it is highly specific, this purpose is identical with a certain kind of (anticipated) use. Where it is “versatile,” it may cover a wide range of uses. But in any case it is planned for some kind of use, and failure to succeed in any of them as reflected in loss of earning power will result in revision of plan” (emphasis added, Lachmann, 1947, p. 203). Sunk costs serve this function to revise plans.
These observations apply to factual sunk costs recognized ex post. Contestability theorists are primarily interested in potential sunk costs, which may appear in the future. Those are considered as an inefficient barrier to entry. Nevertheless most of these observations above apply also to the notion of potential sunk costs.
Let us go back to the hypothetical case from the second section. In our example of widget production, the contestability of the market depends on the possibility of reselling durable equipment without significant losses after initiating a hit-and-run policy. During the first year, 20 units worth of money were used productively by employing the machine. Could the machine be sold for 80 units after that time, so that the entrant could have abandoned the market without covering any costs? According to contestable markets theory, if those exit costs cannot be avoided, the entry is not unrestrained and non-competitive results might follow.
If the factor cannot be easily sold (as in cases of human capital, public relations, research and development etc.), this difficulty reflects its specificity (including transactions costs and adjustment costs). Economic reality does not consist of easily flexible goods, which can be effortlessly substituted for others. To assume that is to entirely blur the nature of the world, and consequently the market process.“In other words, there can be no major change which leaves the existing structure and composition of capital intact. All such change tends to create situations in which there is too much of some capital assets and too little of others. In this fact lies the ultimate reason for that instability of the ‘capitalist’ economy which so many people deplore and so few understand” (Lachmann, 1947, p. 207). The only way to deal with this “instability” is to use one of the greatest inventions of the human mind—economic calculation in monetary terms. Part of that calculation consists of capitalizing sunk costs. As we have observed, the costs do not depend exclusively on the productivity of an undertaken process, but also on alternate productivities of competitive processes. When entrepreneurs pay for the factors of production, they also pay for withdrawal of factors from other alternative employments in which they could have been productively used. Probability (case probability) of sunk costs depends on the length of the process and specificity of factors used in it. It follows that the broader possibility of sunk costs results from the chance of committing the factors to wasteful, longer, and more specific projects. That possibility is not an instance of inefficiency, just as premium risks in insurance companies are not.Thus, when Stiglitz et al. (1987, p. 886) are arguing that sunk costs lead to lack of competition, they are in effect anxious about the fact that reality is heterogeneous, not that markets are “failing.” Markets are economizing to the best extent possible the fact that the world is heterogeneous and uncertain. It is a “failure” (or perhaps the beauty?) of the world, that it is not an easily adaptable homogenous blob.
Baumol notes:
The need to sink money into a new enterprise, whether into physical capital, advertising, or anything else, imposes a difference between the incremental cost and the incremental risk that are faced by an entrant and an incumbent. The latter’s funds are already committed and are already exposed to whatever perils participation in the industry entails. On the other hand, a new firm must take the corresponding amount of liquid capital and turn it into a frozen asset if it enters the business. Thus, the incremental cost, as seen by a potential entrant, includes the full amount of sunk costs, which is a bygone to the incumbent. Where the excess of prospective revenues over variables costs may prove, in part because of the actions of rivals, to be insufficient to cover sunk costs, this can constitute a very substantial difference. This risk of losing unrecoverable entry costs, as perceived by a potential entrant, can be increased by a threat (or imagined threat) of retaliatory strategic or tactical responses of the incumbent (Baumol and Willig, 1981, p. 418)
Bailey, for example, suggested that a proper policy to increase competitiveness, apart from assuring freedom to entry and exit, is to also settle the rules “requiring lease or shared use of sunk costs facilities” (emphasis added, Bailey, 1982, p. XXII).On the supposed necessary role of nationalization and extensive role of government see also Bailey (1981). We have reservations about this thesis, because this kind of approach should increase competitiveness (understood as an increase in the consumer’s choice). More likely it would lead to exactly opposite results.
Contestability theorists’ analysis of fixed costs could be extended to the case of sunk costs. Baumol argued that fixed costs perform valuable economic functions, but so do sunk costs ex post and ex ante. Even in cases where sunk costs exist disproportionately in the market, that is, when they differ from one firm to another (as between incumbents versus entrants), their economic role is comparable to the roles of different rates of return. One company may suffer huge losses, and another company may achieve tremendous profits. Those differences result from social appraisement indicating which processes should be undertaken.Cairns and Mahabir (1988, p. 273) briefly discuss differences in sunk costs between the firms. Despite their suggestions those differences do not imply that competition is inefficient. It is not “losing money” per se that is inefficient, but an inefficient decision leads to losing money. Losing money is only the result and a signal.
If some projects appear to be unprofitable, it implies that the factors devoted to them have more important uses and should be alternatively employed. In the same sense, sunk costs represent economic assessments of more or less specific factors under uncertain environment. If the process uses specific factors, less liquid capital, and is over a longer production period, then the natural consequence of those features is an increased subjective (case) probability of future sunk costs. This is an effective way (although not omnipotent way) of restricting entrepreneurs from starting relatively risky projects.There are opportunity costs of entering the market. The entrepreneur who wants to contest the market has to devote his resources and abstain from investing them somewhere else (Cairns and Mahabir, 1988, p. 271).
Under dynamic circumstances of economic rivalry, some entrepreneurs are more skillful in avoiding sunk costs than their competitors. This also has consequences for consumer sovereignty: if the incumbent in the market has secured his position and has successfully dealt with the problem of sunk costs, he may be considered as more efficient than potential entrants. The profit and loss mechanism (sunk costs included) tells who manages the funds more efficiently and avoids unnecessary costs. The active side of that mechanism are entrepreneurs.On the neglect of entrepreneurial activity in modern economics, Baumol noted, “There is one residual and rather curious role left to the entrepreneur in the neoclassical model. He is the indivisible and nonreplicable input that accounts for the U-shaped cost curve of a firm whose production function is linear and homogenous. How the mighty have fallen!” (Baumol, 1968, p. 66). This applies also to the treatment of entrepreneur as a residual from sunk cost calculations. As French and McCormick show (1984, p. 417) part of entrepreneurial activity is to pay less than one expects to earn from employment. This applies to possibility of recovering costs. Bailey’s proposition seems analogous to a proposition to redistribute additional profits from successful companies to weaker ones. There are compelling reasons to think that this would not create a competitive environment, or increase efficiency in the production of consumer goods. The entrepreneurial incentive to deal predominantly with consumer preferences would severely be weakened. Under a market system, profitability depends on consumers’ choices. Under a government policy of sharing sunk costs, profitability starts to depend on bureaucrats’ choices. This changes the behavior of market participants.The existence of sunk costs affects the cash flows. “[E]xternal financing of capital investment is more difficult when the assets being financed have low recovery (resale) values or are sunk” (Worthington, 1995, p. 59). Government agencies cannot absolutely decrease sunk costs just as they cannot absolutely decrease losses. The state apparatus can merely redistribute losses or sunk costs and externalize burdens on other economic agents. It is the same with possible sunk costs and actual sunk costs.
So far we have avoided the problems of “true” or “objectively” recognized costs. Yet this also is a challenge for the application of contestability theory to antitrust policy. There is no compelling way to accurately determine which prices represent fully competitive conditions. It is impossible to measure (in monetary terms) a true level of sunk costs, since this measurement is based on an entrepreneurial judgment. Truthful assessment would require perfect foreseeing of the future state of the market—that is, it would require being in the position of a perfect planner.“Sunk costs resist accurate measurement. Physical capital is subject to varying measures, and its sunk component is often unknown (in part because it varies with the time interval involved). Nonphysical forms of sunk costs may often be larger, but they too aredifficult to measure” (emphasis added, Shepard, 1984, p. 582). It follows that an antitrust policy is difficult, unknown and resisting accuracy. This fact is often forgotten when the contestability approach is being applied to practical research.“Sunk costs resist accurate measurement. Physical capital is subject to varying measures, and its sunk component is often unknown (in part because it varies with the time interval involved). Nonphysical forms of sunk costs may often be larger, but they too are difficult to measure” (emphasis added, Shepard, 1984, p. 582). It follows that an antitrust policy is difficult, unknown and resisting accuracy.
Capital irreversibility and possible sunk costs are definite constituents of economic calculation:
Irreversibility may have important implications for our understanding of aggregate investment behavior. It makes investment especially sensitive to various forms of risk, such as uncertainty of the future product prices and operating costs that determine cash flows, uncertainty over future interest rates, and uncertainty over the cost and timing of the investment itself. Irreversibility may therefore have implications for macroeconomic policy (Pindyck, 1991, p. 1110)
Macroeconomic policy cannot wither away those risks and uncertainties associated with sunk costs. They are ordinary parts of economic appraisement and need to be priced accordingly. Sunk costs are natural buffers, which help in this process both in ex ante and ex post situations. Possible sunk costs inform about the specificity and length of an uncertain process. Factual sunk costs help to capitalize the losses and to reallocate the factors to more productive uses. Government fiat decrees cannot make those costs disappear. It can only lead to the redistribution of costs. Compulsory externalization of costs, however, does not lead to higher capital accumulation and a higher standard of living, but creates moral hazard incentives (see Hülsmann, 2006).
To summarize this section, sunk costs are sunk for a reason. These costs perform valuable economic functions. We considered both realized sunk costs, as effects of past mistakes, and probable sunk costs, which may be suffered in the future.This concerns even the most specific costs such as advertising, which will be completely sunk in case of a failure (Kessides, 1986, p. 87). The possibility of suffering those is not socially wasteful if one does not consider advertising as an unnecessary burden (see on this Kirzner, 1973, p. 151ff). Possibility of completely sunk costs in adverting certain products makes entrepreneurs aware that they might lose a lot of capital, which is to say, they might grossly misallocate the factors. The necessity to sink costs is certainly a barrier to entry, as contestable markets theorists would tell us, but it is not an inefficient barrier to entry. Just as fixed costs are not an inefficient barrier to entry, because they play their role for the effectiveness of competition, so it is the case with sunk costs. They exist for a reason.
- MARKETS CONTESTABLE UNDER PROPERTY CONSTRAINTSUnder socialism, all the factors are taken away from the owners without their consent. In a collectivist order, there is no competition. Every single decision is made by one entity. Economic problems of the socialist order result from the absence of competitive entrepreneurial appraisements. With private property boundaries, all entrepreneurs and owners are influencing the prices by their own decisions to sell and buy, or to abstain from selling and buying. Prices allow for exclusions of production processes which are considered undesirable (in the current state of the market). This undesirability is expressed numerically in the expected return on capital, i.e., profitability. A legally exclusive force is not profitability, but rather ownership of factors. One of the components of private property rights is the right to exclude. The price system works solely because of that right, since beyond “profitability” there is exclusive property (which can stop any exchange from taking place).
Private property allows any owner to make offers in the market and utilize his resources for the benefit of consumers. Prices are created and changed in response to their decisions. In these realms, entrepreneurial skills in consumer satisfaction can be economized. The discrepancy between costs and revenues stimulates potential entrepreneurs to enter various markets and eliminate price differences. From this perspective, markets based on property boundaries are always contestable, since any exclusive owner of his capital and resources is free to contest any other producer and supplier of goods.
Competitive markets do not require homogenous products, perfect information, an infinite number of producers and consumers, or the lack of fixed costs. As our investigations suggest, they also do not require the absence of sunk costs, or any special type of policy to undermine sunk costs, because they are essential parts of the market process. Effective contestability of the market is guaranteed by freedom of entry. In the neoclassical analysis, this institutional freedom is neglected, because entrepreneurship is treated like a residual which is automatically motivated by existing price differences:
Obviously the entrepreneur has been read out of the model. There is no room for enterprise or initiative. The management group becomes a passive calculator that reacts mechanically to changes imposed on it by fortuitous external developments, over which it does not exert—and does not even attempt to exert—any influence. One hears of no clever ruses, ingenious schemes, brilliant innovations, of no charisma or of any of the other stuff of which outstanding entrepreneurship is made; one does not hear of them because there is no way in which they can fit into the model (Baumol 1968, p. 67)n this paper, one of Baumol’s collegues commented (p. 69, n. 4) that neoclassical analysis does not have a good theory of the entrepreneur, because it does not have a good theory of monopoly.
This critique from one of Baumol’s earlier articles applies to the idea of sunk costs as defining competitive conditions. Under a strict contestability framework, entrepreneurs are also treated as passive calculators responding robotically to existing prices over which they do not exert a specific influence.
Competitive actions can be hampered by compulsory co-ownership. When this institution is introduced, entrepreneurs are interested not only in outcompeting other owners by better judgment, but are also interested in indirect or direct expropriations. Prohibiting entrepreneurs from entering particular markets, and making it difficult for them, are inefficient property-violation barriers. They decrease the motivation of incumbents to competitively respond to potential entrants. This necessarily leads to monopolistic consequences in different forms of inefficiencies of the structure of market prices and qualities of products.
Markets are contestable when there is freedom of entry into all industries. The government can only discourage entries or levy unnecessary costs on some entrants, incumbents, or taxpayers. Because of the above reasoning, we doubt that this kind of policy would produce an increased level of good and socially positive competition, but rather precisely the opposite. Following this line of reasoning, we also see that the modified contestability method can be reconciled with Rothbard’s theory of monopoly (Rothbard, 2004, pp. 668–670). Markets are competitive with freedom of entry, and monopolization is caused by granting special privileges.
CONCLUSIONSContestable markets were a great advancement in the neoclassical competition theory. This new approach led to the rejection of three absurd assumptions of the perfect competition model. Even the fourth assumption on barriers to entry was significantly modified to vindicate positive effects of economies of scale. With our systematization of the concept of sunk costs, we were able to modify the assumption even more. Sunk costs are not negative burdens, because have desirable effects on competition. The general idea of contestability is largely correct, but requires more exactness: the competitive framework of the pricing process requires freedom of entry and conditions in which no entrepreneur is allowed to impose compulsory costs on his competitors.
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Volume 17, No.1 (Spring 2014)ABSTRACT: This paper defends the Rothbardian theory which states that the proportion of consumption spending relative to investment spending is systematically related to the interest rate through time preference in society, contrary to Hülsmann (2008). After clarifying that a time market transaction is based on two exchanges over time, it illuminates the necessary implications when analyzing the demand for and supply of present goods. Building on this insight, it shows that rather than assuming that the demand for present goods is held constant throughout the analysis, the traditional change in time preference necessarily implies a reconfiguration. As a result, the Rothbardian theory still holds.KEYWORDS: Austrian macroeconomics, structure of production, time preference, Rothbard, HülsmannJEL CLASSIFICATION: B25, B53, E19, E25 I: INTRODUCTIONOne of the distinguishing characteristics of the Austrian school throughout the development of modern macroeconomics was its structure of production framework and capital theory. Building on Menger’s (2007 [1871]) insights regarding the categorization of goods as “higher order” or “lower order,” Böhm-Bawerk (1930 [1889]) presented a structure of production theory based upon the roundaboutness of production processes and recognized time preference as a factor in determining the interest rate and economic growth. Mises (2009 [1912]) used these insights among others to sketch a capital and monetary based business cycle theory and later contributed to the pure-time-preference theory of interest (Mises, 2008 [1949]). Hayek (2008 [1931]) made notable contributions to capital and business cycle theory, including a graphical representation of the structure of production that could show both sustainable and unsustainable growth, which he subsequently attempted to further improve (Hayek, 2012 [1941]). Rothbard (2009 [1962]) synthesized this entire system traceable to Böhm-Bawerk through his “development of a capital and interest theory that integrated the temporal production-structure analysis of Knut Wicksell and [F.A] Hayek with the pure-time-preference theory expounded by Frank A. Fetter and Ludwig von Mises” (Salerno, 2009, p. xxvii). Using the ideas of earlier Austrian theorists as well as adding his own contributions, Rothbard presented the relationship between the interest rate and the proportion between consumption and investment in the clearest and most logically deduced manner as well as the capital-based growth that underlies Austrian macroeconomics.For a more detailed historical overview on capital theory and the structure of production, including the works of Kirzner and Lachmann, see Skousen (2007, pp. 13–130). On the evolution of the pure-time-preference theory of interest, especially with regards to the contributions of Fetter, see Herbener (2011). White (2012) provides an informative discussion on the theoretical framework of Hayek and its relationship with his contemporaries and predecessors. A brief list of more recent works on Austrian capital theory in the above line of thought includes Skousen (2007 [1990]), Huerta de Soto (2006 [1998]), and Garrison (2006 [2001]).
The basic growth scenario entails a fall in time preference, which is represented by a decrease in consumption spending and an increase in investment spending. The additional investment funds are spent on higher order goods, and increase the number of production stages to reflect the lower natural rate of interest. The opposite occurs for an increase in time preferences. Graphically, the change in time preference is generally visualized as a movement in the supply curve along a constant demand curve in the loanable funds market, which implies a similar shift in the overall time market (Skousen, 2007, p. 233; Garrison, 2006, p. 62). This capital-based growth is fundamental to all current Austrian macroeconomics since it provides the basis for the generalizations made about the capital structure and time preference, mainly, that the proportion of present consumption spending to investment (future consumption) spending is systematically related to the interest rate through time preference. In other words, changes in time preferences are embodied in changes in both as “the time preferences of the individuals on the market determine simultaneously and by themselves both the market equilibrium interest rate and the proportions between consumption and savings (individual and aggregate).” (Rothbard, 2009, p. 400).
However, Hülsmann (2008) criticizes this “Rothbardian position” and instead states that “the aggregate proportion of savings to consumption is not systematically related to the interest rate” (Hülsmann, 2008, pp. 16, 21). Hülsmann challenges the standard Austrian exposition of growth and presents the case for other types of macroeconomic progress exhibited through changes in time preference. Directed towards the above scenario, most of Hülsmann’s analysis is based on the accusation that Austrian economic theory neglects the demand side of the time market by always assuming it is held constant and thus unilaterally focuses on the supply side.“This neglect of the demand side of the time market is the basic shortcoming of the conventional [Austrian] theory, as criticized in the present paper” (Hülsmann, 2008, p. 19). In Hülsmann’s (2011) words, “the conventional Austrian model more or less exclusively focuses on the ramifications of an increase of the supply of present goods (more precisely, of savings) on the time structure of production, under the assumption that the demand for present goods remains constant” (Hülsmann, 2011, p. 13). Therefore, the Austrian model develops its conclusions prematurely without analyzing all possible changes in time preference.Because most of Hülsmann’s critiques are directed towards Rothbard, this paper concentrates on Rothbard’s work. This exclusive focus is not meant to imply that Rothbard alone was responsible for the edifice of Austrian capital theory. In addition, it concentrates on Hülsmann (2008) as opposed to Hülsmann (2011) because it deals with topics beyond the scope of this paper and is still a working draft. In Hülsmann’s framework, allowing the demand for present goods, such as the pure demand,This is the demand expressed by the original factors and is explained below in greater detail. to independently shift alongside a constant or changing supply of present goods allows him to make the controversial statement that the proportion between consumption and investment is not apodictically related to the interest rate (Hülsmann, 2008, pp. 18–21).
Hülsmann is right in stating that Austrian economics has clearly mentioned very little about the demand side of the time market. When discussing the determination of the interest rate Rothbard (2009, pp. 367–451) analyzes its derivation, but does not explicitly go on much further.It should be noted that Rothbard built his analysis of the demand for present goods from Böhm-Bawerk (1930 [1889]). Other Austrian literature that discusses the demand side includes Salerno (2001) and Garrison (2006).In addition, when the demand for present goods is discussed, it is usually concerned with the demand for loanable funds. For example, while Garrison (1978) references the pure demand for present goods, Garrison (2006) does not, as critiqued by Salerno (2001) but instead analyzes the implications of an increase in the demand for loanable funds by both by the private sector and government (Garrison, 2006, pp. 33–106). The present paper does not discuss Garrison’s macroeconomics or the demand for loanable funds and instead focuses on Hülsmann’s work.
Hülsmann presents a strong accusation and a well-developed case that presents serious challenges for current Austrian macroeconomics to deal with. If correct, Austrian macroeconomics and its theories on time preference, the interest rate, the structure of production, and capital-based growth would have to undergo a massive revision.The reconstruction of Austrian capital theory along these lines is shown in Hülsmann (2011). Méra (2011), although critical of some points of Hülsmann (2008), essentially accepts its main ideas and also presents a new rendition of capital-based growth. However, Hülsmann is in error when he makes the claim that the demand for present goods is neglected in the standard Austrian analysis and, as a result, his theories concerning the interest rate and the structure of production lead to the wrong conclusions. This paper defends the conventional Rothbardian argument and counters Hülsmann’s claims. It accomplishes this by explaining the demand for and supply of present goods in greater depth by showing how a time market exchange spans two transactions. This insight then illuminates the fact that rather than assuming that the demand for present goods is held constant throughout the analysis, the traditional change in time preference always requires a relative shift in demand. As a result, the proportion between consumption and investment is still systematically related to the interest rate.
II: A CLARIFICATION ON THE DEMAND FOR PRESENT GOODSIn order to portray the Austrian theory in detail, space must be first devoted to analyzing the time market of a given Evenly Rotating Economy (ERE), where there is an absence of change and the same exchanges occur over and over again. In this economy the rate of return in all production processes has been equilibrated to the pure, or natural rate of interest. This return is determined by the societal rate of time preference, which is the premium on present goods (money that can be spent on consumption) over future goods (money that is earned from investment). In other words, it is the premium on present consumption over future consumption.
In a typical production process a capitalist buys capital goods from earlier capitalists, pays original factors (land and labor) to work on the goods over time, and sells them in the future to a later capitalist and earns the interest rate return. This process can be described on the time market as one where original factors demand present goods (money) and supply future goods (the monetary value of the product), while capitalists supply present goods to original factors and earlier capitalists and demand future goods when they sell the product to later capitalists.
It is important to understand that the exchanges on the time market are not completed with a single transaction, but instead span two markets at different points in time, namely the earlier market where the factors of production are sold, and the later market where the finished good is sold to a later capitalist. To quote Rothbard (2009, pp. 377–378):
When capitalists purchase the services of factors of production… they are purchasing a certain amount and value of net produce, discounted to the present value of that produce… The pure capitalist, therefore, in performing a capital-advancing function in the productive system, plays a sort of intermediary role. He sells money (a present good) to factor-owners in exchange for the services of their factors (prospective future goods). He holds these goods and continues to hire work on them until they have been transformed into consumers’ goods (present goods), which are then sold to the public for money (a present good). The premium that he earns from the sale of present goods, compared to what he paid for the future goods, is the rate of interest earned on the exchange.
To elaborate, the present good (money) is exchanged in the factor market when the capitalist hires the factors, while the future good (money) is earned after the production process has occurred when the capitalist sells the product. While the original factors are only physically involved in one market, the capitalists are present in both markets. Rothbard (2009, p. 409) drives this point home when he states that
[the capitalists’] activities as suppliers of present goods in exchange for interest return, therefore, are not really completed with their purchase of factors. Obviously, they could not be. The capitalists must transform the factors into products and sell their products for money before they obtain their interest return from their supply of present goods. The suppliers of future goods (landowners and laborers) complete their transactions immediately, as soon as they obtain present money. But the capitalists’ transactions are incomplete until they obtain present money once again… for we must look at both of their exchanges, which are necessarily considered together if we consider their complete transaction. In the second to last sentence, Rothbard is not saying that the supply of future goods is irrelevant to their present demand, but that they are no longer involved in the production process, while the capitalist must recoup his savings by selling the good in the future, as the capitalist plays an intermediary role. On the other hand, the borrower of a consumer loan must physically exchange future money with the capitalist (Rothbard, 2009, p. 417).
Thus a single time market transaction spans multiple exchanges, with individuals on both sides of the market buying and selling money at different points in time. This is emphasized by Rothbard (2009, pp. 383, 388–389, 392–395) when he discusses the aggregate time market and describes the supply of present money as the demand for future money, and the demand for present money as the supply of future money. Both of these exchanges have to be included because the “price” on this time market is not simply the cost of buying inputs or the price of the finished good, but rather the differential or premium between the two money sums in both exchanges, which the “[factor owners] voluntarily pay in the form of the interest rate” (Rothbard, 2009, p. 374). In other words, the interest rate is equal to the rate of price spread across the ERE (Rothbard, 2009, p. 371). Therefore, just as discussing how the supply of present goods is linked with the demand for future goods, a discussion about the demand for present goods must take into consideration the supply of future goods.
The money that the original factors and capitalists selling goods are able to demand is based on what future capitalists believe they can earn, who are compensated due to time preference. The future goods supplied to the later capitalists is their input to the revenue earned from the produced good that is sold in the future, also known as their marginal value product (MVP),In the case of the capitalists’ demand, it is the capital good’s MVP. while the present goods earned is their discounted marginal value product (DMVP). Rothbard clearly explains this when he writes
Suppose, for example, that a capitalist-entrepreneur hires labor services, and suppose that it can be determined that this amount of labor service will result in a net revenue of 20 gold ounces to the product-owner. We shall see below that the service will tend to be paid the net value of its product; but it will earn its product discounted by the time interval until sale (Rothbard, 2009, p. 377).
And in greater detail when he elaborates on factor pricing:
The marginal value product is the monetary revenue that may be attributed, or “imputed,” to one service unit of the factor…. This MVP (marginal value product) is discounted by the social rate of time preference, i.e., by the going rate of interest. Suppose, for example, that a unit of a factor… will, imputably, produce for the firm a product one year from now that will be sold for 20 gold ounces. The MVP of this factor is 20 ounces. But this is a future good. The present value of the future good, and it is this present value that is now being purchased, will be equal to the MVP discounted by the going rate of interest (Rothbard, 2009, p. 456).
Since, as explained earlier, the original factors demand present goods and also supply future goods, the pure demand for present goods on the time market must describe both the markets where the factor is bought and where the finished good is sold. Rothbard (2009, pp. 404–406) describes the demand schedule for present goods by the original factors below:
The pure demanders of present goods on the time market are the various groups of laborers and landowners—the sellers of the services of original productive factors. Their price on the market, as will be seen below, will be set equal to the marginal value product of their units, discounted by the prevailing rate of interest. The greater the rate of interest, the less will the price of their service be, or rather, the greater will be the discount from their marginal value product considered as the matured present good…. A higher rate of interest would lead to a lower price, and a lower rate to a higher price…. It seems likely that the demand schedule for present goods by the original productive factors will be highly inelastic in response to changes in the interest rate. With the large base amount, the discounting by various rates of interest will very likely make little difference to the factor-owner.… Land is very likely to have no reservation price, i.e., it will have little subjective-use-value to the owner…. Labor services are also likely to be inelastic with respect to the interest discount.
It is important to note that since the aggregate supply curves for the original factors are likely to be inelastic, the pure demand for present goods on the time market is also relatively inelastic.In addition, since the supply curves for capital goods are inelastic, the capitalist demand for present goods is also relatively inelastic (Rothbard, 2009, p. 406). However, since the demand for consumers’ loans is likely to be more elastic, changes in the quantity demanded along the aggregate demand for present goods are mainly shown in the consumption demand schedule (Rothbard, 2009, p. 419). Equally crucial is that the demand for present goods on the time market is not simply the supply curves for particular factors transposed on the time market, but rather the intersection of the supply curve with its DMVP schedule at each hypothetical rate of interest. This is because as repeated in the above analysis, the original factors on the time market do not only demand present money (their DMVP) but also supply future money (their MVP). Two exchanges at different points in time are always required for a time market transaction. This point is shown by juxtaposing a part of a demand schedule for present goods on the time market with a part of a supply schedule for a factor (such as labor):
Table 1. Demand for Present Goods Compared with Supply of Labor
It is apparent that the two are not the same. The supply schedule counterbalances units of present money and labor hours, while the demand schedule weighs present money (the factor’s DMVP) versus future money (the factor’s MVP), due to the nature of a time market exchange. In other words, the pre-income demand for present money on the time market is not the same as the pre-income exchange demand for money in the money relation, even though they both refer to an actor working for a money income (Rothbard, 2009, pp. 414–416, 757).
In the real world of uncertainty, the demand for present goods is not exactly as portrayed. This is because the MVP and hence DMVP of a factor are not given to the capitalist but instead must be estimated through entrepreneurial appraisement (Rothbard, 2009, p. 510). When investing in a production process, the capitalist-entrepreneur always tries to gauge the marketplace for the potential revenue that can be earned from employing certain factors. These are then discounted using an estimated interest rate and serve as the maximum buying prices for the capitalist-entrepreneur. When purchasing factors, the capitalist-entrepreneur tries to pay them less than their DMVPs in order to reap a profit (a return greater than the rate of interest) if he has correctly estimated their MVPs. In other cases, the capitalist-entrepreneur overestimates their MVPs and ends up overpaying the factors according to their true DMVPs and suffers a loss (a return less than the rate of interest). Since the capitalist-entrepreneur may end up overpaying or underpaying factors, a particular quantity demanded of present goods by a factor will be greater than or less than their true DMVP and the above demand schedule will not generally hold in the real world. However, the demand for present goods is still dependent on two exchanges over time, only now that demand occurs in a world of uncertainty, entrepreneurial appraisement, and profit and loss (Rothbard, 2009, pp. 509–516).Differences in the rates of return brought about by profits and losses are equilibrated in the long run through the entrepreneurial appraisement process into the uniform natural rate of interest.
The fact that the time market spans over multiple exchanges provides a crucial insight on both the demand and supply of present goods, namely that one must consider the demand and supply of future goods as well. It is shown below that this is fundamental to the analysis of describing how the demand for present goods is utilized during a change in time preferences.
III: AN ELUCIDATION OF TRADITIONAL CAPITAL- BASED MACROECONOMICSThe above clarification allows one to better understand the production structure of a given ERE and ultimately changes in time preferences. Returning to the “typical production process” described earlier, the entire production structure is a cumulative series of these processes, or stages, with the first stage beginning when capitalists exclusively spend money on original factors and the last stage occurring when capitalists instead sell their finished product to consumers. An entire “round,” or period of exchanges in a given ERE spans a time length long enough until all capital goods resolve into being made solely by original factors, i.e., the length of time it takes from the first to the last stage. In this period total investment is the amount of present goods supplied by capitalists, while total consumption is the amount of money spent on finished products. Since there is no hoarding or dishoarding in this economy, gross expenditure in any given round is equal to gross income in the subsequent round.
In Rothbard’s example, the ERE’s round spans a time length of six years, with each stage taking approximately one year (Rothbard, 2009, p. 368). Rothbard breaks down the flow of money and income in his presented production structure, and the remainder of the paper refers to his numbers. Figure 1 presents his hypothetical production structure:
Figure 1. Hypothetical ERE (Murphy, 2006, p. 97) A similar figure is presented in Rothbard (2009, p. 369). The only revision here to the Murphy figure is the labeling of the particular capitalists in each row. In Tables 2 and 3 presented below, Rothbard designated the 6th capitalists as the Nth, so in keeping with his Tables the 6th capitalists are presented as such.
In this ERE, 100 ounces are spent on consumption and 318 are spent on investment spread out over six stages at a roughly 5 percent rate of interest, for a total of 418 ounces of gross expenditure. In order to fully elaborate on this economy it is necessary to trace out the money spent in both “sides” of the economy; i.e. consumption and investment.
The gross income from investment is neatly broken down by Rothbard in Table 2:
Table 2. Income from Investment (Rothbard, 2009, p. 395)
All of the money saved by capitalists1-N (318) is spent on either original factors (83) or capitalists from the prior stage (235). As original factor income does not require further deductions, from savings the original factors earn a net income of 83 ounces. However, the net income of capitalists2-6 (12) is their total gross income from later capitalists minus the money they must pay out, as reflected in the following Table 3:
Table 3. Net Incomes of Capitalists Producing Capital Goods (Rothbard, 2009, p. 396)
The money spent on consumption (100) provides both the gross and net income of Capitalist1 (5). As Rothbard (2009, p. 369) explains, this money then passes through each production stage and is divided amongst the net income of Capitalists1-N (17) and the original factors (83). In any ERE the total amount of consumption spending must always equate to total net income.
Following Figure 1 and Table 2, the components making up the Total time market, i.e., the original factors and capitalists, can be constructed using Rothbard’s numbers. The first is the aggregate of all the original factor time markets. The second shows the aggregate capitalist demand for present goods. The last market is the summation of the other two.Rothbard never formally depicted the time market diagram in this manner, although he did draw the Total time market diagram for any given economy (Rothbard, 2009, pp. 388, 418).
Figure 2. Time Markets for Hypothetical ERE
At this time it is now possible to fully portray a change in time preferences and show the relative changes in the demand for present goods. This paper uses the scenario provided by Rothbard (2009, pp. 518–519), who postulates a fall in consumption spending by 20 ounces and a rise in investment spending by 20 ounces. Since Rothbard does not numerically show the new structure of production, the numbers for the new ERE are taken from Murphy (2006, p. 97). In this scenario, the number of production stages increases to 7 and the interest rate falls to roughly 3 percent. The new structure is depicted below:
Figure 3. Hypothetical ERE Following a Fall in Time Preferences
As stated before, the traditional Austrian portrayal of capital-based growth is exerted through a fall in time preference via a decrease in consumption and a rise in investment. This translates into a lower premium on present goods over future goods and ultimately a smaller price spread and lengthier structure of production.Due to space constraints, the defense of other economic processes involved, such as the lengthening of the structure of production, are not discussed here. They are assumed to hold true in this scenario.
At this point it is now necessary to describe how this reconfigures the demand for present goods. It is first shown by analyzing the changes provoked by consumption spending and investment spending. During this, the relative changes between the higher and lower stages are considered and then finally the relative changes between the original factors and capitalists.
According to the Law of Imputation, which states that the value accorded to a factor of production is caused solely by the value placed on the consumer good it produces, the values of all factors of production are strictly derivative of what consumers are willing to pay. Since value is imputed backwards to the factors and not forwards, all of the MVPs, or future goods supplied, are intricately related to consumption spending. Consumption spending is intertwined with the future money that the capitalists and original factors supply at each stage and thus the total amount of future goods supplied throughout the production structure (Rothbard, 2009, pp. 369, 480). Consequently, both relative and absolute changes in consumption alter the demand schedules for present goods across the production structure.
At this moment the analysis focuses now on the present goods demanded in the higher and lower stages of the economy and not the distribution between the original factors and capitalists. Take, for example, the simplified demand schedule in Table 1, and suppose that the numbers are changed to reflect the final stage of production shown in Figure 1, where original factors and capital goods earn a combined DMVP of 95 ounces while the final capitalists earn their MVP of 100 ounces. This is row 1 on Table 2, and is explicitly described by Rothbard (2009, p. 392). Before the decrease in consumption, it was:
Table 4. Demand for Present Goods in First Stage
However, now that consumption declined from 100 to 80, the supply of future money must necessarily decline, which raises the relative ranking of future money on the schedule. Capitalists1, faced with lower MVPs for their factors, revise the DMVP schedules downward for the factors in the first stage and thereby invest less in them. This process continues as the fall in consumption spending sends “an impetus towards declining money incomes and prices… along the production structure” (Rothbard, 2009, p. 518), which changes the relative rankings of future goods and present goods at each stage as the MVPs and DMVPs of factors fall.
On the other hand, the increase in investment from 318 to 338 raises the overall prices (DMVPs) of factors in the higher stages of production. These prices increase because the prices of the capital goods they make (their MVPs) have increased. The opposite phenomenon of what was described above, namely a relative fall in the rankings of future money supplied to the capitalists, occurs in these stages. Thus the price spread in the economy pivots as the relative demands for present goods fall in the lower orders while they rise in the higher orders. To quote Rothbard (2009, pp. 521–522):
Let us consider the price changes in the various stages and the processes by which they occur. In the lower stages, prices fall because of the lower consumer demand and the resulting shift of investment capital from the stages nearest consumption. In the higher stages, on the other hand, demand for factors increases under the impact of the new savings and the shift in investment from the lower levels. The increased investment expenditure in the higher levels raises the prices for the factors in these stages. It is as if the impact of the lower consumer demand tends to die out in the higher stages and is more and more counteracted by the increase and shift in investment funds.
Now it is appropriate to describe the relative changes in present goods and future goods between the original factors and capitalists in the aggregate.
The decrease in consumption leads to a smaller “consumption fund” that finances interest and original factor income.This is not meant to imply that consumption spending drives economic activity or that a certain amount of consumption spending is needed in order to keep the production structure stable (Rothbard, 2009, pp. 397–404). With a decrease in consumption, this net income fund always declines (Rothbard, 2009, p. 524). What happens to both original factor and interest income individually is impossible to say. Since interest income is gross investment times the interest rate, total net income accruing to capitalists may increase or decrease depending on the relative alteration in the interest rate and changes in investment spending. For this analysis, following Rothbard (2009, p. 524) and Murphy (2006, pp. 96–98), this paper assumes both original factor (83 to 70) and interest (17 to 10) income fall.
Thus, while some demand schedules for present goods by certain original factors increase in the higher stages from the rise in investment, with the fall in consumption spending there is a decrease in the total demand for present goods by the original factors. This means that while some original factors may command higher prices, particularly in the higher stages, as Rothbard (2009, p. 524) puts it, the prices of original factors decline “in general.” In other words, the total MVPs of the original factors are now smaller, and therefore the total DMVPs are as well.
By itself, Rothbard’s analysis here provides evidence that he did not neglect changes on the demand side of the time market. If original factor income (generally) falls, how else can the quantity of present goods demanded by them and the interest rate decrease without a change on the demand side? Basic price theory explains that for a decrease in both price and quantity to occur, the change must come from the demand side. Illustrations showing only a shift in the supply curve would lead to the conclusion that original factor income always increases during a lowering of time preferences and a fall in the interest rate, which is not true. Also notice that the aggregate change in the pure demand for present goods is not caused by any change in the aggregate supplies of factors, as they have been held constant in the analysis (Rothbard, 2009, p. 524).
On the other hand, the savings that would have gone to the original factors (13) and the increase in investment spending (20) are instead absorbed into the capitalist time market (235 to 268). Here the demand for present goods increases due to the relative increase in the profitability of producing capital goods, particularly in the higher stages. Once again, while some capitalists decrease their demand for present goods, i.e., those producing capital goods in the lower orders, overall their demand increases.
On the whole then, not only does the relative demand for present goods change between the stages, but also between the two subdivisions of the Total time market. Rothbard clearly explains the relative shift in savings and the demand for present goods when he writes:
One question that immediately presents itself is: How can the prices of factors decline while the gross income remains the same and gross investment even increases? The answer is that…the increase in gross investment, in particular, raises the prices of capital goods at the highest stages...the larger gross investment fund is absorbed, so to speak, by higher prices of high-order capital goods and by the consequent new stages of turnover of these goods (Rothbard, 2009, pp. 526–527).
Figure 4 presents the updated markets in red:
Figure 4. Time Markets for Hypothetical ERE Following a Fall in Time Preferences
Overall, in the Total market the demand curve remains relatively constant and the supply curve shifts outwards, resulting in a typical illustration of a lowering of time preferences. Although the demand curve appears to have not moved, the composition of the demand for present goods has undergone a complete revolution as the demand curves for the markets making up the general time market have drastically changed, and the fall in the demand for present goods by the original factors is compensated by the rise in the demand by capitalists.Clearly, the supply and demand curves shifts will not be as smooth and proportional as shown above; their jaggedness and changing elasticities during the transition produce totally different curves in each market. Furthermore, the intricacies of changes in the supply of present goods are also not shown. The main purpose of Figure 4 is to just illustrate the relative alteration in the demand for present goods., Bear in mind that the depiction of the changes in the demand for present goods above refers to the new curves in the new ERE. During the transition (i.e., a world of uncertainty and profit and loss), the strictures regarding the demand for present goods in the real world described earlier apply.
Thus, while superficially it appears that the demand for present goods is held constant while the supply of present goods increases in the traditional Austrian scenario, in fact a complete reconfiguration of the demand curve occurs.Following Rothbard (2009, p. 531), the typical rise in time preference can be portrayed simply by proceeding backwards from the above scenario. The demand for present goods, as Hülsmann asserts, is not neglected throughout the analysis, but in fact its changes play an integral role in transforming the production structure to reflect the fall in time preferences. Without such a modification of the demand for present goods the traditional Austrian scenario cannot occur at all.
It is important to note that in Rothbard’s framework, changes in the total demand for present goods are not due to changes in factor supply as described by Hülsmann (2008, p. 19), but rather due to relative changes in spending; in the above case, a decrease in consumption and increase in investment. This creates an entirely different constellation of market prices, and hence future goods supplied and present goods demanded, as the comparative changes in the prices of factors of production increase or decrease depending on where they are located in the production structure. The individual demand schedules for present goods by a given factor of production can change independently depending on a relative change in the particular demand curve for the product they produce or the particular factor’s supply curve, but this is counterbalanced by the schedules for other factors. But a change in the aggregate supply of the original factors, holding the spending patterns constant, cannot change the aggregate demand for present goods in such a way to change the interest rate as it is ultimately linked to the comparative spending between consumption and investment.Following the above analysis, while the demand curve will strictly not be exactly the same, holding spending patterns constant, then new demand curve will intersect the supply curve at the same rate of interest and quantity of savings. The error in assuming that it does is linked to the belief that the pure demand for present goods is synonymous with the original factor’s supply curve, which is not true.
Thus changes in time preferences are always reflected in the concomitant alteration between the proportion of consumption and investment spending and the interest rate. Lower time preferences are embodied in a fall in the proportion of consumption to investment and the interest rate, while higher time preferences imply the reverse. The proportion represents the degree of spending on present consumption versus future consumption, and the interest rate reflects the premium on present consumption versus future consumption. The independent demand for present goods, as portrayed by Hülsmann, exerts no exogenous influence on the structure of production.
It is imperative to reiterate that ultimately, changes in the aggregate production structure through capital-based macroeconomics are systematically determined by consumption and investment spending. Changes in investment spending exert their influence through an increase in the supply of present goods, while changes in consumption spending modify the demand for present goods. A change in time preference is always embodied in the systematic relationship between consumption and investment and the interest rate. Contrary to Hülsmann (2008, pp. 15–16), Rothbard can be quoted approvingly when he states,
Each individual, on the basis of his time-preference schedule, decides between the amount of his money income to be devoted to saving and the amount to be devoted to consumption. The aggregate time-market schedules (determined by time preferences) determine the aggregate social proportions between (gross) savings and consumption. It is clear that the higher the time-preference schedules are, the greater will be the proportion of consumption to savings; while lower time-preference schedules will lower this proportion. At the same time… higher time-preference schedules in the economy lead to higher rates of interest, and lower schedules lead to lower rates of interest. From this it becomes clear that the time preferences of the individuals on the market determine simultaneously and by themselves both the market equilibrium interest rate and the proportions between consumption and savings (individual and aggregate). Both of the latter are the obverse side of the same coin… The important consideration, therefore, is time preferences and the resultant proportion between expenditure of consumers’ and producers’ goods (investment) (Rothbard, 2009, pp. 400–404).
IV: CONCLUSIONThis paper defends the Rothbardian theory relating the proportion between consumption and investment spending with the interest rate from Hülsmann (2008). It explains that a time market exchange spans over two transactions and the resultant consequences for the analysis of the demand for and supply of present goods. It shows that with a change in time preference, there is necessarily a total change in the demand for present goods between the higher and lower stages of production as well as the original factor and capitalist time markets. The above analysis provides a detailed framework that reinforces the systematic relationship between time preference, the capital structure, and the interest rate.
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——. 2009. “Introduction to the Second Edition.” In Murray Rothbard, Man, Economy, and State with Power and Market. Auburn, Ala.: Ludwig von Mises Institute.
Skousen, Mark. 1990. The Structure of Production. New York: New York University Press, 2007.
White, Lawrence H. 2012. “Editor’s Introduction,” in Friedrich A. Hayek, The Pure Theory of Capital, ed. Lawrence H. White. Indianapolis, Ind.: Liberty Fund Inc.
Volume 9, No. 1 (Spring 2006)What sets Austrians apart from mainstream economists is methodology and consequent analyses. The first section contains an analysis of their methods, which are found wanting. Although G&V “tip their hats” to Austrian economics, in section two, “Incompatibility with Austrian Economics,” we challenge their claim that their analysis is compatible therewith. In the conclusion we make some final statements.
Volume 15, No. 3 (Fall 2012)
In this paper we tackle two shortcomings of the present efficiency wage models. Firstly, they do not fully account for labor heterogeneity, thus implying that high-effort and low-effort units of labor are interchangeable. Secondly, building on this assumed homogeneity of labor, the models derive involuntary unemployment from effort decisions of workers, which are patently voluntary. We offer a consistent reformulation of the theory: Each of the effort or quality levels is regarded as a separate market which has its own clearing quantity and price. As such unemployment is a result of workers’ reluctance to adjust to the prevailing market conditions on the respective labor sub-market. To further clarify heterogeneity in labor markets, we propose to employ the demand for workers’ characteristics instead of the demand for workers. This microeconomic approach shows that in standard equilibrium, employers will not choose among all workers but only select specific characteristic-types. Therefore, to become attractive, an unemployed worker has to significantly alter either his wage or the bundle of offered characteristics. Both of these modifications reinforce our central claim that free market interaction cannot lead to unemployment other than voluntary.
Volume 7, No. 3 (Fall 2004)There exists a modest but steadily growing literature on the economics of science. Much of it concerns the funding of research and the reaping of societal benefits therefrom, but one also sees increasing interest in applying economic concepts to the conduct of research itself, extending even to matters traditionally falling within philosophy of science. The publications of Science Bought and Sold: Essays in the Economics of Science provided an opportunity to take stock of these efforts. The editors, Philip Mirowski and Esther-Mirham Sent, have assembled 19 essays from a diverse array of authors with intellectual roots in economics, in philosophy and sociology of science, and in the sciences themselves. Some of these entries were written especially for this volume, others reprinted or excerpted from elsewhere. The book is seriously flawed, as important voices have been shut out and the editors' 60-page introduction itself is virtually unusable. Nevertheless, the result is a telling portrait of inquiry into this field.
Volume 9, No. 3 (Fall 2006)Rothbard (1993, pp. 638–45) refuted the important economic fallacy that excess capacity is a normal consequence of profit maximizing behavior by businesses in some industries when they are in long-run equilibrium. And, in so doing provided a manifest example of misuse of mathematics in modern economics.
Volume 8, No. 4 (Winter 2005)This paper has incorporated challenges to the dominant neoclassical model that were fashioned by Rothbard and, to a much lesser extent, Baumol. In examining the work of both economists, we conclude that the Rothbard model is more complete, as it factors time into the model, where Baumol’s does not, which renders it fatally incomplete. Both authors, however, make a solid point that if one is to analyze the workings of the firm in the real world, other models such as revenue maximization must be taken into account if we are to assume that firms attempt to maximize profits.
Volume 10, No. 1 (Spring 2007)
Tony Yu’s Firms, Strategies, and Economic Change joins a growing list of book-length treatments applying Austrian economics to the theory of the firm, corporate strategy, innovation, new venture formation, and other popular issues in management.
Volume 10, No. 3 (2007)
Most of the economists of the Austrian School use straightforward representations of the Hayekian structure of production. Even though these depictions are helpful in order to visualize the most basic features of growth and cycle theories in the Austrian tradition, a more detailed formalization is necessary in order to deal with more difficult and subtler problems. The model developed in this paper permits, in the case of a proportional goods-in-process structure, (1) to calculate the macroeconomic values characterizing all the stages of a structure in static equilibrium, (2) to illustrate a structure and to visualize the distribution of the added value between wages and interest, (3) to demonstrate a series of mathematical formulas describing the structure (and for the first time a very simple formula for the average length of a structure: λ = I(1+ i)/C), and (4) to analyze the complex dynamic changes that occur in the rates of return and the investments at different stages when the contour of a structure changes.
Volume 10, No. 3 (2007)
Does Structuralist unemployment theory in the spirit of Edmund S. Phelps (1994) contain Austrian elements? Austrian macroeconomics concerns itself with the intertemporal capital structure and entrepreneurial expectations. This paper shows that Structuralist theory is “Austrian” by being dynamic and considering entrepreneurial expectations which are however rational. Yet, by neglecting the intertemporal capital structure and the monetary process which leads to credit-induced booms and bust, Structuralist theory misses the core element of Austrian macroeconomics.
Volume 11, No. 1 (2008)
This paper deals with the recent empirical phenomenon of intra-industry trade, i.e., trade in similar goods between similar countries. It treats this phenomenon from the point of view of the theory of the structure of production, highlighting the importance of the sequential nature of production and heterogeneity and specificity of factors of production, as developed by Carl Menger, Eugen von Böhm-Bawerk and their followers of the Austrian School of economics.
Volume 12, No, 2 (2009)
Mises created an artificial construct, the evenly rotating economy (ERE), from which to ascertain the source of entrepreneurial profit and loss. In particular, the ERE is characterized by two distinct elements. First is the elimination of the temporal element, second is the removal of changing market data. The second point necessarily arises from the first. Is it possible that the efficient market hypothesis (EMH), despite its practical flaws, may be used as a similar theoretical construct? If we envision a similar state of affairs as under the ERE, is it possible to grasp more fully the effect that information has on prices? We argue that it cannot, for two main reasons.
Abstract: Economists have tried to explain business cycles as well as fluctuations in the economy, but over the past two centuries, the explanations have fallen into two areas. The first area tries to explain business cycles as being the result of fluctuating aggregate demand; if overall demand for goods is strong (or to put it another way, consumers are confidently buying goods), then the economy is in a boom. However, if consumers choose not to spend, then the economy is in recession. The second area, as outlined by Sowell is that of seeing an economy as operating within internal proportions that are brought into imbalances. Say’s Law is found in this second category, and the Austrian theory of the business cycle (ATBC) also is a proportionality-based theory. However, most economists have failed to make the connection between Say’s Law and the ATBC.
William L. Anderson (banderson@frostburg.edu) is associate professor of economics at Frostburg State University.
- INTRODUCTION During the 1980 U.S. presidential campaign, many American voters for the first time were introduced to Say’s Law, and while the politicians debating it managed to mangle its concepts, nonetheless a staple of classical economics for a brief moment held center stage. Today, it seems that the zeitgeist of political economy is moving in another direction, as those in political power today are reaching back into the 1930s to the borrow-and-spend policies that marked what governments did in the United States and Europe.
Economists have tried to explain business cycles as well as fluctuations in the economy, but over the past two centuries, the explanations have fallen into two areas. The first tries to explain business cycles as being the result of fluctuating aggregate demand; if overall demand for goods is strong (or to put it another way, consumers are confidently buying goods), then the economy is in a boom. However, if consumers choose not to spend, then the economy is in recession.
The second area, as outlined by Sowell (1985) is that of seeing an economy as operating within internal proportions that are brought into imbalances. Say’s Law is found in this second category, and the Austrian theory of the business cycle (ATBC) also is a proportionality-based theory. However, most economists have failed to make the connection between Say’s Law and the ATBC, whether or not people are aware of the connection.
This article seeks to demonstrate how the ATBC and Say’s Law are interrelated, and to show that in his Treatise on Political Economy (1803, 1826) J.B. Say anticipated the ATBC and at the same time delivered a devastating critique against the Keynesian theories that dominate the political discussion today. The economic thought that Say introduced in his Treatise, while not explaining (or attempting to give) what one might call a business cycle theory, nonetheless lays an important foundation for the theory that Mises (1912, 1981) and other Austrian economists would develop.
The article is organized in the following way. I first explain what is meant by “Say’s Law” and how it was developed. In the next section, I briefly deal with the critics and supporters of Say’s Law. I then briefly explain the ATBC and show how Say’s Law explains a critical foundation of the ATBC, and afterward, I draw some conclusions.
- WHAT IS SAY’S LAW? Traite’ d’Economie Politique or Treatise on Political Economy first appeared in 1803 as a general book on economic thought. Like Adam Smith (1776, 1982), Say wished to discredit the doctrines of “mercantilism,” or, as called in France, “Colbertism,” after J.B. Colbert, the finance minister for Louis XIV, who developed a Byzantine system of taxes, monopolies, and business regulations for France.
There is no specific “law” that Say pronounces in his book, but the concept of what we call Say’s Law is developed in book one, chapter 15, which begins (from the 1826 edition):
It is common to hear adventurers in the different channels of industry assert that their difficulty lies not in the production, but in the disposal of commodities; that products would always be abundant, if there were but a ready demand, or market for them.When the demand for their commodities is slow, difficult, and productive of little advantage, they pronounce money to be scarce; the grand object of their desire is a consumption brisk enough to quicken sales and keep up prices. (p. 132; emphasis added)
In other words, Say is describing something akin to a recession. In explaining this passage, Mises (1960) writes:
Whenever business was bad, the average merchant had two explanations at hand: the evil was caused by a scarcity of money and by general overproduction. Adam Smith, in a famous passage in The Wealth of Nations, exploded the first of these myths. Say devoted himself to a refutation of the second. (p. 315)
It is important to point out that in chapter 15, Say does not attempt to explain why the condition he is describing has happened. In other words, the chapter does not contain a business cycle theory itself. Instead, he explains why the scarcity of money or overproduction/under- consumption explanations are fallacious, but in so doing, he also explains a set of conditions that find their way into the ATBC.
The explanation that Say gives is based upon what Sowell (1994, pp. 39–41) writes are the following propositions:
“The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output.”“There is no loss of purchasing power anywhere in the economy.” (In other words, no Keynesian “leakages.”) “People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period.”“Investment is only an internal transfer, not a net reduction, of aggregate demand.”“In real terms, supply equals demand ex ante, since each individual produces only because of, and to the extent of, his demand for other goods.”“A higher rate of savings will cause a higher rate of subsequent growth in aggregate output.”“Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate.” As we shall see, the sixth proposition is important to understanding the ATBC. Not surprisingly, the sixth (and really the last three) propositions are the ones that are disputed among economists in debates about the causes (and “cures”) for problems related to business cycles.
The popular definition of Say’s Law is: Supply creates its own demand. In the next section, I briefly shall point out how critics have misinterpreted that statement, something that is common in economic and popular literature, but in this section I will explain what the phrase actually means.
First, and most important, nowhere in the chapter does Say make the “supply creates its own demand” statement. Instead, he applies economic logic to production and consumption and demonstrates that consumption and production are interrelated, as opposed to being two separate and random activities, as was proposed by economists like Thomas Malthus and later Karl Marx and even John Maynard Keynes.
As Benjamin Anderson (1949) writes in support of this concept:
The prevailing view among economists,...has long been that purchasing power grows out of production. The great producing countries are the great consuming countries. The twentieth-century world consumes vastly more than the eighteenth-century world because it produces vastly more. Supply and demand in the aggregate are thus not merely equal, but they are identical, since every commodity may be looked upon either as supply of its own kind or as demand for other things. But this doctrine is subject to the great qualification that the proportions must be right; that there must be equilibrium. (p. 390; emphasis added)
Second, as Hazlitt notes, the purpose of Say’s chapter is to lay out the logical case that general bouts of “overproduction” or “underconsumption” are impossible. In other words, an economic downturn cannot occur because an economy has produced too much of everything, or that consumers lack the will (Malthus) or the ability (Harrington) to purchase what has been produced. Writes Harrington (1981):
During the 1930s, there was a glut of consumer goods because workers lacked the purchasing power to buy back what they produced. That was why government began to play a role in the economy on behalf of middle- and low-income people during the period of Franklin Delano Roosevelt’s New Deal. (p. 31)
Again, we see in Harrington’s statement the belief that (1) production and consumption are unrelated, and (2) unless enough workers can find the means to “buy back the product,” then the overproduction/ underconsumption problem reappears. Hazlitt (1979), includes a chapter that attacks the “buy back the product” viewpoint, noting that a payment to a worker also is a cost to the employer, which means that the believers in the “buy back the product” view are saying that the way to increase consumption is to increase business costs, which is easily and logically refuted.
One also must keep in mind that Say is not declaring that business downturns or recessions are impossible, something that will be discussed at greater length in the next section. Instead, he simply is attempting to counter the argument that a business downturn is not the result of “general overproduction” of goods within the economy. Furthermore, “Say’s Law” is not a law in the sense of what economists consider a law like the Law of Scarcity, the Law of Demand, the Law of Opportunity Cost, or the Law of Supply. Instead, Say extrapolates the logic found in these other laws to point out the simple fact that production and demand are intricately related, as one cannot consume without someone producing that which is to be consumed, and that the more one produces, the more one can consume.
While not giving a business cycle theory in particular, nonetheless Say does outline some basic parameters from which to build a theory. Furthermore, these parameters are a necessary foundation for the ATBC and for understanding the boom and bust cycle in general (including the present economic troubles that exist at the writing of this article). This will be covered in more detail in the ATBC section, but I include the item here as well.
Say held that business downturns would be proportional in nature, that too many goods in one sector—more than would be able to be consumed, given the preferences and income of consumers—could be produced, at least temporarily, but that there would be a corresponding shortfall in the production of other goods. In other words, business downturns were a matter of proportional “malinvestments” (to use the Austrian term), not overall lack of consumption. As we shall see, this point is crucial to understanding the ATBC.
- CRITICS AND SUPPORTERS OF SAY’S LAW Say was not without his critics then and now. As Sowell (1985) points out, the contemporary critics included Malthus, Sismondi, and Marx. The most important critic of the twentieth century was John Maynard Keynes (1937, 1953), whose “refutation” of Say’s Law will be examined in this section, as Keynes and the modern critics build on the earlier contemporary criticisms.
Sweezy (1947) declares about Keynes and his General Theory:
Historians fifty years from now may record that Keynes’ greatest achievement as the liberation of Anglo-American economics from a tyrannical dogma, and they may even conclude that this was essentially a work of negation unmatched by comparable positive achievements (p. 105).
However, Sweezy strikes a more ominous tone when he says that the “Keynesian attacks, though they appear to be directed against a variety of specific theories, all fall to the ground if the validity of Say’s Law is assumed” (p. 105). Thus, it was important that Keynes and his followers “discredit” Say’s Law.
As Hazlitt (1959) points out, Keynes “refuted” Say’s Law by taking a passage from Mill in which he states that
the means of payment for commodities is simply commodities.... Could we suddenly double the productive powers of the country, we should double the supply of commodities in every in every market; but we should, by the same stroke, double the purchasing power. (Quoted in Hazlitt, 1959, p. 34)
Keynes targets that passage as being false on its face because it allegedly declares that every good produced automatically will find a buyer and, thus, recessions are impossible, writing:
Thus Say’s Law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussion concerning the volume of aggregate employment are futile. (p. 26 )
Harrington also makes a similar statement, declaring, “Say’s Law maintains that if business can produce products, it can sell them. The Great Depression discredited Say’s Law” (p. 31). Thus, the chapter that was written to explain what did not cause business recessions has been turned into something that was not written at all: that classical economists claimed “full employment” always was the norm.
Yet, as Hazlitt points out, Mill (1848, 1919) himself in the next passage explains the context of his previous statement in which he says, “It is probable, indeed, that there would now be a superfluity of certain things” (Hazlitt, 1959, p. 35). Sowell (1974, p. 43) quotes Mill (1844) elsewhere saying that “production is not excessive, but merely ill-assorted.” Likewise, on that same page, Sowell quotes Ricardo who says that “it is at all times the bad adaptation of the commodities produced to the wants of mankind which is the specific evil, and not the abundance of commodities.” Ricardo add, “Men err in their productions (but) there is no deficiency of demand.”
In other words, the same people who recognized and agreed with Say’s logic also recognized that business recessions were a possibility and that they themselves had observed them. As Hazlitt (1959) puts it:
If you had presented the classical economists with “the Keynesian case”—if you had asked them, in other words, what they thought would happen in the event of a fall in the price of commodities, if money wage-rates, as a result of union monopoly protected and insured by law, remained rigid or rising—they would have undoubtedly replied that sufficient markets could not be found for goods produced at such economically unjustified costs of production and that great and prolonged unemployment would result. (p. 36)
Thus, the critics of Say’s Law have claimed that it is absurd on its face, and that it denies something that has been observed many times in history: the business recession. Yet, as those who support Say’s Law might ask, “How could a chapter that acknowledges the presence of a business recession then deny that such a recession actually was taking place?” Indeed, Say’s Law is not about the denial of recessions or even a partial overproduction of goods relative to demand; it is about dealing with the claims that a recession occurs because of a general overproduction of goods.
- HOW SAY’S LAW HELPS FRAME THE ATBC The details of the ATBC are explained in Mises (1912) and Rothbard (1975) and elsewhere and will not be expounded here. However, because this article relates Say’s Law directly to the ATBC, Rothbard’s explanation about the economic crisis being one of proportionality is vital to understanding the relationship.
In explaining how the boom-and-bust of the business cycle occurs, Rothbard writes that the problem is in what Austrian economists call the “cluster of errors” by entrepreneurs and business owners:
The explanation of depressions, then, will not be found by referring to specific or even general business fluctuations per se. The main problem that a theory of depression must explain is: why is there a sudden general cluster of business errors? This is the first question for any cycle theory. Business activity moves along nicely with most business firms making handsome profits. Suddenly, without warning, conditions change and the bulk of business firms are experiencing losses; they are suddenly revealed to have made grievous errors in forecasting. (p. 16)
The widest fluctuations, Rothbard notes, are not in the consumer goods industries, but rather in capital or producers’ goods. In other words, the downturn does not begin by consumers suddenly deciding to purchase fewer goods, but rather because economic conditions in certain industries suddenly turn sour.
Rothbard goes on to say that in a normal, free-market economy, there will be no cluster of errors by entrepreneurs, but rather that those errors will be distributed on a more random basis. However, the combination of fractional reserve banking and aggressive efforts by the central bank to expand the supply of money in the economy will distort the structure of production. Rothbard first points out that if people change their time preferences by consuming less in the present so they can consume more in the future, then the addition of savings they add to the system will signal entrepreneurs to lengthen the structure of production and invest in capital goods as opposed to consumer goods, which appeal to people who prefer to spend their resources at the present time.
However, he points out that if the money that is directed toward the capital goods sectors comes because governments and their banking allies expand credit without a similar expansion of real savings, then problems begin:
Now what happens when banks print new money (whether as bank notes or bank deposits) and lend it to business? The new money pours forth on the loan market and lowers the loan rate of interest. It looks as if the supply of saved funds for investment has increased, for the effect is the same: the supply of funds for investment apparently increases, and the interest rate is lowered. Businessmen, in short, are misled by the bank inflation into believing that the supply of saved funds is greater than it really is. (p. 18; emphasis Rothbard’s)
From there, the dislocations begin as investments are poured into lines of production that cannot be sustained. The new “investments” alter the structure of production into a direction and scope that will not reflect the actual desires and spending patterns of consumers. Rothbard adds:
people will rush to reestablish the old proportions, and demand will shift back from the higher to the lower orders. Capital goods industries will find that their investments have been in error: that what they thought profitable really fails for lack of demand by their entrepreneurial customers. Higher orders of production have turned out to be wasteful, and the malinvestment must be liquidated.
A favorite explanation of the crisis is that it stems from “underconsumption”—from a failure of consumer demand for goods at prices that could be profitable. But this runs contrary to the commonly known fact that it is capital goods, and not consumer goods, industries that really suffer in a depression. The failure is one of entrepreneurial demand for the higher order goods, and this in turn is caused by the shift of demand back to the old proportions. (pp. 18–19; emphasis Rothbard’s)
Rothbard continues:
The “boom,” then, is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit’s tampering with the free market. The “crisis” arrives when the consumers come to reestablish their desired proportions. The “depression” is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments. Some of these will be abandoned altogether (like the Western ghost towns constructed in the boom of 1816–1818 and deserted during the Panic of 1819); others will be shifted to other uses. (p. 19; emphasis Rothbard’s)
In other words, the problem with the economy is one of incorrect proportions of production, as opposed to being a general fall in consumption. This point is vital to understanding not only the ATBC, but also understanding how Say’s Law helps lay the foundations of that theory. Sowell (1985) writes:
Long before Engels and Marx came upon the scene, economists had divided into two main groups—(1) those who explained depressions by inadequate demand (the “general glut” theorists, let by Sismondi and Malthus) and (2) those who insisted that depressions were caused by internal disproportionalities in the composition of aggregate output—too much of A and too little of B—rather than by its total being excessive relative to aggregate demand. (pp. 92–93)
In speaking of proportionality, Say writes:
But it may be asked...how does it happen, that there is at times so great a glut of commodities in the market, and so much difficulty in finding vent for them? Why cannot one of the superabundant commodities be exchanged for another? I answer that the glut of a particular commodity arises from its having outrun the total demand for it in one or two ways; either because it has been produced in excessive abundance, or because the production of other commodities has fallen short.
It is because the production of some commodities has declined, that other commodities are superabundant. (p. 135; emphasis added)
To put it another way, the relative proportions are incorrect. If one accepts this proposition (as opposed to holding to an “underconsumption” theory), then the critical question is this: Why are the economic fundamentals out of kilter?
The reason, as outlined by Garrison (1984), is that the growth of new money also changes the relative prices within a structure of production. Classical, as well as Austrian, economists believed that while money served as a medium of exchange, nonetheless the real economy, that is, the relationships between real goods, was key to understanding what was occurring. For example, a barrel of oil and a meal at a good restaurant might both cost $50. While the prices are denominated in dollars, they are equal in real terms, at least in barter.
Yet, these relationships can change under certain circumstances. Assume that consumer preferences change over the long term and people are wishing to use more oil, thus making oil twice as valuable as a restaurant meal. Economically speaking, while it means there will be adjustments in the economy due to this change in preferences, but it does not cause dislocations. It is just that in real terms oil now is twice as valuable to consumers relative to meals at good restaurants, and consumer choices will adjust accordingly, as entrepreneurs will recognize the consumers’ change in preferences and direct more resources toward oil.
However, if there is a bout of inflation, the relationships also will change, but in a very different way. The typical classroom model that tracks changes in the money supply is MV = PY, where M equals the stock of money, V is its “velocity,” or how quickly it is dispersed through the economy, P is the “price level,” or a weighted average of all consumer prices, and Y is national “output.” If M were to double but V and Y remain unchanged, then P also would double.
Although this is a convenient model to show to students, nonetheless it does not accurately demonstrate what occurs during a period of inflation. Prices of consumer and producer goods do not rise equally in tandem; instead, inflation, which really is a situation in which the value of the marginal unit of money decreases relative to real goods, as pointed out by Mises (1912) and Rothbard (1993). This simple but important point often is missed by many mainstream economists who insist on defining inflation as a rise in a constructed and stylized average of consumer prices. (The government also has a Producer Price Index, but this, too, is a weighted average of selected prices, except they are prices for factors of production, not consumer goods.)
Although these statistics might provide interesting fodder for discussion, they do not explain what happens during an inflationary period. Prices for goods indeed rise, but they rise in a manner in which the relative prices change even though consumer preferences do not do likewise. For example, when money loses its value after its stock is expanded, the prices of commodities like oil and gold (and other such goods that are publicly traded in commodity exchanges) increase more quickly than do prices of services and some consumer items, not to mention labor prices, which often are set via contracts or other longer-term agreements.
This is not the only problem. As Rothbard earlier explained, the mechanism of injecting new money into the economy—the banking loan process—brings two dislocation problems. First, if central banking authorities hold interest rates below levels where they would naturally be due to the demand for and supply of loanable funds, then this process will favor producers’ goods over consumer goods, changing that relationship even if consumer preferences have not changed. Second, when the new money spreads throughout the economy, it reduces the value of money, further changing relative prices of goods.
Only someone who understands how such action disturbs the real relationships of goods to one another can understand why central-bank led booms are unsustainable. At some point, the relationships of goods in an economy undergoing such injections of credit become dysfunctional and break down on their own. Economists who insist on defining inflation as a situation in which all prices rise in tandem are not going to see how increases in the supply of money via government-sponsored bank credit injections can distort the inner workings of an economy.
Indeed, that is one of the things that separates the two groups of economists as outlined above by Sowell. Economists who believe that economic recessions are caused by a sudden fall in aggregate expenditures also are going to believe that a new injection of bank credit and government spending will set matters right. However, economists who agree with Say and the Austrians that booms disturb the fundamental proportions of goods within an economy also will recognize that government policies—and especially the kind advocated by Keynes and his followers—will cause further distortions, thus making the economic downturn even worse.
It is true that Say did not give reasons as to the cause of the disproportionalities (Rothbard writes that David Ricardo developed a prototype for what would be the ATBC), and it would be a century later before Mises formally developed a theory that encompassed not only the reasons for the distortions, but also explained how the central bank usually was the originator of the crisis. However, it is clear that he and his supporters were on the right track.
- CONCLUSION Say’s Law, often misunderstood and certainly wrongly vilified, is an important part of the ATBC. This “law” is not sufficient, but it is necessary for the ATBC to be true. Despite the fact that the ATBC is an intricate and sophisticated economics theory (as opposed to the more crude notions of “aggregate demand” and “aggregate supply” that currently are in vogue), at its heart is the simple fact that monetary intervention by government authorities ultimately distorts the relationships of economic fundamentals and throws the economy out of balance.
This is why Austrians say that a recession is a necessary part of restoring the “proper” economic relationships that are seen in the fundamentals of the economy, with both consumer goods and the factors of production. Say’s Law provides the ATBC with a crucial reminder that there cannot be a recession without the fundamental economic relationships within an economy first being disturbed.
It is unfortunate that economists continue to misrepresent and even vilify Say’s Law. At its most simple point, it is an economic tautology: one cannot consume without first producing, and what one produces becomes a basis for determining what one consumes. Say did not “discover” this fact, but he highlighted it, and two centuries later, Say’s Law is as applicable as it was when Treatise first appeared in print.
I would like to thank Joe Salerno for his kind invitation to present the Ludwig von Mises lecture for 2010, in this way giving me the opportunity to present these views on the classical theory of the cycle and Say’s Law to a wider audience. I would also like to thank my good friend, Peter Smith, who provided excellent and sympathetic advice on an earlier draft of this paper.
Ludwig von Mises LectureAustrian Scholars ConferenceLudwig von Mises InstituteAuburn, AlabamaMarch 13, 2010
It is a great honor for me to have been asked to present the Ludwig von Mises lecture here at the Austrian Scholars Conference.
Let me begin with a story. When I came to select my list of the ten most influential economists of the twentieth century in an article published in the Canberra Times on December 1999, an article which can still be found on the Societies for the History of Economics website, the economist I chose as the most influential—not the best nor the greatest, mind you, but as the most influential—was John Maynard Keynes. No one, I regret to say, has had more influence than Keynes.
Then, second on my list, was Friedrich Hayek, placed there because of his recognized relevance for the economies of Eastern Europe that were then emerging from beneath the horrors of their communist regimes.
But third was Ludwig von Mises, who might have just as easily been second, about whom I wrote these words:
Ludwig von Mises took the fight up to the socialist dogmas of the early twentieth century and showed on paper that no economy could ever solve the problem of allocating resources without a price mechanism, free markets and private property. Who doesn’t know it now? He knew it eighty years ago.
Ludwig von Mises is an economist for whom I have had the greatest imaginable regard which is why having been given this opportunity to speak to you today means as much to me as it does.
And in beginning this address, I would like to mention something that Mises and I have in common. He had been for twenty-four years the economist for the Austrian Chamber of Commerce. Well, as it happens, I had myself been, also for twenty-four years, the economist for the Australian Chamber of Commerce.
And while to some extent this is mere coincidence, I believe that for both of us, as the economic representative of the business communities in both of our countries, even though more than two generations apart, it was this experience that allowed us to understand the workings of an economy with certain kinds of insights that may generally not be appreciated by others.
But it was one aspect of my work that ended up having an immensely large impact on my life, and that is the discovery of Say’s Law for myself. It is because I reinvented this principle that I believe I understand it so well.
And what happened was this. As part of the way in which the Australian economy is managed, we have what was once known as the National Wage Case. It is a court case in front of a panel of industrial relations judges who at the time determined the level of wages for something like ninety percent of the working population.
And as part of the union claim for higher wages, it was always argued that increased incomes would be good for the economy because it would increase demand. I would counter this by pointing out how useless it would be for businesses to find their revenues increased through first increasing their costs by an equivalent amount. And then, a year after I had formulated this argument, I came across the identical argument in a passage in an essay by John Stuart Mill, published as long ago as 1844. This is what Mill wrote:
The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained.... It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasonings of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves … that the man who steals money out of a shop, provided he expends it all again at the same shop, is a benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman’s fortune. (Mill, 1874 [1974])
Although it would be years before I would work this out, what Mill wrote is based on a proper understanding of Say’s Law. High levels of public spending do not encourage industry. Spending does not of itself create growth and employment. You cannot make an economy prosper through expenditure but only through value adding production. Demand does not drive an economy forward, nor does demand deficiency cause recessions.
It was this most fundamental of all economic propositions that Keynes deliberately and willfully destroyed. Say’s Law has, for all practical purposes, now disappeared from economic discourse and policy. And until it returns, the ability for the economics profession to provide sound and sensible advice during recession will remain sharply constrained. But to understand what Say’s Law means one must first understand the role Say’s Law played in the Keynesian Revolution.
UNDERSTANDING THE KEYNESIAN REVOLUTION The Keynesian Revolution, and therefore the origins of virtually all macroeconomic theory today, can only be understood in relation to Keynes’ coming across Malthus’ economic writings in 1932. In particular, it was his reading of the Malthus side of the Malthus-Ricardo correspondence, which had been unearthed in 1930 by his close associate Piero Sraffa, that turned Keynes’ mind to the possibility of demand deficiency as a cause of recession. Until that time, economists had been near unanimous in arguing that insufficient demand as a cause of recession was fallacious.
There has been universal recognition amongst historians of thought that something does happen in late 1932 to turn Keynes in a new direction. Yet not one of the works devoted either to understanding the nature of the Keynesian revolution nor to examining the road between the Treatise on Money published in 1930 and the General Theory published in 1936, has suggested that the reason for this change in direction occurs specifically because Keynes was at that time updating his essay on Malthus.Keynes was at the time completing the essay for inclusion in his Essays in Biography which would be published the following year. Indeed, there is no reason given of any kind why at that particular moment Keynes came to the conclusion that demand deficiency was the missing link in the theory of the cycle. Yet it is as close to a certainty as one can have in such reconstructions that Keynes would never have written the General Theory as he did, focusing on demand deficiency, had he not become deeply interested at the end of 1932 in Malthus’ economic writings. It was Malthus, of course, who had been the leading advocate in the nineteenth century of demand deficiency as a cause of recession and of increased levels of unproductive spending as the cure. Reading Malthus’ letters to Ricardo, and then the text of Chapter VII of Malthus’ Principles, ought to be recognized as the single most important reason why Keynes was to write what he wrote in the way he did.
Recognizing that this was the inspiration should make it easier to understand what the intent of the General Theory was and to understand the nature of the change in economic theory that occurs as a result. In the General Theory Keynes is very clear about what he has learned from reading Malthus.
The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from the economic literature. (Keynes, 1936, p. 32, emphasis added.)
It was the “great puzzle of Effective Demand” that Malthus had been wrestling with which had disappeared and it was this that Keynes was intent on restoring to economic theory.
Nor was Keynes wrong on the implications of Say’s Law to his contemporaries. It was precisely this issue that is the dividing line between pre-Keynesian economics and the economics that has dominated theory ever since. Mainstream economists before 1936 had actively denied any role for aggregate demand in understanding the business cycle. Although there had been some attempts to overturn the law of markets, demand deficiency as an explanation for recession was until then almost entirely the province of cranks.Keynes discussed a number of these in the General Theory, referring to them as his “brave army of heretics” (Keynes, 1936, p. 371), a band of brothers that included Bernard Mandeville, Malthus, Major Douglas, Silvio Gesell and J.A. Hobson. The two most important diagrammatic innovations of the 1930s were the IS-LM curves published by Hicks in 1937 and the Keynesian cross diagram first published by Paul Samuelson in 1939 (see Schneider 2010). Both were developed in response to Keynes’ General Theory, and both feature in economics texts to this day.
The problem of recession as conceived in the General Theory was that an economy, once it has passed a certain level of production, will run out of demands for the goods and services it produces.
This is not excess supply for individual goods and services, the “particular glut” whose existence no one had ever denied, but an actual excess supply of all goods taken together, that is, a “general glut.” Keynes made the possibility of demand failure the culminating point at the end of the introductory chapters of the General Theory.
The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. (Keynes, 1936, p. 33)
The possibility of a failure of effective demand is the very point behind the Keynesian-cross diagram, IS-LM curves or the AD-AS relationship. It is taught to undergraduate economists worldwide, and is embedded almost universally in our present policies designed to pull economies out of recession. And while other possible explanations for recession are now usually discussed as well, demand failure remains the single most important concept most economists are taught in relation to the causes of recession and involuntary unemployment. It is the argument that recessions can best be understood as occurring because of a fall in aggregate demand that continues to mark economic theory to this day, along with the implication that stimulating demand through deficit spending is the optimal approach to take in dealing with recessions when and where they occur.
Aggregate demand is intrinsic to the modern understanding of the level of economic activity. The implication is that it is the level of aggregate demand that is responsible for the level of output, the rate of economic growth and the number of persons employed. An insufficient level of aggregate demand is held generally responsible for high levels of unemployment and it is almost universally accepted that deficit financed public spending can permanently raise the level of output and thereby lower the rate of unemployment. There is an aggregate supply curve associated with aggregate demand, but its principal role is the determination of the rate of inflation. Production levels are not determined by supply capabilities but by the willingness of individuals to buy what has been produced with the incomes they have received.
Indeed, the issue went farther than this. Keynes argued that if Say’s Law were valid, continuing and persistent unemployment simply could not occur and this was unrecognized by classical economists whom he was about to correct. As he wrote:
Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile. (Keynes, 1936, p. 26, emphasis added.)
For the vast majority of the economics profession even now, this is the way in which Say’s Law and its implications are understood. It is the very meaning of the Keynesian Revolution. Mises made the same point in 1950:
Lord Keynes’s main contribution did not lie in the development of new ideas but “in escaping from the old ones,” as he himself declared at the end of the Preface to his “General Theory.” The Keynesians tell us that his immortal achievement consists in the entire refutation of what has come to be known as Say’s Law of Markets. The rejection of this law, they declare, is the gist of all Keynes’s teachings; all other propositions of his doctrine follow with logical necessity from this fundamental insight and must collapse if the futility of his attack on Say’s Law can be demonstrated. (Mises, 1950 [1980])
It is precisely here that we find the division between the economics of the classics and virtually all modern economic theory, especially of the mainstream variety. As was recognized at the time, and as Mises clearly notes, Keynesian economics, that is all of modern macroeconomics with its focus on aggregate demand, must collapse if the attack on Say’s Law turns out to be wrong.
It is only to be regretted that Mises did not recognize how singularly important it was to hammer home this point. He treated Say’s Law as so obviously valid, beyond any possibility of argument, that I suspect he found it impossible to understand how anyone who called themselves an economist could accept Keynesian theory. All he ever directly wrote on Say’s Law he contained in a brief article in a collection of essays. But as for the validity of Say’s Law, he could not have been more clear:
The exuberant epithets which these admirers have bestowed upon his work cannot obscure the fact that Keynes did not refute Say’s Law. He rejected it emotionally, but he did not advance a single tenable argument to invalidate its rationale. (Mises, 1950 [1980])
Mises accepted Say’s Law as unquestionably valid, as part of the “perennial laws” of economics. But because he found rejection of Say’s Law inconceivable he did not do what he might otherwise have done, which was to explain why it must remain an integral part of the bedrock foundation of economic theory if that theory is to provide us with the guidance needed when recessions and high unemployment occur.
UNDERSTANDING SAY’S LAW—MALTHUS AND THE “GENERAL GLUT” DEBATE What is relevant about Say’s Law cannot be contained within a single statement. Say’s Law, if it is to be understood in full, must be understood as a series of related propositions which when taken together constitute the basic ingredients of the classical theory of the cycle. The most extraordinary of the many ironies that have surrounded this issue since Keynes first pronounced on it in 1936 is that Say’s Law was the foundation stone within classical theory for understanding why a cycle exists at all. Keynes’ argument was that belief in Say’s Law meant that classical economists assumed there was never at any stage an obstacle to full employment. The reality is that Say’s Law was an integral part of the explanation of why in fact unemployment actually occurred.
Keynes, in attacking “Say’s Law” in 1936 was not attacking some one-sentence statement of principle. In attacking Say’s Law, he was attacking the entire classical theory of the cycle. Unless this is understood, it is impossible to understand in full exactly what Keynes was able to do. The propositions associated with Say’s Law need to be seen as the constituent elements of the classical theory of the cycle and to understand why this was so, it is necessary to enter into some of the early history of economic theory itself.
What became the classical theory of the cycle was formed during what is now known as the “General Glut” debate that lasted from the publication of Malthus’ Principles of Political Economy in 1820 through until John Stuart Mill published his own Principles of Political Economy in 1848. Malthus was, in 1820, the single most famous economist in the world. His 1798 publication, On Population, had been an international sensation. As a result, when he published his text on economic theory, it was not just another text but a work that would instantly attract the widest attention.As an interesting parallel, Keynes, too, was the most famous economist of his time after having written his Economic Consequences of the Peace at the end of World War I. It had also been a worldwide sensation in its time.
What in particular distinguished Malthus’ arguments from virtually all other writings on economic issues at the time was his belief that the recessions experienced by England at the end of the Napoleonic Wars had been caused by oversaving and demand deficiency. And so a debate was commenced across the whole of the economics community of the time, with a raft of books on economic theory published over the next few years in which much of the argument centered on a discussion of what Malthus had written. All agreed it was possible to have an excess supply of individual goods and services. The question was whether there could be an excess supply of all goods and services taken together.
Importantly, it was not a debate over whether recessions and large-scale unemployment were possible. On this there was obviously unanimity. The only question was whether recessions, when they occurred, were the result of too much saving and too little effective demand. That this could never be a realistic explanation was ultimately accepted by the whole of the mainstream of the economics community.
Moreover, during classical times there was no economic principle known as “Say’s Law.” The term would not be coined until the twentieth century or enter economic discourse until the 1920s (see Kates, 1998, pp. 148–149). There was Jean-Baptiste Say’s théorie des débouchés, known in English as the “law of markets,” which stated that demand was constituted by supply. It was the law of markets that was employed as part of the response to Malthus’ views but as only one strand in a far more complex series of counter arguments. It was a crucially important part of the argument, but it was only one of the arguments in a longer chain of reasoning. It was the entire set of counter arguments that when taken together became the related propositions that formed the classical theory of the cycle. Leaving Say’s Law in Keynes’ desiccated form of words—“supply creates its own demand”—not only reverses the point that classical economists had tried to make—that demand in real terms can only be derived through the production of value adding goods and services—but ignores every other related aspect that was central to an understanding of the classical theory of the cycle.
By discrediting the crucially central idea that demand is formed on the supply side of the economy, the related propositions that had emerged from the debate over Malthus lost their coherence. The publication of the General Theory caused the entire classical perspective on the business cycle to disappear. The propositions presented below are therefore intended to reassemble the arguments that were at the core of pre-Keynesian business cycle theory and need to be seen as the full meaning of Say’s Law as it emerged during the General Glut debate.For historical accuracy I will note that these arguments had been first brought together by James Mill in 1808 where he, too, specifically invoked the théorie des debouches to explain why demand deficiency is a fallacious explanation for recession. It is for this reason that in my view James Mill had been the first to properly state “Say’s Law” (see Kates, 1998, pp. 24–29). They are also put in a form so that the entire argument can be seen as a full and complete response not just to Keynes and the arguments of the General Theory, but also as a reply to modern macroeconomics to the extent that it continues to rely on demand deficiency to explain why recessions occur.
THE RELATED PROPOSITIONS OF SAY’S LAW The related propositions that make up Say’s Law are discussed below, along with concrete examples from the pre-Keynesian literature to demonstrate their importance as integral components of classical thought.
Proposition 1: Recessions are never due to demand deficiency. An economy can never produce more than its members would be willing or able to buy. A general glut (i.e. general overproduction) is impossible. Neither high levels of saving nor the redirection of resources into higher levels of capital formation cause recessions to occur.
This is the starting point for any understanding of the pre-Keynesian theory of recession and Say’s Law. Four examples of how this statement was an integral part of economic theory across the entire classical period will help put the law of markets into its proper context.
First Adam Smith. He specifically denies that there is any danger from oversaving and that a community has anything to fear from the saving of its more provident members. It was this argument that Keynes specifically set out to deny.
What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people. That portion of his revenue which a rich man annually spends, is in most cases consumed by idle guests, and menial servants, who leave nothing behind them in return for their consumption. That portion which he annually saves, as for the sake of the profit it is immediately employed as a capital, is consumed in the same manner, and nearly in the same time too, but by a different set of people, by laborers, manufacturers, and artificers, who reproduce with a profit the value of their annual consumption. His revenue we shall suppose, is paid him in money. Had he spent the whole, the food, clothing, and lodging, which the whole could have purchased, would have been distributed among the former set of people. By saving a part of it, as that part is for the sake of profit immediately employed as capital either by himself or by some other person, the food, clothing and lodging, which may be purchased with it, are necessarily reserved for the latter. The consumption is the same, but the consumers are different. (Smith, 1776 [1976], p. 359)
A second example is Alfred Marshall writing in a publication co-authored with his wife, Mary Paley Marshall, in 1879. Here it is made abundantly clear that deficient aggregate demand is not the proper explanation for depression.
After every crisis, in every period of commercial depression, it is said that supply is in excess of demand. Of course there may easily be an excessive supply of some particular commodities; so much cloth and furniture and cutlery may have been made that they cannot be sold at a remunerative price. But something more than this is meant. For after a crisis the ware-houses are overstocked with goods in almost every important trade; scarcely any trade can continue undiminished production so as to afford a good rate of profits to capital and a good rate of wages to labour. And it is thought that this state of things is one of general over-production. We shall however find that it really is nothing but a state of commercial disorganisation. (Marshall and Marshall, 1879 [1881], p. 154)
And lest it be thought that this is the early Alfred Marshall which was later subsumed by a different point of view, in a section introduced into the fifth edition of the Principles in 1907 he emphatically made the point again. Note that problems on the demand side are seen only to exacerbate a problem that has been due to other causes.
It is true that in times of depression the disorganization of consumption is a contributory cause to the continuance of the disorganization of credit and of production. But a remedy is not to be got by a study of consumption, as has been alleged by some hasty writers. (Marshall, 1907 [1961], p. 711n)
Finally, Friedrich Hayek. His 1931 article, “The ‘Paradox’ of Saving,” is a full-scale discussion, more than 40 pages in length, on the arguments of Catchings and Foster who during the 1920s and 1930s had argued that over-saving was the cause of recessions. Hayek’s opening paragraph is not only an attack on the belief that excess saving is a cause of recession, but he also specifically refers to the théorie des débouchés as providing the appropriate position. And while Hayek had his own theory of the cycle, the article is not in the least dependent on such views. It is nothing other than a straightforward statement of the classical position. Hayek wrote:
The assertion that saving renders the purchasing power of the consumer insufficient to take up the volume of current production although made more often by members of the lay public than by professional economists, is almost as old as the science of political economy itself. The question of the utility of ‘unproductive’ expenditure was first raised by the Mercantilists, who were thinking chiefly of luxury expenditure. The idea recurs in those writings of Lauderdale and Malthus which gave rise to the celebrated Théorie des Débouchés of James Mill and J.B. Say, and in spite of many attempts to refute it, permeates the main doctrines of socialist economics right up to Tugan-Baranovsky, Thorstein Veblen and J.A. Hobson. But while in this way the idea has found a greater popularity in quasi-scientific and propagandist literature than perhaps any other economic doctrine hitherto, fortunately it has not succeeded as yet in depriving saving of its general respectability. (Hayek, 1931, pp. 74–75, bolding added)
It is highly noteworthy that it was only five years later that the General Theory would in fact do what Hayek had feared, and “deprive saving of its general respectability.”The existence of this critique of Catchings and Foster may also help explain why Hayek, having invested the time and effort in dealing with their arguments, almost completely ignored Keynes’ attempt to achieve the same result. By the time Keynes wrote, Hayek may well have found trying to explain the fallacies in such reasoning completely stale. To have bothered responding to Keynes in the detail required would have for him involved going over old ground.
Proposition 2: Demand is constituted by supply. Aggregate demand is not independent of aggregate production but is identical with it. A community’s purchasing power is constituted by its value added. Aggregate demand can only increase when the value of the goods and services produced is greater than the value of the inputs used up in the production process.
This proposition is a restatement of Jean-Baptiste Say’s original théorie des debouches, wrongly characterized by Keynes as “supply creates its own demand.” Moreover, the statement that “demand is constituted by supply” may be the most important concept in coming to grips with the classical theory of the cycle, but because it is so foreign to modern macroeconomic thought, it may also be the most difficult. Yet it was fully accepted by pre-Keynesian economists.
Here is James Mill, in the first presentation of what would become the classical theory of the cycle, explaining the significance of this principle. He could not be more emphatic nor does he leave any doubt about just how crucial he believes this principle to be.
No proposition however in political economy seems to be more certain than this which I am going to announce, how paradoxical soever it may at first sight appear; and if it is true, none undoubtedly can be deemed of more importance. The production of commodities creates, and is the one universal cause which creates a market for the commodities produced. (Mill, 1808 [1966], p. 135)
Moving forward a century, the same concept is found in the following passage from one of the most widely used economic texts ever published, in which this principle is stated in very clear terms:
It is only because our exchanges are made through money that we have any difficulty in perceiving that an increase in supply is (not “causes”) an increase in demand…. An increase in the supply of cloth is an increase in the demand for other things; and vice versa, an increase in the supply of anything else may constitute a demand for cloth. What is divided among the members of society is the goods and services produced to satisfy its wants; and the same goods and services are both Supply and Demand. (Clay, 1916, p. 242)
The notion of aggregate demand separate from aggregate supply was foreign to pre-Keynesian economic thought. Aggregate demand grows at the same rate and by the same amount as aggregate supply, and will not grow unless supply has grown. It is not, however, just any production that will lead to an increase in aggregate demand. What creates demand is the production of forms of output for which enough buyers can be found to cover in aggregate the entire costs of production. Only if the goods and services produced can be sold for more than was paid for the inputs that went into their production can it be said with certainty that value has been added during the production process. Conversely, if the goods and services produced do not create more value than is used up in the production process, there can be no increase in aggregate demand because there has been no increase in aggregate supply in any relevant sense.
Proposition 3: The process involved in purchase and sale is the conversion of one’s own goods or services into money and then the re-conversion of the money one has received back into other goods and services. There is no implication of a barter economy. Money is intrinsic to the processes involved.
At the very core of the classical propositions surrounding Say’s Law is an appreciation that money is infused with value only by being received in exchange for value adding production. The process is one that may be characterized in the formula C–M–C’ where the set of goods or services in one’s own possession (C) is converted into a different set of goods or services (C’) by the sale of what one owns for money (M) and then the reconversion of the money received into what one wishes to buy.This is the formula used by Marx to explain the classical mechanisms associatedwith the law of markets but was used by him as a criticism. Keynes had accused classical economists of confusing a barter economy with the operation of a money economy, but from the first statements on Say’s Law by Say himself that had never been the case. Here is J.B. Say, in the fourth edition of his Treatise,It is the fourth edition that has been the one translated into English because that was the latest edition available when Malthus published his Principles in 1820. There would be a fifth edition in French that has not been translated. trying to explain the obvious.
Should a tradesman say, “I do not want other products for my woollens, I want money,” there could be little difficulty in convincing him that his customers could not pay him in money, without having first procured it by the sale of some other commodities of their own. … You say, you only want money; I say, you want other commodities, and not money…. To say that sales are dull, owing to the scarcity of money, is to mistake the means for the cause; an error that proceeds from the circumstance, that almost all produce is in the first instance exchanged for money, before it is ultimately converted into other produce. (Say, 1821, pp. 163–165)
But more importantly, the process lay in ensuring that those who produced made sure that they created value in the process. Demand was only constituted by the value added that arose from the sale of goods or services to others. If output could not be sold at prices that repaid the costs of production, then no value added had occurred. That this frequently did take place provided the core insight into the classical theory of the cycle. That demand was built on productive activities was also pointed out by Mises, who was explicitly following Say in making this point:
Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities. (Mises, 1950 [1980])
To understand demand being constituted by supply, it is necessary to recognize that in a properly functioning economy, purchases are effected with the revenue from the previous sale of goods and services or with money borrowed from others who have earned incomes by producing. For those who earned their incomes from the sale of goods and services, the process is direct. The creation of value and the sale of what had been produced provided the income for the purchase of other goods and services. For businesses investing borrowed funds, the purchases are effected through the transfer of funds through a saving-investment process. For governments, purchases are effected through revenues raised through taxation of the incomes of those who had sold goods or services to the market.
Proposition 4: Recessions are common and result in high levels of involuntary unemployment.
It really ought to be unnecessary to point out that this proposition ought to be completely non-controversial. It really ought to have been inconceivable to have suggested, as Keynes did in 1936, that economists until then had had no explicit theory of involuntary unemployment and recession. Yet one of the consequences of the publication of the General Theory was the belief that classical economists had no theories to account for recessions and involuntary unemployment. It is therefore necessary to make the explicit statement that classical economists did indeed have such theories of recession and they most assuredly did understand that involuntary unemployment was a frequent feature of economic life. The theory of the business cycle had been developing for over a century by that stage, so that for Keynes to have stated of his fellow economists that they had no theory of involuntary unemployment was absurd.
A compendium of all of the theories of the cycle is found in a League of Nations publication by Gottfried Haberler, titled Prosperity and Depression whose first edition was published in 1937, the year following the publication of the General Theory. The first words of the preface ought to make it absolutely plain that recession and unemployment were amongst the most important questions under examination by the economics community of the world during the 1930s, and had been for generations:
This book has its origin in a resolution adopted by the Assembly of the League of Nations in September 1930 by which it was decided that an attempt should be made to co-ordinate the analytical work then being done on the problem of the recurrence of periods of economic depression. The literature concerning economic depressions and what is currently and somewhat loosely described as the trade cycle is abundant…. It is apparent from the persistence with which depressions occur, from the gravity of their economic and social effects, and from the growing consciousness of that gravity, that – however abundant the literature on the subject, however elaborate and specious the theories – our knowledge of the causes of depressions has not yet reached a stage at which measures can be designed to avert them. (Haberler, 1937, p. iii)
That what ought to have been seen as absurdly improbable was nevertheless accepted from the moment it was first published is an issue that demands the attention of historians of ideas. Here we merely note that Keynes’ statement, that economists before him had no theories to explain recessions and unemployment, is false as a moment’s reflection ought to have led anyone to recognize at the time, just as it ought to be recognized today.
Proposition 5: Recessions are due to structural problems of one kind or another. In particular, recessions occur where the structure of supply does not match the structure of demand. Recessions occur when the pattern of demand is different from the actual composition of output so that a significant proportion of the goods and services put up for sale remains unsold.
For anyone basing their understanding of these issues on Keynes’ writings, it is something of a surprise to discover that the law of markets was at the very centre of the classical theory of the recession and, in fact, provided the foundation for the theory of the cycle as understood by classical economists. Because demand was constituted by supply, cyclical activity was understood to be the result of individuals and businesses producing what could not be sold at prices which covered costs. Why this might happen was the underlying issue, but that it frequently did happen, of this no one had the slightest doubt. The more than one hundred year classical literature on the nature and causes of the business cycle is a testament to the recognition that pre-Keynesian economists gave to unemployment and recession.
Torrens, writing in 1821 in a direct response to the arguments presented by Malthus, makes the point as explicitly as it is possible to make it. The classical theory of the cycle was built on these very concepts. Demand is constituted by supply but only so long as supply consists of what those with incomes to spend want to buy. Keeping demand and supply properly proportioned was the imperative, but once that had been achieved all went well. It was when the proportions were not maintained that recessions would occur. Torrens firstly notes that there is no possibility that supply will ever outrun demand.
So long as the proportion is preserved, every article which the industrious classes have the will and power to produce, will find a ready and profitable vend. No conceivable increase of production can lead to an overstocking of the market…. Increased production will create a proportionally increased demand [sound familiar?] …. (Torrens, 1821 [1965], pp. 370–372)
What is particularly notable is that Torrens uses almost the very words Keynes would use to summarize Say’s Law. “Increased production will create a proportionately increased demand” is the lineal ancestor of “supply creates its own demand.” Torrens is invoking Say’s law of markets to show that demand deficiency is never a problem. But he does not conclude from this that economies cannot therefore go into recession or that there are no obstacles to full employment. He instead uses this very principle to explain why recessions occur. Following on from the above passage, Torrens immediately sets out the consequences should something happen to disturb the balance between the structure of production and the structure of demand.
This happy and prosperous state of things is immediately interrupted when the proportions in which commodities are produced are such as to disturb the equality between effectual demand and supply…. Then gluts and regorgements are experienced. (Torrens, 1821 [1965], pp. 370–372)
Torrens was not the first to make this point, but he made it very well. A lack of proportion between supply and demand is the cause of a descent into recession. The problems of recession are due to structural problems in an economy, not because of a failure of demand. And it required an understanding of the law of markets to understand that recessions occur when what has been produced does not coincide with what those with incomes want to buy.
In these passages, Torrens captured the theory that became during the following century the common ground amongst the economics community in discussing the business cycle. Recessions and depressions were due to structural problems. Haberler, in his Prosperity and Depression, provided a synopsis of the theory of the cycle as it had been understood until then. In summarizing the views of the economic profession of his time, he wrote:
An expansion or contraction may be interrupted on the one hand by an accident…or it may on the other hand itself give rise to maladjustments in the economic system…. Most cycle theorists have tried to prove that the second type of restraining force is all-important. (Haberler, 1937, p. 245)
This is Torrens once again. It is this maladjustment in the structure of production, where demand and supply are out of proportion with each other, that was the fundamental explanation for recession. Demand deficiency played no part in the process within orthodox theory.There was, however, an under-consumptionist literature which argued that too little demand from consumers was the systematic cause of economic recession. This was at the time almost entirely the province of economic cranks, as Keynes’ reference to the “brave army of heretics” plainly shows. Hobson was seen as the leading exponent of this view as both Keynes (Keynes, 1936, pp. 364–370) and Haberler (1937, p. 115) make clear.
Where demand was crucial was in relation to the structure of demand relative to supply, that is, in situations where what buyers would have been willing to pay the full costs of production for did not match what suppliers had actually put on the market. Starting from the proposition that demand is constituted by properly proportioned supply, recessions are caused by events that mislead producers into producing goods and services that cannot be sold at cost covering prices.
Proposition 6: Partial overproduction of individual goods and services occurs continuously within economies and can lead to a general downturn in an economy. The transmission mechanism is from a reduction in earnings in some sectors of the economy where sales have been below expectations to a fall in demand in other sectors and therefore to a wholesale downturn in activity.
Walter Bagehot, as editor of The Economist, wrote one of the most influential nineteenth century works on the operation of the money market. As part of this work, he included a chapter on the nature of the business cycle, in which he described the evolution of a general downturn built out of a downturn in one part of the economy. Given Keynes’ accusation that classical economists had ignored monetary factors and their effects on economic activity, it should not go unnoticed that the following is from Bagehot’s Lombard Street which had as its subtitle, A Description of the Money Market. What Bagehot wrote was this:
No single large industry can be depressed without injury to other industries; still less can any great group of industries. Each industry when prosperous buys and consumes the produce probably of most (certainly of very many) other industries, and if industry A fail and is in difficulty, industries B, and C, and D, which used to sell to it, will not be able to sell that which they had produced in reliance on A’s demand, and in future they will stand idle till industry A recovers, because in default of A there will be no one to buy the commodities which they create. (Bagehot, 1873, 121–122)
The essence of this process is the creation of an economic downturn built upon the systematic failure of producers to sell what they have produced in their own markets. This is not a description of a Keynesian multiplier but a trail of purchase and sale between different producers. It accepts that when the recovery comes there may be different firms and industries in different proportions. But the conception that lies behind it is that the pieces in the economy must interlock as firms provide a market for each other with the entire structure ultimately aimed at producing goods and services for final home consumption.
Proposition 7: Monetary factors, most notably structural imbalances in the market for credit, can also be and often are an important cause of recession. Even where monetary instability has not been the originating cause of recession, monetary factors will often deepen a recession brought on for other reasons.
It is because Keynes argued that classical economists thought only in terms of real variables that such an obvious statement even needs to be made. It was, in fact, the specific conclusion reached by Becker and Baumol that ought to have put this issue to rest for all time, and also have raised some questions about the foundations of the Keynesian economic theory that had been built on the rejection of so flimsy a straw man. Becker and Baumol could not have been more explicit in dealing with this caricature of classical theory, which they labeled “Say’s Identity.” In discussing what they term “the clearest statement on the point”—Mill’s second essay in his Essays on Some Unsettled Questions of Political Economy—they wrote:
It is all there and explicitly—Walras’ Law, Say’s Identity which Mill points out holds only for a barter economy, the “utility of money” which consists in permitting purchases to be made when convenient, the possibility of (temporary) oversupply of commodities when money is in excess demand, and Say’s Equality which makes this only a temporary possibility. Indeed, in reading it one is led to wonder why so much of the subsequent literature (this paper included) had to be written at all. (Becker and Baumol, 1952, p. 374.)
Monetary factors can and do cause recession. It is stating nothing but what ought to be obvious, that classical economists were fully aware that monetary factors were often part of the process even when not the initiating factor in causing recessions to occur.
The approach to economic policy becomes very different if one begins from a classical perspective rather than from one built that commences with demand deficiency. These different perspectives are part of the matrix of ideas that were part of the structure of understanding that existed under a theory of the cycle built on classical foundations.
Proposition 8: Because recessions are not due to a failure of demand, practical solutions to recession do not encompass increased levels of public spending. While such expenditure may provide some limited benefit if spending is concentrated on value adding goods and services, such expenditure is merely a palliative rather than a cure.
The policy consequences of Keynesian theory have over the years provided ample evidence that on this matter classical economists were correct. There has been no instance of a peacetime increase in public spending during recession that has led to recovery. Reductions in taxation have a different effect on economic outcomes, and can be consistent with classical principles in generating economic growth. Increases in public spending, however, are not. John Stuart Mill’s statement, found at the start of this paper, is about as clear-cut as one could find.
The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained.... It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods. (Mill, 1874 [1974])
The stimulus packages that have been associated with attempts to revive economies internationally following the onset of the Global Financial Crisis, especially in the US and UK, have been failures. The absence of signs of success and the growing problems related to the rising levels of public debt are indications that these Keynesian policies did not work as their advocates suggested they would. The outcomes of these stimulus packages ought to be recognized as the major test of Keynesian theory and policy that they have been. Based on this experience, the macroeconomics that is almost universally taught should be recognized as of no theoretical or practical value. Ridding economic theory of the aggregate demand curve should be the single most important theoretical issue of our time.The downturn in activity, because the cycle is cyclical, will end at some stage with an upturn. What is evident already, however, is that the spending programs which have been introduced have not been factors in generating recovery. Indeed, not only have they been of virtually no use in creating a net addition to employment they have also coincided with deteriorations in economic conditions generally that have been unexpected by those who introduced the stimulus programs. The argument has been made that economic conditions would have been even worse than they were had these programs not been introduced even though at the time of their introduction, the expectation was that there would be a generally rapid upturn in activity and the labor market. None of this has occurred, as anyone looking at these programs from a classical perspective would have expected.
If public spending and deficit finance are recognized to have failed, just as they failed in Japan during the 1990s and in the United States during the Great Depression, support for Keynesian theory and policy should erode and a search for an alternative theoretical approach should commence. The proper place to begin such as investigation is amongst the long-forgotten theories of the cycle, which were discarded after the publication of the General Theory. There should be a newfound recognition that perhaps, after all is said and done, that so far as Say’s Law is concerned, Keynes was wrong and the classical economists were right.
MEN ERR IN THEIR PRODUCTIONS, THERE IS NO DEFICIENCY OF DEMAND It was Keynes himself who made it clear that the economics of the General Theory was to be seen as a refutation of Say’s Law. Recessions, he wrote, were caused by a deficiency of aggregate demand.
This was utterly contrary to mainstream classical thought. Classical economists understood that economies are not driven by demand but by value adding production, which is what they referred to as “supply.” They understood perfectly well that raising demand without an increase in the level of value adding output cannot be an answer to recession and unemployment.
This was summarized by classical economists in various ways: demand is constituted by supply, there is no such thing as a general glut, overproduction is an impossibility. However, the most remarkable short statement, not just on the nature of aggregate demand but also on the related issue of how recessions occur, can be found in Ricardo’s reply to Malthus in a personal letter written on October 9, 1820. Ricardo was writing a few months after Malthus’ Principles had been published: “Men err in their productions, there is no deficiency of demand.” (Ricardo, 1951–73, p. 277)
This is, first of all, a statement on the causes of recession: “men err in their productions,” that is, there is some kind of market disequilibrium which has occurred across the economy. And beyond that, it is a statement of what does not cause recessions: “there is no deficiency of demand.” Whatever might have caused the recession, it is not due to a lack of demand. What is found in Ricardo’s short statement is in summary form the entire classical theory of recession with its explicit rejection of demand factors as their cause. To understand what Say’s Law really means and why it matters, this is what you need to know.
What if Ricardo’s short and to-the-point statement were at the core of modern macroeconomics in the way it was at the core of the classical theory of the cycle? Here there is no ambiguity of meaning, none of the uncertainty that currently exists over what “supply creates its own demand” does or does not mean. Ricardo’s brief statement of classical principle means that when recessions occur, they cannot be understood as a consequence of too little demand but should be understood as some sort of derangement within the
market process. Were this understanding at the core of modern macroeconomics, policy makers would have no excuse for the levels of deficit spending that occurred after the commencement of the Global Financial Crisis but would understand that far different measures are needed to get markets and an economy back on track.
My book, Say’s Law and the Keynesian Revolution, which covers in far more detail all that has been discussed in this paper, has as its subtitle, How Macroeconomic Theory Lost Its Way. Macroeconomics replaced the classical theory of the cycle in the 1930s and has been Keynesian ever since. No metaphorical statement on the death of Keynes or of Keynesian economics can be true so long as aggregate demand maintains its presence at the core of macroeconomic theory and policy. Macroeconomics, with its focus on aggregate demand, has been systematically misleading economists since the 1930s. Because of the near universal acceptance of Keynesian theory within the mainstream, economists have repeatedly formulated policies around the need to stimulate demand during periods of high unemployment. Keynesian economics has, however, not had a single peacetime success but has recorded many, many failures to which one more can now be added. It is the very concept of aggregate demand that must be removed from economic theory. Its pervasive presence has caused a blackout curtain to fall across the whole of macroeconomic theory making it all but impossible to understand the underlying workings of an economy or to provide useful advice when recessions occur.
The use of public spending and deficit finance to deal with the Global Financial Crisis has been massive and worldwide. This ought to be recognized as having been a decisive test of the validity of Keynesian theory and policy. These policies have been tried to their utmost limits in the United States and elsewhere and should be recognized as having been an abject failure. A return to an economic theory based around a proper understanding of Say’s Law and the classical theory of the cycle should be the direction in which economic theory now moves.
Volume 4, No. 4 (Winter 2001)Fiscal policy means simply that the government steals the public’s assets (taxes them), and then either spends the money itself (what is usually termed “government expenditure”) or donates the funds to others (makes subsidies), who then spend them. Clearly, the government may not make expenditures or donations unless someone has already supplied something of value to the market. The demands of the government or the recipients of government funds must always be matched by equally valued supplies. Even with government fiscal policy, it is still the supplies that “create” the demands, and fiscal policy may be seen as mere income redistribution that can have no effect on aggregate output or employment other than those caused by the misallocation of resources they impose on the economy.
Volume 4, No. 4 (Winter 2001)Austrian insights are useful for not only interpreting recent claims, but also for understanding their reach. In particular, Misesian insights are helpful here, and it may be argued that there is a certain in ance in the above writings because of their neglect of these insights. Thus, I have argued that Mises’s insights in entrepreneurship, property rights, and the complementarity of elements in economic systems are useful ones for claiming a role for authority and the boundaries of firms, as well as for helping to uphold the notion that there are discrete organizational forms (for example, firms, markets, and hybrids), and that coordination mechanisms cannot be combined arbitrarily. This strongly suggests that Austrian economics (still) has an important contribution to make to the study of economic organization; in particular, that important principles of efficient organization design can be derived from Misesian foundations.
Mihai Vladimir TopanMihai Vladimir Topan (mihai.topan@rei.ase.ro) is President of the Ludwig von Mises Institute—Romania. He is also assistant professor at the Department of International Business and Economics, Academy of Economic Studies—Bucharest. The present paper is supported by the research project CNCSIS TE nr. 38/03.08.2010. The author would like to thank Marius Spiridon, Dan Cristian Comănescu, Radu Mușetescu and Matthew McCaffrey for valuable comments and suggestions. The remaining errors are, of course, my own.Volume 15, Number 1 (Spring 2012)In his Man, Economy, and State, Murray Rothbard introduces the catallactic function of decision-making owner, and the correspondent income of decision-making ability rent. These are supposed to exist both in ERE (they are, therefore, distinct from the capitalist function and his income, from labor and wages, or land and the corresponding rent) and in the real world permeated by uncertainty (they must also be different from the entrepreneurial function and profit and loss). Even though these concepts seem to suggest an important breakthrough into the theory of the firm, we argue that they are problematic. They must dissolve into (atbest, be elaborations of) either the standard economic functions present in the ERE (such as labor, for instance), or the entrepreneurial function.
KEYWORDS: decision-making ability, decision-making rents, ownership function, entrepreneurship, firm JEL CLASSIFICATION: D20, D21, L20, L21, L26INTRODUCTIONOne elegant way of solving the problems posed by the theory of the firm would be to discover, within the framework of the classical theory of distribution, an economic (or catallactic, in Misesian terminology) function responsible for the creationMore precisely, for the creation and structuring, expansion, reorientation/restructuring, reduction or dismantling of firms. of firms. By positively identifying and describing this function, by negatively differentiating it from all other functions and by connecting it to a specific form or share of income, a satisfactory theory of the firm could be provided. Rothbard (2009 [1977], pp. 601–603) comes very close to such an objectiveThis was pointed out by Joseph T. Salerno, both in the introduction to Rothbard (2009 [1977], p. xliv) and in Salerno (2008, p. 206). In the study guide to Rothbard (2009 [1977]), Robert Murphy also designates this Rothbardian contribution as “fairly unique” (Murphy, 2006, p. 115). through his decision-making owner function and decision-making ability rent. After a very brief restatement of the Misesian-Rothbardian theory of entrepreneurship, we will present these concepts as Rothbard introduced them. Then we will discuss briefly some other instances in which he makes use of them, as well as the source of inspiration the author himself mentioned. After an analytical/theoretical critique of the mentioned concepts, we conclude.
THE MISES-ROTHBARD VIEW OF ENTREPRENEURSHIPThere is no doubt that—at least from a theoretical point of view—the closest disciple of Ludwig von Mises was Murray N. Rothbard. This can also be seen, among the many topics these two giants tackled, in their theory of the entrepreneur. The role or economic function of the latter they both see as uncertainty bearing:
The term entrepreneur as used by catallactic theory means: acting man exclusively seen from the aspect of the uncertainty inherent in every action. (Mises, 1998 [1949], p. 254)
Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of the consumers. (Mises, 1998 [1949], p. 288)
If all people were to anticipate correctly the future state of the market, the entrepreneurs would neither earn any profits nor suffer any losses […]. What makes profit emerge is the fact that the entrepreneur who judges the future prices of the products more correctly than other people do buys some or all of the factors of production at prices which, seen from the point of view of the future state of the market, are too low […]. On the other hand, the entrepreneur who misjudges the future prices of the products allows for the factors of production prices which, seen from the point of view of the future state of the market, are too high. His total cost of production exceeds the prices at which he can sell the product. This difference is entrepreneurial loss. (Mises, 2008 [1951], pp. 7–8)
We shall deal further with the nature of profit and loss, but suffice it to say here that the active entrepreneurial element in the real world is due to the presence of uncertainty. (Rothbard, 2009 [1977], p. 434)
They [the capitalist-entrepreneurs] must advance present money in a speculation upon the unknown future in the expectation that the future product will be sold at a remunerative price. In the real world, then, quality of judgment and accuracy of forecast play an enormous role in the incomes acquired by capitalists. (Rothbard, 2009 [1977], p. 510)
Entrepreneurship deals with the inevitable uncertainty of the future. (Rothbard, 2009 [1977], p. 552)
A distinguishing mark of the Rothbardian analysis of entrepreneurship is the utmost care not to fall into the Kirznerian (“propertyless”) interpretation of the Misesian entrepreneur. much-debated topic in the Austrian economics literature. One of the main points of contention is the view laid out in ch. 2 (“The Entrepreneur”) of Kirzner (1973). For outstanding analyses of this matter (and much more) see Salerno (1993) and Hülsmann (1997). For Rothbard’s views see Rothbard (1997 [1957], ch. 14, (Professor Kirzner on Entrepreneurship), for example. He always insists, therefore, on the entrepreneur as owner of property. In addition, as one of the quotes above also shows, he always speaks about the capitalist-entrepreneur, precisely so as not to deprive of any element the person who copes with uncertainty in the real world. For Rothbard he is most certainly an owner (if not, what is he risking?); he is also a capitalist (advances property/resources within a temporal horizon implying waiting/time); he is an entrepreneur because the future he has in view is uncertain, and the resources advanced in production can be lost. The gross income, therefore, of a real world entrepreneur will be composed of several elements: a wage component (if he also provides labor, such as management); an interest component; and a (pure) profit and loss component.An (self) insurance premium could also be included; or various other rents, such as for self-provided location, for instance. We ignore these further, as they do not change the substance of our argument.
THE ROTHBARDIAN CONCEPT OF DECISION-MAKING RENTSIt is here that Rothbard introduces a supplementary element which we think is problematic. Namely, he identifies the “ownership function” as sufficiently delineated conceptually by the idea of decision-making, some sort of ultimate assuming of the resource allocation responsibility/burden. The owner must decide the allocation of his property/resources. And for this decision, Rothbard ”rewards” him with a special form of income: the decision-making rent (or the “decision-making ability rent”):
But is there a function which owning businessmen perform, and would still perform in the ERE, beyond the advancing of capital or possible managerial work? The answer is that they do execute another function for which they cannot hire other factors. It goes beyond the simple capital-advancing function, and it still continues in the ERE. For want of a better term, it may be called the decision-making function, or the ownership function. Hired managers may successfully direct production or choose production processes. But the ultimate responsibility and control of production rests inevitably with the owner, with the businessman whose property the product is until it is sold. It is the owners who make the decision concerning how much capital to invest and in what particular processes. And particularly, it is the owners who must choose the managers. The ultimate decisions concerning the use of their property and the choice of the men to manage it must therefore be made by the owners and by no one else. It is a function necessary to production, and one that continues in the ERE, since even in the ERE there are skills needed to hire proper managers and invest in the most efficient processes; and even though these skills remain constant, the efficiency with which they are performed will differ from one firm to another, and differing returns will be received accordingly.
The decision-making factor is necessarily specific to each firm. We cannot call what it earns a wage because it can never be hired, and thus it does not earn an implicit wage. We may therefore call the income of this factor, the “rent of decision-making ability.” (Rothbard, 2009 [1977], pp. 601–603)
The total gross earnings of an entrepreneur consist then of up to four possible elements: interest, wage, decision making rent and pure profit/loss. At this point, Rothbard comes dangerously close to the conclusions of the very author he strived so hard to differentiate from: Israel Kirzner. Specifically, by introducing this additional distinct function of ownership and its subsequent (supplementary) form of remuneration/income, he ends up separating—something considered as a shortcoming in Kirzner—ownership from entrepreneurship. If this is not so, and if it is still the ownership function that also receives the profit/loss residuum, then we have a function with two incomes, a situation which violates the “one function—one income” principle implied in the theory of distribution.See Hawley (1907, p. 112). Frederick B. Hawley has a very interesting treatment of enterprise and entrepreneurship, very much like that of Mises. Without the sophisticated tools of the latter (such as economic calculation, case probability, specific understanding etc.) he manages to de-homogenize the role of the entrepreneur (or, as he calls him, “enterpriser”) from various other contributions to the final product: laborer (including manager), capitalist, and insurer. Apart from his theory of entrepreneurship, he is interesting for his methodology (staunch defender of deductive method). Nevertheless, in his “macro” analysis, he is rather pre-Keynesian, considering the business cycle to be a normal occurrence in market economies due to (natural) disproportions between available savings and possible investment channels. See Topan (2009). Not to mention the emptying of the catallactic function of the entrepreneur, that would remain without an income share.
OTHER PLACES IN WHICH ROTHBARD EMPLOYS THE CONCEPTWhile Rothbard does not make extensive use of the “decision-making ability” and “decision-making rents,”The same can be said about other concepts touched upon in Rothbard’s works, such as “quasi-money” (Rothbard, 2009 [1977], pp. 826–827). he does mention (at least one of) them several times in Man, Economy, and State. First, there is this place (we quote extensively to better clarify the context; the concepts appear in the second paragraph):
Labor is usually treated as a perfectly divisible factor, as one that varies directly with the size of the output. But this is not true. As we have seen, the truck driver is not divisible into fractions. Further, management tends to be an indivisible production factor. So also salesmen, advertising, cost of borrowing, research expenditures, and even insurance for actuarial risk. There are certain basic costs in borrowing which simply arise from investigating, paperwork, etc. These will tend to be proportionately smaller the larger the size—another indivisibility, with returns increasing over a certain area. Also, the broader the coverage, the lower insurance premiums will be.
Then there are the well-known gains from the increase in the division of labor with larger outputs. The benefits from the division of labor may be considered indivisible. They arise from the specialized machines that must first be used with a larger product, and similarly from the increased labor skills of specialists. Here too, however, there is a point beyond which no further specialization is possible or where specialization is subject to increasing costs. Management has usually been stressed as particularly subject to overutilization. Even more important is the factor of ultimate-decision-making ability, which cannot be enlarged to the extent that management can.
What any given firm’s size and output will be is therefore subject to a host of conflicting determinants, some impelling a limitation, some an expansion, of size. At what point any firm will settle depends on the concrete data of the actual case and cannot be decided by economic analysis. Only the actual entrepreneur, through the give and take of the market, can decide where the maximum-profit size is and can set the firm at that point. This is the task of the businessman and not of the economist. (Rothbard, 2009 [1977], pp. 597–598)
Then, after the standard quote provided above, Rothbard mentions the decision-making rents again in chapter ten, when discussing monopoly profits versus monopoly gains to factors of production:
The monopoly gains must, then, be imputed to either labor or land factors. In the case of a brand name, for example, a certain kind of labor factor is being monopolized. A name, as we have seen, is a unique identifying label for a person (or a group of persons acting co-operatively), and is therefore an attribute of the person and his energy. Considered generally, labor is the term designating the productive efforts of personal energy, whatever its concrete content. A brand name, therefore, is an attribute of a labor factor, specifically the owner or owners of the firm. Or, considered catallactically, the brand name represents the decision-making rent accruing to the owner and his name. (Rothbard, 2009 [1977], p. 679; his emphases)
And fifteen pages later, in the same chapter and a similar context:
Yet many monopolized […] factors are labor factors—such as brand names, unique services, decision-making ability in business, etc. (Rothbard, 2009 [1977], p. 694)
In all these instances, Rothbard seems to assimilate, more or less, the income of decision-making to a type of wage, and to view the decision-making ability as some sort of labor. This can also be found in other works of the great Austrian master. For instance somewhere else, he says:
The fact remains that just as the costumer earns interest plus managerial wages plus profit, so will a landowner earn interest plus managerial wages plus profit (and “wages” can include wages of “decision-making”). The profit goes to better forecasters, and poorer ones will suffer losses.Rothbard (1997 [1957], p. 308). It is rather peculiar that Rothbard includes, on the previous page, entrepreneurship in the labor category: “Over the whole economy, then, the prices of capital goods are imputed back to land and labor, until finally, the net incomes are earned by: land, time, labor (including entrepreneurship).”
For now let us just notice the tension in Rothbard’s usage of the concept. On the one hand decision-making is not labor, as it is something logically antecedent to it. Someone has to decide the hiring of laborers (and, presumably, actually hire them, managers included). On the other, it is labor, even if a special type of labor (some unique ability or talent, possibly even associated with a brand name).
ROTHBARD’S SOURCE OF INSPIRATIONIn a footnote,Footnote 50, p. 602 of Rothbard (2009 [1977]). Rothbard indicates as his source of inspiration a “fertile, but neglected hint” of Eugen von Böhm-Bawerk, who in the introduction to his Capital and Interest wrote the following:
But even where he [the undertaker (BB)/the businessman (MR)] does not personally take part in the carrying out of the production, he yet contributes a certain amount of personal trouble in the shape of intellectual superintendence – say, in planning the business, or, at the least, in the act of will by which he devotes his means of production to a definite undertaking. (Böhm-Bawerk, 1890, p. 8)
So far, it seems that a decision-making function is suggested. But Böhm-Bawerk goes on like this (again, we quote extensively so as not to miss the context):
The question now is whether, in view of this, we should not distinguish two quotas in the total sum of profit realized by the undertaking; one quota to be considered as result of the capital contributed a second quota to be considered as a result of the undertaker’s exertion.
On this point opinions are divided. Most economists draw some such distinction. From the total profit obtained by the productive undertaking they regard one part as profit of capital, another as undertaker’s profit. Of course it cannot be determined with mathematical exactitude, in each individual case, how much has been contributed to the making of the total profit by the objective factor, the capital, and how much by the personal factor, the undertaker’s activity. Nevertheless, we borrow a scale from outside, and divide off the two shares arithmetically. We find what in other circumstances a capital of definite amount generally yields. That is shown most simply by the usual rate of interest obtainable for a perfectly safe loan of capital. Then, of the total profit from the undertaking, that amount which would be enough to pay the usual rate of interest on the capital invested in it, is put down to capital, while the remainder is put to the account of the undertaker’s activity as the profit of undertaking. […]
On the other hand, there are many, especially among the younger economists, who hold that such a division is inadmissible, and that the so-called undertaker’s profit is homogeneous with the profit on capital.
This discussion forms the subject of an independent problem of no little difficulty—the problem of the Undertaker’s Profit. The difficulties, however, which surround our special subject, the problem of interest, are so considerable that I do not feel it my duty to add to them by taking up another. I purposely refrain then from entering on any investigation, or giving any decision as to the problem of undertaker’s profit. (Böhm-Bawerk, 1890, pp. 8–9)
Böhm-Bawerk, by deliberately trying to restrict his inquiries to the phenomenon of interest, avoids altogether the thorny question of profit and of the specific economic function thereby remunerated. While he indeed suggests a decision-making function, he does not speak (or suggest, I think) a decision-making rent. And when considering the corresponding income share of the said function, he speaks about profit. Two possible roads open up at this point: (1) either Böhm-Bawerk would have elaborated on the undertaker’s contribution apart from labor as the entrepreneurial function, remunerated with profit; and, as he abstracted from/assumed away uncertainty in his concept of the “perfectly safe loan” in order to more precisely delimit the role of capital and the fundamental source of interest, this entrepreneurial function would have most probably incorporated uncertainty. (2) Or, he would have discussed this “act of will” type of undertaker’s contribution in the context of certainty (or in ERE, as Rothbard has put it); but, then again, what remains of the idea of entrepreneurship as uncertainty bearing?
Whatever Böhm-Bawerk might have thought on these matters is, in a sense, irrelevant. It is not uncommon for later authors to rescue insights from previous ones, and to use them in ways that would have totally surprised the latter. Rothbard’s insight, then, must be judged on its own merit. To this we now turn.
AN ANALYTICAL CRITIQUE OF THE CONCEPTLet us take a closer look at the decision function and the decision-making rents to see if they hold water. A fundamental question to be answered immediately would be: can these rents be negative? Rothbard’s answer is no (Rothbard, 2009 [1977], pp. 603–604), and is based on his standard analysis of rent (which must always be positive—no matter how small, but positive—in order to induce the factor owner to partake in the production process). But what is “rewarded” through these (positive) rents when there are losses and in his capacity as entrepreneur the owner has failed to correctly forecast the relevant market data? (He made a wrong judgment; can we in some sense emphasize only the fact that he made a decision nevertheless?) We would be in the strange—if not outright contradictory—situation of rewarding the individual (as owner) for the mere fact that he took a decision, only to concomitantly penalize him (as entrepreneur) for his uninspired decision. Does not, one wonders, the idea of decision-making imply the desideratum of successful decision-making?Even if it might look like we are torturing a bit the texts to find arguments on our side, there are instances in which Rothbard suggests decision-making comes with success/failure, and cannot be meaningfully separated from uncertainty (and, therefore, confined to, and isolated in ERE). Thus, in Ethics of Liberty, he says at some point that: ”If Crusoe had eaten the mushrooms without learning of their poisonous effects, then his decision would have been incorrect—a possibly tragic error based on the fact that man is scarcely automatically determined to make correct decisions at all times.” (Rothbard, 1998 [1982], p. 32) And again: “The less farsighted entrepreneurs suffer losses for poor handling of decisions under uncertainty.” (Rothbard, 1998 [1982], p. 39, n. 3) Passages of this sort can also be found in Man, Economy, and State: “In addition to the capital-supplying function, the corporate capitalists also assume the entrepreneuriall function: the crucial directing element in guiding the processes of production toward meeting the desires of the consumers. In the real world of uncertainty, it takes sound judgment to decide how the market is operating, so that present investment will lead to future profits, and not future losses.” (Rothbard, 2009 [1977], p. 434) And, if so, does not successful decision-making refer to uncertainty bearing and overcoming?
We have stumbled here upon a thorny question: up to what point, and for what purposes is ERE as such useful? Specifically, what remains of decision-making in ERE? Rothbard himself seems to suggest in another place that the answer might be “nothing”:
In the ERE, where all techniques, market demands and supplies, etc., for the future are known, the investment function becomes purely passive and waiting. There might be a supervisory or managerial labor function, but this can be analyzed under prices of labor factors. (Rothbard, 2009 [1977], p. 434)
On the other hand, if we were to suppose that decision-making rents can be negative, it becomes very difficult to understand what the difference would be between them and profits/losses. They both vary; they can both be positive or negative. Moreover, they must both pertain to ownership, as otherwise the question arises: if decision-making pertains to ownership, to what does uncertainty bearing pertain? (If the answer were again “entrepreneurship”, what would this concept still mean?)
One route has been left in suspension above, when we discussed Rothbard’s inclusion of the decision-making function under labor factors (and of the decision-making rents under “wages”). That is, the implied suggestion that it might be fruitful to separate within the broader category of labor, a special subcategory, special enough so that it deserves a separate and dedicated catallactic function, together with a form of income. While not without merits, this idea falls under heavy fire by Rothbard himself elsewhere:
Catallactically, labor is hired by entrepreneur-capitalists. It is grossly unscientific to separate laborers into arbitrary categories and to refer to one group as “labor” and “workers,” while the other group receives various other names. To give them other names implies a difference in kind between their contribution and the contribution of others, but this difference does not exist. (Rothbard, 2009 [1977], p. 565)
WHAT’S AT STAKE?Succinctly put, the problem is the following: will the Austrian theory of the firm be an entrepreneurial theory of the firm, or a decision-making ability theory of the firm? Which one is the fundamental/essential aspect, and provides for the nature of the economic phenomenon of the firm?
An element of appeal in this perspective (the one accepting the decision-making rents concept) could be the idea of specificity induced into the activity of the businessmen. Some affinities with the resource-based theories of the firm are immediateSee, e.g., Nelson (1991). (even though the Rothbardian theoretical edifice in its entirety permits a quite thorough criticism of such theories). Professor Joseph Salerno, for instance, builds up the concept of the “real/integral entrepreneur” by means of the integration of the ownership, capitalist and entrepreneurial functions:
An important sidelight of this integration of the ownership function with the capitalist and uncertainty-bearing functions is a new perspective on the nature and organization of the firm. The firm appears now as the projection of the owner’s personality, with all its cognitive and temperamental idiosyncrasies, into objective reality. Each firm’s organization is shaped to accommodate the unique decision-making ability of the owner and it is perpetually transformed in a dynamic world by his decisions. The firm’s organization is, furthermore, the immediate source of the integral entrepreneur’s decision rents. (Salerno, 2008, p. 206)
Nevertheless, in my opinion, the specificity element does not by itself justify the introduction of the above-discussed new element (decision-making rents). Seeing human action under uncertainty exactly for what it is—real world human action—at once implies that entrepreneurial judgments must be as specific as possible.One could define entrepreneurial judgments, along Misesian lines, as referring to particular circumstances of time, place and persons from the future. See Topan (2005), for instance. Moreover, profit and loss can account for the correctness of specific (idiosyncratic, even) entrepreneurial judgments or decisions:
Most uncertainties are uninsurable because they are unique, single cases, and not members of a class. They are unique cases facing each individual or business; they may bear resemblances to other cases, but are not homogeneous with them […]. Estimates of future costs, demands, etc., on the part of entrepreneurs are all unique cases of uncertainty, where methods of specific understanding and individual judgment of the situation must apply, rather than objectively measurable or insurable “risk.” (Rothbard, 2009 [1977], pp. 554–555)
The entrepreneur, in making his decisions, is on the contrary confronted with unique cases about which he has some knowledge and which have only limited parallelism to other cases. (Rothbard, 1956, p. 19)
As for the “high” versus “low” cost firms in any line of business, they can be explained at least in two ways, without the need for the special (ERE) decision-making ability. On the one hand, the possibility of error implies the possibility of being way off target, or just a bit off the mark. This would suffice to explain differences in profit, although it is true that these would have to be of a rather ephemeral nature. As for the more lasting differences, the idea of non-monetary income (or even direct consumption) could explain the constantly low profits (high costs) of skillful entrepreneurs who (for instance) opt for poor commercial locations because they are closer to their home.
CONCLUSIONIt is our conviction, therefore, that the separation of the ownership and entrepreneurship functions even at the theoretical level (therefore as catallactic functions, as opposed to real persons) remains problematic. The “residual” functions of property/ownership—isolated by the elimination of labor and waiting elementsAs well as implicit insurance premiums or various land rents, if such is the case.—imply at once both uncertainty bearing and decision-making.
Volume 5, No. 2 (Summer 2002)Empirical analysis and interpretation of employment and interest data based on the Hayekian triangle have proved highly fruitful in revealing new information about the structure of U.S. production. Statistical inference has demonstrated the Hayekian triangle’s strong explanatory power. Demonstration of stable, long-run equilibrium relationships among sectoral employment rates and interest rates indicate the data used are amenable to this kind of analysis.
Volume 5, No. 2 (Summer 2002)The authors’ proposed solutions are interesting but ultimately disappointing. Laudably, they do call for what they believe to be the privatization of urban transit. They call for an increase of fares, as well as reductions in the frequency of service and route coverage. They argue that with competition, the bus will replace the rail, and that automobile transportation will increase. New modes of transport would appear, they believe. They also propose a complete deregulation of the taxi market. When it comes to political strategy, however, they blink.
Volume 5, No. 1 (Spring 2002)The existence of and need for property is a consequence of scarcity, which is further affected by the very institution to which it gives rise. However, this “problem” in a sense supplies its own solution, as ownership implies the ability to exchange, and consequently, the emergence of exchange ratios in a common unit (that is, money prices) that permit economic calculation and thus the ability to coherently compare prospective courses of action.This article will attempt to elaborate on this idea, and applications of this notion will be made to the problems of socialism, monopoly capitalism, and business cycle theory.
Volume 14, Number 2
This paper reviews Austrian approaches to the firm and drafts a theory that emphasizes the firm as a market phenomenon. Here the firm is a vehicle for imaginative entrepreneurs to create artificially high factor density, thereby increasing its internal "extent of the market" to support specialization of factors beyond the general level of division of labor in the market. The firm therefore becomes a product of, and prospective catalyst for progressing the market's overall division of labor, and the firm emerges as a entrepreneur-generated means toward increased efficiency and more roundabout production. It consequently may play a crucial role in the evolution of market structure and, by extension, the development of civilization.
Volume 3, No. 3 (Fall 2000)It is a rare individual who is able to draw from many disparate traditions in economic thought and combine these into a coherent research program. Brian J. Loasby, longtime professor of economics at the University of Stirling, United Kingdom, is one such individual. This first of two volumes of essays written in his honor demonstrates the diversity of thought inspired by his work. Professor Loasby, longtime professor of economics at the University of Stirling, United Kingdom, is one such individual. This first of two volumes of essays written in his honor demonstrates the diversity of thought inspired by his work. Professor Loasby has been a persistent critic of mainstream approaches to the issues of knowledge, entrepreneurship, and organization in economics—issues that stand at the forefront of Austrian research agenda. In fact, contributions from Austrians and Marshallians (another nonmainstream school emphasizing dynamic rather than static analysis) to this volume show a surprising degree of complementarity, and serve as a forceful challenge to Walrasian orthodoxy.
Volume 2, No. 2 (Summer 1999)Recently, scholars working in the field of modern Austrian economics have wondered about what this literature might offer for an understanding of the nature of modern business organizations (for example, Foss 1994, 1997b; Sautet 1998; Mathews 1998). In this article, we examine the received literature on firms and strategies and find that Austrian economics has important contributions to make in two particular areas—to the theory of rent and to an understanding of the meaning of equilibrium. The legacy of perfect competition casts a long shadow, inhibiting an adequate understanding of the dynamic market process in which rent is earned in disequilibrium.Rent features as a key concept in the modern Resource-Based Theory of Strategy. This concept is borrowed from neoclassical economics but derives ultimately from Ricardo. It is used in the Resource-Based literature in a confused and inconsistent way. We examine this theory with a view to providing a more satisfactory foundation for the theory of rent, that provided by Frank Fetter, and a more satisfactory foundation for the theory of competition, that provided by Market-Process economics. The theory of the firm that emerges is, indeed, a “strategic” theory of the firm, one that depends crucially on the entrepreneur and one that is built on a thoroughly “Mengerian” (subjectivist) theory of rent.The new Resource-Based theory (RBT) of the firm, like the Coasian literature, takes as its point of departure the neoclassical microeconomic model of perfect competition. In perfect competition there are no “profits” and all firms are identical. The RBT explains why firms differ; that is, what aspects of the perfect-competition model most plausibly do not apply. Different firms possess different (heterogeneous) resources and are (somehow) able to maintain those valuable differences (for example, Barney 1991; Foss 1997ab). As a result, according to the RBT, successful firms are able to earn “rents.” This concept of rents is also derived from economic foundations, namely the theory of rent as developed by David Ricardo (1973) and subsequently modified by Alfred Marshall (1961).[1]From both of these constructs, the perfect competition model and the theory of rent, it is possible to feel that the RBT has borrowed too uncritically. In the case of rent theory in particular, RBT has complicated its own framework by reproducing (or inventing) needless distinctions and overlooking others. We offer here a reformulated theory of rent derived from the work of Frank Fetter (1977). Fetter’s work has been linked by Murray Rothbard to the Austrian tradition.
Rent and Value According to Frank FetterThe value of any economic organization (firm, business, company) derives from and reflects the value to it of the resources[2] under its control; that is, resources that it owns or rents. Most resources can be owned or rented, though some (like reputations) cannot be rented and others, like human capital, cannot be alienated from their owners and must be rented for wages. At any time, the economy as a whole will possess an inventory of potentially productive resources (that is resources that are capable of producing value). This productive potential can only be realized through the combination of these resources, often in complex ways. The values attributed to the resources, and thus to the companies that own or control them, is part of the market process underlying the formation and mutation of the resource structure. But, as we shall see, these values may look different from different perspectives and will have different magnitudes and effects depending on who is able to create them and appropriate them (in whole or in part).From the perspective of the economy as a whole, adopting, as it were, a “God’s eye” view, the value of these resources, at any point in time, can be seen as the discounted total of the (estimated) income stream attributable to them. In other words, the value of any economic resource is logically the present value of any income stream that can be attributed to the use of that resource in production.[3] That is the maximum price that anyone appraising that resource would be prepared to pay for it.[4] Anyone considering the purchase of any resource cannot avoid (perhaps implicitly) referring to the value that this resource is expected to add to economic production. Even if the resource is purchased for resale, ultimately its value must derive from some potential productive use.Imagine for a moment that no ambiguity or uncertainty whatsoever attaches to the production processes in the economy. All individuals possess the same hard knowledge of what resources can do and, therefore, what they are worth. In such a world, when a resource is rented its rental rate must reflect the value of the current addition it makes to the value of production (its value-marginal-product) or else the owner would be reluctant to rent it to the firm. Where the resource is not rented but is owned by the firm, the implicit “cost” of using the resource must reflect that same value. Thus there is no “surplus value” to be had, since all values are known and become incorporated into the (implicit and explicit) prices of resources. Nevertheless, in the sense advanced here, rents are earned by the factor owners.[5]“Rents” refers here to the income streams attributable to the resource-inputs in the productive process. Resources can generally be conceived of as a stock of potential productive services. Rents are the prices paid for these services. Rents are the prices of the flow of services emanating from the stock of resources (Penrose 1995). The price of any resource stock is the discounted present value of the prices of the services it yields. In this framework, rent is nothing more nor less than the rental price of the service of a productive input. As Murray Rothbard has explained:
We are using “rent” to mean the unit price of the services of any good. It is important to banish any preconceptions that apply the concept of rent to land only. Perhaps the best guide is to keep in mind the well-known practice of “renting out.” Rent, then, is the same as hire: it is the sale and purchase of the unit services of any good. It therefore applies as well to prices of labor services (called “wages”) as it does to land or any other factor. The rent concept applies to all goods, whether durable or nondurable. In the case of a completely nondurable good, which vanishes fully when first used, its “unit” of service is simply identical in size with the “whole” good itself. In regard to a durable good, of course, the rent concept is more interesting, since the price of the unit service is distinguishable from the price of the “good as a whole”. . . . The price of the “whole good,” also known as the capital value of the good, is equal to the sum of the expected future rents discounted by the rate of interest. (Rothbard 1993, pp. 417–18: emphasis in original)[6]
This conclusion is not changed at all when we drop our assumption of perfect and certain knowledge. In the real world where the future is irredeemably uncertain, the value of any productive resource will still reflect the discounted value of its expected future rental stream. Certainly, different people will have different estimates of these rental streams and, therefore, will appraise differently the value of the resources that yield them. The market process of production and exchange will work in such a way that resources will tend to move to those who appraise them most highly. As mentioned above, a firm may employ resources in production by owning or renting them. If a firm decides to purchase a resource, it must do so because, in its estimation, the additional value to it of the future income streams attributable to the use of that resource meet or exceed the price paid for it. Similarly, a firm will not rent a resource unless, in its estimation, the value added to production, by combining that resource with others in the production process, meets or exceeds the rental rate asked.This framework suggests the following conclusions:1. There is no categorical distinction between the earnings of some resources and others; they are all rents.2. The value of any productive resource is the discounted value of the rent streams that can be attributed to it.[7]3. The price of any resource (and therefore, its rental stream) will be affected by its relative scarcity.These conclusions invite a consideration of the relationship between the above treatment of rent and the rent concept as originally introduced by Ricardo and as used in the modern literature. The above approach to the theory of rent probably found its most complete and cogent expression at the hand of the early-twentieth-century economist Frank Fetter (1977) and so we shall refer to this approach as the Fetter theory.
Ricardian and Other RentsAccording to Ricardo, “rent is that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil” (1973, p. 33). He was concerned to explain the earnings that accrued to the different groups in society (capitalists, workers, and landowners). He tried to eliminate rent as a determinant of exchange value, so that he would be free to concentrate on the relationship between labor and capital. Thus he argued that the amount paid to the landowner was
determined by the scarcity and differential fertility of land; it is the difference between what capital and labor can earn on the more fertile land and on land . . . which is just worth cultivating . . . but yields no surplus in the form of rent. In this respect rent differs from other forms of income: it does not enter into the cost of production for society as a whole; it cannot determine the value of corn, rather it is created by the fact that corn has value. (Winch 1973, p. xi)
The notion that land is special because it alone does not enter into the cost of production is encouraged by Ricardo’s perception that land was a special and different category of input. From the perspective of the above discussion, what makes land different (in Ricardo’s model) is simply that it is in fixed supply. Its supply curve is vertical. Rents are earned simply by virtue of the (fixed) existence of the resource without any action having to be taken; they are pure scarcity rents.Marshall tried to defend and extend Ricardo’s approach and it is the Ricardo-Marshall (RM) approach that is the basis for the modern treatment, including that found in the Coasian and RBT literature. Marshall recognized that the phenomenon Ricardo had identified as scarcity rents applied equally well to any factor (resource) in (temporarily or permanently) fixed supply. A scarce (unique) ability or a highly specialized machine may be valued very highly. Marshall referred to this as quasi-rent. It is that part of the value of the machine that is due to its temporarily restricted supply.As it has been extended and developed further in the modern literature, the RM approach is distinguished by two key ingredients:1. rent is a phenomenon that accrues only to factors in fixed (or “quasi-fixed”) supply; and/or2. rent is a surplus, an excess of earnings over some benchmark taken to indicate the “normal” situation.According to the latter condition, rents are seen as “super-normal profits” or “above normal earnings.” This usage derives (incorrectly) from Ricardo’s observation (as noted above) that some types of land may earn more rent than others by virtue of superior fertility. If land of inferior fertility were in large abundance, it would not have any value on the market. That is to say, it would be a free good and it would not command a rental rate. The rent on the more fertile and scarce land could then be seen as a surplus for fertility, a differential payment. This seems to have created the impression in the modern literature that all rent partakes of this differential status. But in an economy where no land is free, all land is scarce and all land earns rent. Rent is not due to the existence of land of differing fertility. Rent is caused solely by the fact that land is scarce. It will be paid even when all land is homogeneous (see, for example, Mill 1871, p. 433).It is true, of course, that differences in fertilities will result in differences in rental rates. And in many situations, it is the differences in rents that are the relevant objects of attention. In fact, in most of the modern literature the usage of rent in its various forms can be more accurately identified as differential rent. It is differential rent that is being sought or is in danger of being appropriated.While we do not speculate as to how or when this particular usage got started, it is clear that:1. It is not strictly consistent with Ricardo or Marshall.[8]2. The RM theory itself is arguably convoluted and misleading by comparison with the Fetter theory.[9]
Rent Concepts in StrategyIn the strategy literature, five different concepts of rent have been identified, namely,• Ricardian rents,• Marshallian (or Paretian) rents,• monopoly rents,• entrepreneurial rents, and• quasi-rents.Different theorists have defined these differently, however.[10] Inconsistency, in and of itself, is perhaps not a big problem in a rapidly developing field, particularly if there is some reason to believe that a speedy convergence to a uniform taxonomy is imminent. We believe, however, that Occam’s razor suggests the adoption of an alternative simpler system, one based on Fetter’s approach to the concept of rent.The RBT of strategy emphasizes the fact that industries are populated by firms that are different (that perform differently). Indeed, it has been noted that the variance in firm performance between industries is, surprisingly, substantially less than that within industries (Rumelt 1987, p. 141). This suggests some essential firm heterogeneity. Firms are different because they know how to do different things (even in the production of the same or similar products) or because they have been lucky enough to stumble upon a superior technique, in short because, for one reason or another, they possess different capabilities (Barney 1986). Thus, the observation of firm heterogeneity leads naturally to the inference of resource heterogeneity (Barney 1991; Foss 1997b). Some firms possess things that are valuable in production that other firms do not and thus are able to outperform them. In this way, the performance of firms is tied to the earnings (rents) that can be attributed to these resources and the ability to sustain such a competitive advantage is linked to the ability of the firm to identify and protect (and perhaps extend) that essential resource heterogeneity. The theory must explain, therefore, how this is possible; that is, how it is possible that the firm may be able to successfully isolate its distinctiveness from imitation or emulation (Rumelt 1984).The identification of distinct categories of resource rent may be seen as instrumental in this regard. If different resource characteristics give rise to different categories of rent, then this can be taken into account when formulating firm strategy. Some rents, like Ricardian rents, will result simply from the possessions of unique, non-reproducible resources; and the strategy relating to these is simply to identify and protect them, ensure that they remain under the ultimate control of the firm (though it may be possible to gain from leasing them out, see Gabel 1984). Marshallian (quasi-) rents are similar except that they are attributable to resources whose supply is variable in the long run, so that an effective strategy should aim to maximize these rents by protecting them as long as possible. On the other hand, entrepreneurial rents are difficult to tie to specific resources and may inhere more in the particular combination (organization, supervision) that the entrepreneur-manager brings. In this case, the “resource” has to be “created” and then protected. The other categories of rent lead similarly to particular strategic actions; for example, protecting monopoly rents implies the maintenance of entry barriers and the exercise of market power (controlling product supply to maintain price, Peteraf 1993), while the existence of quasi-rents implies strategies (like integration) to guard against ex post appropriation by opportunistic trading partners.All this is correct and helpful as far as it goes (and is discussed a little more below). An understanding of the different rent types is equivalent to an understanding of the circumstances under which they occur and can be used to suggest appropriate strategies. Ultimately, however, in every case, the existence and size of a particular rent, in the RM sense (that is in the sense used in all of neoclassical economics), boils down to circumstances surrounding the supply of particular resources to the market and to the firm. As explained above, in a more inclusive and helpful sense (as developed by Fetter) a rent is nothing more nor less than a resource value (or more accurately the value of the services of a resource) and all resource based strategies come down to the creation, enhancement, and protection of such values.
Rents and the Market ProcessWith this in mind we may note that different economic frameworks view the discovery, generation, and capture of rent differently. In this section, we contrast an equilibrium framework (as implicitly or explicitly presumed by the neoclassical approach (and, to some extent the RBT approach)) with a disequilibrium or market process approach (as derived from an Austrian-economics framework). A brief outline of the relevant ingredients of the market-process approach follows.
Rent and EquilibriumConsider the relationship between rent and equilibrium. If equilibrium is understood as a situation of consistent and correct plans and expectations (Hayek 1937; Lewin 1997a), then it can be argued that the rent that matters for strategic decisions is rent that is earned in disequilibrium—call this strategic rent.[11] In equilibrium, all rents are uniformly capitalized and no strategic opportunities exist. This follows from considering the relationship between rent and resources as discussed above. If the price of any resource reflects the discounted value of its expected future earnings, and if everyone shares the same correct expectations, then that price will include all correctly anticipated value components. There are no strategic decisions to be made. Ex ante values will turn out to be equal to ex post values. There will be no “surplus” or “abnormal” rents, because all resource owners, whether they sell or rent their resource, will correctly impute any value added by their resource to any production process of which they (the resources) are a part. Resource owner users will thus treat these rents as a cost. There is no discrepancy between total cost and total revenue and both equal total rents earned. Thus strategic rent, rent that follows from a discovered discrepancy between revenue and cost, and is therefore equal to what we normally understand as profit, applies only to disequilibrium situations. But since equilibrium, as defined above, is a very rare event, we should expect strategic rent to be quite common. Disparate expectations provide the opportunity for strategic rents (for different appraisals of the worth of resources).
Resources as CapitalWe may see this more clearly if we reformulate our framework slightly. All resources may be seen as a type of “capital.” Their prices are the capitalized values of their expected future rents. Value gets created by entrepreneurial decision makers who form new capital combinations (Lachmann 1978, Lewin 1997b, 1998). From this perspective, the particular organizational form in which the capital combination exists may be seen as a resource if it adds value to the productive process. That is, since organization matters for productive value it is a resource. Resources in general may thus be seen as part of an intricate capital structure composed of heterogeneous capital goods.Like Schumpeter, Lachmann envisages production as a process driven by the entrepreneur who forms new and continually changing capital combinations. Within these combinations the individual capital items (resources) stand in complementary relationships to each other. They are joint inputs into the achievement of a production plan in the broadest sense. When the plan fails in part or in whole, the entrepreneur has to adapt by making substitutions. Thus, substitutability and complementarity are not so much attributes of capital resource inputs (as in neoclassical economics with its emphasis on equilibrium) as they are of states of the world. Complementarity is a feature of stability, substitution is a feature of change. Together they describe two aspects of the capital structure (broadly understood), its resilience and its flexibility.When substitutions have to be made, the entrepreneur must change the capital combination in a manner dictated by the physical and institutional constraints. Some resources will have only one use and will be rendered useless by the change. Their value will fall to zero. These, as explained, are completely specific resources. Most resources will have more than one use (they are characterized by multiple specificity). The more adaptable a resource, the greater its value in alternative uses. A resource that has to be sold for scrap in the face of change has limited uses, while a resource that can be used in a variety of alternatives (an opera house that can be turned into a movie theater) is more resilient.
Heterogeneity Matters only in DisequilibriumClearly, heterogeneity, and the complementarity that it implies, are relevant only in conditions of disequilibrium. In equilibrium where no unexpected changes occur, the capital structure will be perfectly sustainable requiring no changes. In this way, heterogeneity and change are intimately related. Only if ex ante values (as seen by someone in the market) turn out to be different from ex post values, will heterogeneity matter. If the values of all resources turn out as expected, their heterogeneity would have no strategic significance. But in the absence of equilibrium, the heterogeneous nature of resources significantly reflects the fallible decisions of the past as well as the possibilities and constraints of the future.So, in a fundamental sense, it is the heterogeneity of expectations that matters more than the heterogeneity of resources as such. Heterogeneous resources give rise to differing expectations of their worth as conceived in various possible capital combinations. Those expectations that turn out to be correct give rise to strategic rents.
Rent and OpportunismOpportunistic behavior or the potential for opportunistic behavior is a key ingredient of the transaction-cost approach to the theory of the firm (Klein et al., 1978; Williamson 1985, for example). From the above discussion, however, it should be clear that while the presumption of the potential for opportunistic behavior (shirking, holdups, etc.) may shed considerable light on the existence of the firm as a vertically integrated productive unit, or on productive organizational arrangements more generally, this can never have any strategic implication in the absence of disequilibrium. In other words, opportunism matters only if there is a divergence of expectations. It is true that this literature places some emphasis on the existence of asymmetric information; that is, the possession of different information by different trading parties. But this asymmetry is strategically irrelevant unless it gives rise to a divergence of expectations between the parties.For example, if both the buyer and the seller confidently expect the buyer to appropriate the enhanced value of a constructed specific resource by “holding up” the seller after the asset has been constructed, and if both believe that a contract to prevent this is unenforceable or insufficient (incomplete) (Hart 1995), then either integration will occur or the transaction will be abandoned or the opportunism will be tolerated, whichever is most economical. The point is, there is no disagreement about which alternative is the most economical (efficient) and, therefore, no real strategic questions arise, only potential ones. If, however, there are asymmetric expectations, one of the parties will turn out to be wrong and the value of the resource will turn out to be different from that expected by at least one party. That difference is a strategic rent. For example, the buyer may have a different “vision” (Penrose 1995) of the potential use of a particular resource that the seller does not share because he has less or different information, or, more significantly, because he interprets the same information differently. If the buyer turns out to be correct, he will have earned a profit, a strategic rent, the difference between the ex ante price paid for the resource (built by the seller), his cost, and the ex post value to him of the resource, as reflected by its contribution to his revenue. Of course, the buyer too may be (pleasantly) surprised if the ex post value of the resource turns out to be even higher than he expected, but this has no strategic implication since, there being no expectation of this enhanced value, it could not have been part of his strategic behavior. It is a windfall gain; a profit, but not a strategic rent. Thus, not all rents earned in disequilibrium are strategic rents, but all strategic rents are earned in disequilibrium.Furthermore, there is an important sense in which the existence or absence of potentially profitable opportunistic behavior cannot, in itself, be an explanation for the existence of the firm. All businesses surely have their origins in the resources of the entrepreneur (innate or otherwise) and the resources that the entrepreneurial team controls or creates, can potentially acquire, and finally combines. From this perspective, the existence of potentially appropriable rents is logically subsequent to the perception of a potential profit. All profitable business ventures must trace back to some differential insight or some unexpected event. There must first be the perception of a potentially appropriable rent before the question of organizational arrangement can be relevant. And this perception must signal the “discovery” of some undervalued resource or resource combination that was hitherto unperceived.
What makes profit emerge is the fact that the entrepreneur who judges the future prices of the products more correctly than other people do buys some or all of the factors of production at prices which, seen from the point of view of the future state of the market, are too low. Thus the total costs of production—including the interest on the capital invested—lag behind the prices which the entrepreneur receives for the product. This difference is entrepreneurial profit. (Mises 1980, p. 109; see also Sautet 1998)
Once a potential profit is perceived by at least one person, the question then arises as to which organizational arrangement is best suited to its appropriation or renders it vulnerable to appropriation by others. We discuss this further in the next section.
Time and Knowledge in the Market ProcessAll this points to the role of time and knowledge in the market process. The process is a disequilibrium process in the sense that it is driven by the continual arrival of new knowledge (and thus the falsification of old expectations). It is almost inconceivable that the passage of time should not imply some form of learning. Time and knowledge belong together. “As soon as we permit time to elapse, we must permit knowledge to change” (Lachmann 1976, pp. 127–28). Real time, as opposed to mathematical time, is suffused with unique unanticipatable events. At the very least, this insight is an implication of the observation that at any given point of time, different individuals have different expectations, so that all but one of them are bound to be falsified. Individuals are bound to learn by the passage of time.Related to this is the importance of recognizing the private nature of knowledge. While information (data) has objective existence, knowledge is inescapably personal (Fransman 1994). The same information is often interpreted differently by different individuals. Knowledge is different from the information from whence it derives. This means that different individuals appraising the same resources may perceive different uses and expect different earnings; in short, the same resources may have different values for different individuals. Without differences of opinion there is no market process.Knowledge, in fact, is an additional and necessary dimension attaching to every resource. Without the “knowledge” of how to profitably use a resource, it is not a resource, it has no value. Resources without knowledge have no meaning. And given the personal and often idiosyncratic nature of knowledge, it appears to us that the “knowledge based” variant of the RBT (Libeskind 1996; Grant 1996; Conner and Prahalad 1996) has considerable merit. Firms and other forms of business organizations (joint ventures, business alliances, arms length contracts, etc.) serve as experimental incubators for the entrepreneurial visions of various and varied resource combinations that reflect the particular knowledge and expectations of their designers.
Strategic and Other RentsFrom the market process perspective then, rents may be revealingly divided between strategic rents and all other rents. Strategic rents are profits and are earned only in disequilibrium. (Profits are the difference between the ex ante prices [values] of resource stocks, their costs, and their ex post value in use, the revenues they generate.) A summary appears in Table 1.Table 1Rente in Equilibrium and DisequilibriumSource of Rent Equilibrium Rents Schumpeterian-Disequilibrium Rents1. Ricardian Rents earned from resources in absolutely fixed supply Differential rents earned from the “discovery” of new resources in absolutely fixed supply2. Marshallian (quasi-rent) Rents earned from resources in relatively fixed supply Differential rents earned from the “discovery” of new resources in relatively fixed supply3. Opportunistic No rents earned Differential rents earned (extracted) from the “superior” insight into the value of resources in alternative usesThis table shows the result of adding another dimension to the usual taxonomy of rents found in the RBT literature, the dimension of equilibrium and disequilibrium states. The addition of this dimension allows one to view strategic rent-earning as a dynamic process in real historical time. Schumpeterian rents, from this perspective, include all rents earned in disequilibrium. They encompass Ricardian, Marshallian, opportunistic, and any other imaginable rents in disequilibrium situations. The key aspect of Schumpetarian rents is that they arise from innovation, from the introduction of something new. “[I]n capitalist reality as distinguished from its textbook picture, [the] . . . kind of competition which counts [is] the competition from the new commodity, the new technology, the new source of supply, the new type of organization” (Schumpeter 1947, pp. 84–85, quoted in Penrose 1995, p. 114n).Ricardian rents may be understood to refer to rent from resources in absolutely fixed supply, i.e., with vertical supply curves (a Picasso painting, a unique location, a unique talent). In equilibrium, the value of these resources is known to everyone and the institutional environment, the configuration of ownership rights, is likewise known and accepted. By definition of equilibrium, there is no decision that needs to be taken to extract and protect this value. All actions are a sort of mechanical playing out of the already determined efficient steps that must be taken by resource owners to extract maximum rents. All relevant decisions must have been taken prior to the establishment of equilibrium.By the same token, where a Ricardian resource is newly discovered or created or where a new method of protecting its value (restricting the use of its services) is found, a Schumpeterian innovation has been made. This shows up in an increase in the ex post recognized value of the resource that, in our story, should be thought of as a strategic rent. Once introduced, strategic rents become embodied in the rent stream and in the absence of further changes (innovations) lose their strategic character.Similarly, Marshallian rents, those that can be imputed to any resource in less than infinite supply (relative to the demand), may be strategic or otherwise. As with Ricardian rents, where a resource is newly discovered or created or where a new method of protecting its value (restricting the use of its services) is found, a Schumpeterian innovation has been made. This shows up in an increase in the ex post recognized value of the resource and is a strategic rent.The key general distinction is whether or not the value of the resource is a matter of uniform agreement or whether, as explained, because of differences of opinion (of judgment) or because of unanticipated events, there exists a wedge between the ex ante appraisal and the ex post realization of some traders in the market. Wherever there is room for the exercise of judgment, there exists the potential for the earning of strategic rents.A consideration of the question of so called “opportunistic rents” raises related questions. Earnings from opportunistic behavior arise because of time and information asymmetries. Time asymmetries refer to the widely noted potential that exists, whenever some fixed co-specialized investment of a specific nature is made by more than one party, for opportunistically changing the nature of the agreement for sharing the fruits of that investment. This potential arises because of the “irrelevance of sunk costs.” Since the value of the resource in alternative uses (by alternative users) is less than in its current use, a potential exists for one of the parties to “blackmail” the other for an amount up to the difference between the value of the resource in its current use and its value in the next best use, by threatening to withdraw the co-specialized resources necessary for the achievement of the full value of the project. This is sometimes (confusingly) referred to as an “appropriable quasi-rent.” It exists because the only costs that matter for decisions are opportunity costs; that is, the value of alternatives to be sacrificed. Before a specific investment is made, resources could be committed elsewhere. However, after the investment is made this is irrelevant, since the alternative to commit them elsewhere no longer exists even if they end up earning less than anticipated. The only alternative that remains is the re-deployment of the constructed specific asset. This is an essential time asymmetry.This time asymmetry is not sufficient, however, for the existence of an appropriable rent. There must also be a particular information asymmetry, and this is the key to an Austrian theory of the firm. If both parties are equally aware of the potential for ex post opportunism and to the same extent, then this, as explained earlier, will already be reflected in the value of the resources. Thus, in equilibrium, where all parties share the same expectations, there can be no opportunistic rents actually earned. In a disequilibrium situation, however, where the parties will have different opinions as to the values of resource combinations, such opportunities will be manifest. An optimistic, visionary, entrepreneur who values resources more highly than the owners from whom he rents them, and who turns out to be right, is vulnerable to being held up by the resource owners, once the enhanced value of the resources becomes apparent. He will attempt to take steps to protect himself by fashioning an appropriate organizational structure. But even if he is unsuccessful, the rents earned by him or by the opportunistic owner will be Schumpeterian in nature. They are the result of “superior” insight, of an innovative combination or use. Hence, we conclude that in order for opportunistic rents to exist some value must have been entrepreneurially (strategically) added. This is the ultimate explanation of the firm, i.e., the value added by the particular combination of resources and the way in which they are organized.Insofar as strategic rents are the product of a dynamic market process, the calculus of neoclassical microeconomics is not immediately relevant to them. In a disequilibrium situation, the cost curves as depicted, for example, by Peteraf (1993) are as much a matter of judgment as the demand curves, and the costs that matter are those that apply to anticipated rather than to historical events. They include so-called “dynamic transactions costs” (Langlois 1991; Langlois and Robertson 1995) of not correctly anticipating and providing for future resource needs. In such a world, strategic rents can be earned by better assessing such costs.
Conclusion: A Tale of Two WorldsIn this article, we have examined and reformulated the theory of rent and related it to the concept of equilibrium and the theory of competition in order to arrive at a more consistent and satisfactory basis for a theory of the firm. Such a theory is necessarily a strategic theory. Firms are formed in order to realize, and perhaps protect, the creation of value. Table 2 summarizes the differences in the two perspectives we have been analyzing, the neoclassical-microeconomic perspective (using the RM approach to rent) and the market-process perspective (using the Fetter approach to rent). In a neoclassical world, rents indicate “unsolved” or unexploited “inefficiencies.” This is because every hypothetical outcome is viewed against the standard of perfect competition in which all products are produced and provided to the consumer at minimum possible costs; that is, with the least sacrifice in alternative value. In this world, discrepancies in the values of resource combinations across firms is an indication of unexploited profits and, therefore, of inefficiency. This viewpoint invites a curious normative ambiguity. While an economy characterized by large profits may, in some sense, be viewed as dynamic and desirable, the large profits, at the same time, signal gross inefficiencies. While we seek the knowledge to inform business strategists in their pursuit of profit, we seek also the wisdom as economists to structure the world to ensure their elimination.By contrast, in the market process world there is no single ideal standard by which to measure any particular outcome. All action takes place in an open-ended universe in which the future is continually being created, and in which, therefore, competition is a “discovery process” (Hayek 1978). The likelihood that the expectations of different individuals will be mutually compatible is extremely low. There is no assurance that the market will, through the competitive process, always arrive at the least costly way of doing things, but the availability of the opportunity to experiment in different means, methods, and products suggests that not only will there be pressure to keep the costs of producing any given product as low as possible, but that the choices available to consumers will tend to expand without limit. From the market-process perspective, high profits are an indicator of economic dynamism and the efficient uncovering of continually emerging profitable opportunities, unless, of course, they are the result of special privilege (legal barriers to entry). As such the market process perspective does not share the ambiguous view of profits (which are the difference between ex ante resource costs and ex post resource values) characteristic of the neoclassical approach. A market-process approach is thus not only more “realistic,” it is surely better suited to an understanding of the origins and workings of the real-world business organizations we call firms.Table 2Contrasting Perspectives Neoclassical Market ProcessSource Rents refer to differences in the earnings of similar resources and result from monopoly, opportunism, or innovation. Rents are the prices of the services of resources.Equilibrium: Perfect Competition No rents earned. Conditions are “efficient.” Rents are the prices of the services of resources. Conditions are “stagnant.”Equilibrium: Monopolistic Competition Rents refer to differences in the earnings of similar resources and result in monopoly. Monopoly rents are earned from special privileges or “barriers to entry.” Conditions are “inefficient” Rents are the prices of the services of resources. Monopoly rents are earned only from special privileges. Conditions are “inefficient”Disequilibrium Rents refer to differences in the earnings of similar resources and result from opportunism or innovation. Entrepreneurial and other rents may be earned. Conditions are “inefficient” Rents are the prices of the services of resources. Strategic rents refer to ex ante—ex post differences in the earnings of resources and result from opportunism or innovation. Innovation occurs. Conditions are “dynamic.”
ReferencesBarney, Jay B. 1986. “Strategic Factor Markets: Expectations, Luck and Business Strategy.” Management Science 32 (10): 1231–41 as reprinted in Foss (1997a).Barney, J. 1991. “Firm Resources and Sustained Competitive Advantage.” Journal of Management 17 (1): 99–120.Conner, K.R. and Prahalad, C.K. 1996. “A Resource-Based Theory of the Firm: Knowledge versus Opportunism.” Organization Science 7: 477–501.Fetter, Frank A. 1977. Capital, Interest, and Rent: Essays in the Theory of Distribution. Edited with an introduction by Murray N. Rothbard. Kansas City: Sheed Andrews and McMeel.Foss, Nicolai J. 1994. “The Theory of the Firm: The Austrians as Precursors and Critics of Contemporary Theory.” Review of Austrian Economics 7 (1): 31–66.———. 1997a. “Resources and Strategy: A Brief Overview of Themes and Contributions.” In idem., Resources, Firms, and Strategies: A Reader in the Resource Based Perspective. Oxford: Oxford University Press.———. 1997b. “Austrian Insights and the Theory of the Firm.” Advances in Austrian Economics 4: 175–98.Fransman, Martin. 1994. “Information, Knowledge, Vision, and Theories of the Firm.” Industrial and Corporate Change 3 (3): 713–57.Gabel, L. 1984. “The Microfoundations of Competitive Strategy.” Insead Working Paper.Grant, Richard M. 1996. “Toward a Knowledge-Based Theory of the Firm.” Strategic Management Journal 17 (Winter): 109–22.Hart, Oliver. 1995. Firms, Contracts, and Financial Structure. Oxford: Oxford University Press.Hayek, F.A. 1937. “Economics and Knowledge.” Economica IV(NS): 33–54.———. 1978. “Competition as a Discovery Process.” In idem., New Studies in Philosophy, Politics, Economics, and the History of Ideas. Chicago: University of Chicago Press.Klein, Benjamin, Robert A. Crawford, and Armen Alchian. 1978. “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process.” Journal of Law and Economics 21: 297–326, as reprinted in L. Putterman and R.S. Kroszner, The Economic Nature of the Firm. Cambridge: Cambridge University Press. 2nd Ed. (1996): 105–24.Lachmann, Ludwig M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society.” Journal of Economic Literature (March): 24–62.———. [1956] 1978. Capital and Its Structure. Kansas City: Sheed Andrews and McMeel.Langlois, Richard N. 1991. “Transaction Cost Economics in Real Time.” Industrial and Corporate Change 1 (1): 99–127, as reprinted in Foss (1997a).Langlois, Richard N. and Robertson, Paul L. 1995. Firms, Markets, and Economic Change: A Dynamic Theory of Business Institutions. London: Routledge.Lewin, Peter. 1997a. “Hayekian Equilibrium and Change.” Journal of Economic Methodology 4 (2): 245–66.———. 1997b. “Capital in Disequilibrium: A Reexamination of the Capital Theory of Ludwig M. Lachmann.” History of Political Economy 29 (3): 523–48.———. 1998. Capital in Disequilibrium: The Role of Capital in a Changing World. London and New York, Routledge.Lewin Peter, and Phelan, Steven E. 1998. “Rent and Resources: A Market Process Perspective.” University of Texas at Dallas Working Paper.Libeskind, J.P. 1996. “Knowledge, Strategy, and the Theory of the Firm.” Strategic Management Journal 17: 93–107.Marshall, Alfred. [1920] 1961. Principles of Economics: An Introductory Volume. London and New York: Macmillan.Mathews, Don. 1998. “Management vs. The Market: An Exaggerated Distinction.” Quarterly Journal of Austrian Economics 1 (3): 41–46.Mill, John Stuart. [1871] 1987. Principles of Political Economy. Fairfield, N.J.: Augustus M. Kelley.Mises, Ludwig von. [1951] 1980. Profit and Loss. In idem., Planning for Freedom. Spring Mills, Penn.: Libertarian Press.Penrose, Ernest F. [1959] 1995. The Theory of the Growth of the Firm. London: Basil Blackwell.Peteraf, M.A. 1993. “The Cornerstones of Competitive Advantage: A Resource-Based View.” Strategic Management Journal 14: 179–91.Ricardo, David. [1821] 1973. The Principles of Political Economy and Taxation. London: Guernsey Press.Rothbard, Murray N. [1962] 1993. Man, Economy, and State. Auburn, Ala.: Ludwig von Mises Institute.Rumelt, Richard P. 1984. “Towards a Strategic Theory of the Firm.” In R.B. Lamb, ed. Competitive Strategic Management. Englewood Cliffs, N.J., Prentice-Hall.———. 1987. “Theory, Strategy, and Entrepreneurship.” In D.J. Teece, ed. The Competitive Challenge: Strategies for Industrial Innovation and Renewal. Cambridge, Mass.: Ballinger.Sautet, Frédéric. 1998. An Entrepreneurial Theory of the Firm. Ph.D. Dissertation. Université de Paris-IX-Dauphine.Schumpeter, Joseph. 1947. Capitalism, Socialism, and Democracy. New York: Harper.Stonier, Alfred W., and Douglas C. Hague. 1964. A Textbook of Economic Theory. London: Longmans, Green.Williamson, Oliver. 1985. The Economic Institutions of Capitalism. New York: The Free Press.Winch, Donald. 1973. Introduction in David Ricardo, The Principles of Political Economy and Taxation. London: J.M. Dent and Sons.[1] A closer disciple of Ricardo than Marshall, John Stuart Mill, writes: This is the theory of rent, first propounded at the end of the last century by Dr. Anderson and, which, neglected at that time, was almost simultaneously rediscovered, twenty years later, by Sir Edward West, Mr. Malthus, and Mr. Ricardo. It is one of the cardinal doctrines of political economy: and until it was understood, no consistent explanation could be given of many of the more complicated industrial phenomena. (Mill 1987, p. 425)[2] The term “resources” has been variously used in the RBT literature. Here it is used to denote valuable assets that may be tangible or intangible (like reputations, patents, organizational routines).[3] We use “production” here in the broadest possible sense to refer to the addition of economic value for the ultimate consumer. So, for example, distribution and marketing activities are, from this perspective, part of the productive process.[4] We leave aside for the moment the question of how it is possible to attribute to any resource an income flow. Clearly, insofar as resources must invariably be used in combination, it is no simple matter to impute to any single resource a value for its individual contribution (how does one divide up and evaluate the contributions of individual members of a team, for example?). And the estimation of the value of any production plan is in itself a speculative matter.[5] As Rothbard has explained, from the perspective of the economy as a whole, in an economy in which from the start everything is known with certainty, the sum of all rents earned on resources that are constructed is zero since all such rents are “swept back” to the owners of the “original” factors of production. What one person pays for a piece of capital equipment, for example, a machine, will fully reflect the seller’s knowledge of the discounted marginal value sum to be earned by that machine. By the same token, the prices of all of the inputs into the production of that machine will reflect their capitalized income streams in the same manner, all the way back to the original inputs. In this way, the only remaining “net” rents are those earned by the “fixed” factors of land and raw labor. And if we regard the pure earnings of labor as necessary for its existence and maintenance (reproduction), then perhaps the only “pure” rent remaining is that on land (see Rothbard 1993, chap. 5). This perspective appears to be related to Ricardo’s identification of land as the only rent-earning resource, but it is not the same point, as will become clear from the discussion below.[6] Also: we have been using the term rent in our analysis to signify the hire price of the services of goods. This price is paid for unit services, as distinguished from the prices of the whole factors yielding the service. Since all goods have unit services, all goods will earn rents, whether they be consumers’ goods or any type of producers’ goods. Future rents of durable goods tend to be capitalized and embodied in their capital value and therefore in the money presently needed to acquire them. (Rothbard 1993, pp. 502–03)[7] It need hardly be added here that there is no valid “cost of production” theory for the determination of value. All value derives from the value of final outputs to consumers. It follows then that there are no “unearned” rents in the sense of Ricardo (to be examined below) or in the sense of any “monopoly rents.” All rents reflect the “value contributed” to the production process.[8] An admiring textbook treatment of the subject of rent notes as follows: “There is no explicit formal definition of quasi-rent in Marshall, and the term has been used both by him and by other writers in a variety of related but not identical senses” (Stonier and Hague 1964, p. 292). They continue, in an attempt to provide their own definition, “The quasi-rent of a machine is its total short-run receipts less the total costs of hiring the variable factors used with it and of keeping the machine in running order in the short run. In long-run equilibrium quasi-rent will become equal to the (constant) normal earnings of the machine” (p. 93, italics added). Thus there is no suggestion here that (quasi-)rent refers to any type of surplus, though it is attributable to the fact that the machine, even in the long run, has value, i.e., is scarce.[9] It is also true that the usage of terms relating to rent in the modern strategy and microeconomics literature is not clear or consistent (see Lewin and Phelan 1998).[10] For example, Peteraf (1993) confounds Ricardian and Marshallian rents and uses Paretian rents as synonymous with quasi-rents, whereas Rumelt (1987) uses quasi-rents as synonymous with Marshallian rents.[11] We use the word “strategic” here in a manner different from its use in Game Theory, where it can refer to actions taken in an equilibrium playing out of certain “strategies.” We are referring to situations in which the outcomes are radically uncertain as requiring “strategic decisions.”
Volume 23, Number 2 (Summer 2003)
Morgan O. Reynolds is interviewed about his life in academia and his work with the U.S. Government.
The corn, sugar, and ethanol industries in the US are all part of a complex system of government subsidies and other favors, writes Dave Albin. This audio Mises Daily is narrated by Robert Hale.
Labor unions work to prevent increases in the productivity of workers, which is ultimately the only way to increase real wages, writes George Reisman. This audio Mises Daily is narrated by Robert Hale.
Right-to-work laws substitute one government mandate for another, writes Logan Albright. This audio Mises Daily is narrated by Robert Hale.
Stiglitz wants to revitalize industrial policy through greater government intervention to favor certain technologies over others, writes Stewart Dompe and Adam C. Smith. This audio Mises Daily is narrated by Robert Hale.
Smuggling has often played a pivotal role in important events and episodes in American history, writes Mark Thornton. This audio Mises Daily is narrated by Clay Barnett.
Swiss voters recently rejected a proposal to introduce the world’s highest minimum wage, writes Benjamin M. Wiegold. This audio Mises Daily is narrated by Clay Barnett.
One of Carl Menger’s contributions was his primacy of the consumer in determining value and price, not only in the marketplace but in all economic activity, writes Christopher Westley.
This audio Mises Daily is narrated by Keith Hocker.
War increases government spending, inhibits free trade, and lays the foundation for numerous future conflicts, writes Ron Paul. This audio Mises Daily is narrated by Clay Barnett.
The James M. Rodney Lecture, presented at the 2012 Mises Institute Supporters Summit. Recorded at Callaway Gardens, Georgia, on 26 October 2012. Includes an introduction by Llewellyn H. Rockwell, Jr.
Interviewed by host Thom Hartmann, Mark Thornton explains why the minimum wage actually hurts the workers it is supposed to help.
Peter G. Klein responds to a recent NPR story by Uri Berliner entitled "Coffee Futures: The Highs And Lows Of A Cup Of Joe". Dr. Klein explains how a free market in coffee commodities would function. Klein is the Mises Institute's Executive Director and Carl Menger Research Fellow.
After studying and teaching Keynesian economics for 30 years, I conclude that the “sophisticated” Keynesians really do believe in magic and fairy dust. Lots of fairy dust. It may seem odd that this Austrian economist refers to fairies, but I got the term from Paul Krugman.
According to Krugman, too many people place false hopes in what he calls the “Confidence Fairy,” a creature created as a retort to economist Robert Higgs’s concept of “regime uncertainty.” Higgs coined that expression in a 1997 paper on the Great Depression in which he claimed that uncertainty caused by the policies of Franklin Roosevelt’s New Deal was a major factor in the Great Depression being so very, very long.
Nonsense, writes Krugman. Investors are not waiting for governments to “get their financial houses in order” and protect private property. Instead, he claims, investors are waiting for governments to spend in order to create enough “aggregate demand” in the economy to bring about new investments and, one hopes, full employment.
According to Higgs, the “humor columnist for the New York Times, Paul Krugman, has recently taken to defending his vulgar Keynesianism against its critics by accusing them of making arguments that rely on the existence of a ‘confidence fairy.’ By this mockery,” Higgs says, “Krugman seeks to dismiss the critics as unscientific blockheads, in contrast to his own supreme status as a Nobel Prize-winning economic scientist.”
It seems, however, that Krugman and the Keynesians have manufactured some fairies of their own: the Debt Fairy and the Inflation Fairy. These two creatures may not carry bags of fairy dust, but they might as well, given that their “tools” of using government debt and printing money to “revitalize” the economy have the same scientific credibility.
Let us first examine the Debt Fairy. According to the Keynesians, the U.S. economy (as well as the economies of Europe and Japan) languishes in a “liquidity trap.” This is a condition in which interest rates are near-zero and people hoard money instead of spending it. Lowering interest rates obviously won’t spur more business borrowing, so it is up to the government to take advantage of the low rates and borrow (and borrow).
If governments issue enough debt, argue Debt Fairy True Believers, the economy will gain “traction” as government spending, through the power of pixie dust, fuels a recovery. Governments spend, businesses magically gain confidence, and then they spend and invest. (At this point, we are apparently supposed to just overlook the fact that the Keynesians are saying that we need the Debt Fairy to resurrect the Keynesian version of the Confidence Fairy.)
The Inflation Fairy also plays an important role, according to Keynesians, for if bona fide inflation can take hold in the economy and people watch their money lose value, then they will spend more of their savings. In turn, this destruction of savings will, through the power of Keynesian sorcery, revive the economy. Thus inflation undermines what Keynesians call the “Paradox of Thrift,” a theory that says if a lot of people withhold some present consumption in order to save for future consumption, the economy quickly will implode and ultimately will slip into a Liquidity Trap in which no one will spend anything.
These fairies can work their magic if (and only if) one condition exists: factors of production are homogeneous, which means that government spending will enable all lines of production simultaneously. The actual record of the boom-and-bust cycle, however, tells a different story. It seems that the Debt and Inflation Fairies enable booms along certain lines of production (such as housing during the past decade), but as everyone knows, the fairy dust lost its magical powers and the booms collapsed into recessions.
Austrians such as Mises and Rothbard have well understood what Keynesians do not: the structures of production within an economy are heterogeneous and can be distorted by government intervention through inflation and massive borrowing. Far from being creatures that can “save” an economy, the Debt Fairy and the Inflation Fairy are the architects of economic disaster.
Despite Keynesian protestations that the U.S. and European governments are engaged in “austerity,” the twin fairies are active on both continents. The fairy dust they are sprinkling on the economy, however, is more akin to sprinkling ricin on humans. In the end, the good fairies turn into witches.
Archived from the live Mises.tv broadcast, this lecture was presented by Jeff Herbener at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 22 July 2013.
Archived from the live Mises.tv broadcast, this lecture was presented by Peter Klein at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 23 July 2013.
Archived from the live Mises.tv broadcast, this lecture was presented by Jeff Herbener at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 22 July 2013. Includes an introduction by Mark Thornton.
Part of the Authors Forum, presented at the Austrian Economics Research Conference. Recorded 21 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
[This article is excerpted from volume 2, chapter 12 of An Austrian Perspective on the History of Economic Thought (1995). An MP3 audio file of this chapter, narrated by Jeff Riggenbach, is available for download.]
Even assuming that the unexplained incompatibility between the productive forces and the relations of production exists, why shouldn't this incompatibility continue forever? Why doesn't the economy simply lapse into permanent stagnation of the technological forces? This "contradiction," so to speak, was scarcely enough to generate Marx's goal of the inevitable proletarian communist revolution.
The answer that Marx supplies, the motor of the inevitable revolutions in history, is inherent class conflict, inherent struggles between economic classes. For, in addition to the property rights system, one of the consequences of the relations of production, as determined by the productive forces, is the "class structure" of society. For Marx, the fetters are invariably applied by the privileged "ruling classes," who somehow serve as surrogates for, or living embodiments of, the social relations of production and the legal property system. In contrast, another, inevitably "rising" economic class somehow embodies the oppressed, or fettered, technologies and modes of production. The "contradiction" between the fettered material productive forces and the fettering social relations of production thus becomes embodied in a determined class struggle between the "rising" and the "ruling" classes, which are bound, by the inevitable (material) dialectic of history to result in a triumphant revolution by the rising class. The successful revolution at last brings the relations of production and the material productive forces, or technological system, into harmony. All is then peaceful and harmonious until later, when further technological development gives rise to new "contradictions," new fetters, and a new class struggle to be won by the rising economic class. In that way, feudalism, determined by the hand mill, gives rise to middle classes when the steam mill develops, and the rising middle classes, the living surrogates of the steam mill, overthrow fetters imposed by the feudal landlord class. Thus, the material dialectic takes one socioeconomic system, say feudalism, and claims that it "gives rise" to its opposite, or "negation," and its inevitable replacement by "capitalism," which thus "negates" and transcends feudalism. And in the same way electricity (or whatever) will inevitably give rise to a proletarian revolution which will permit electricity to triumph over the fetters that capitalists place upon it.
It is difficult to state this position without rejecting it immediately as drivel. In addition to all the flaws in historical materialism we have seen above, there is no causal chain that links a technology to a class, or that permits economic classes to embody either technology or its "production relations" fetters. There is no proffered reason why such classes must, or even plausibly might, act as determined puppets for or against new technologies. Why must feudal landlords try to suppress the steam mill? Why can't feudal landlords invest in steam mills? And why can't capitalists cheerfully invest in electricity as they already have in steam? Indeed, they have in fact happily invested in electricity, and in all other successful and economical technologies (as well as bringing them about in the first place). Why are capitalists inevitably oppressed under feudalism, and why are the proletariat equally inevitably oppressed under capitalism? (On Marx's attempt to answer the latter question, see below.)
If, finally, class struggle and the material dialectic bring about an inevitable proletarian revolution, why does the dialectic, as Marx of course maintains, at that point come to an end? For crucial to Marxism, as to other millennial and apocalyptic creeds, is that the dialectic can by no means roll on forever. On the contrary, the chiliast, whether pre- or post-millennial, invariably sees the end of the dialectic, or the end of history, as imminent. Very soon, imminently, the third age, or the return of Jesus, or the Kingdom of God on earth, or the total self-knowledge of the man-God, will effectively put an end to history. Marx's atheist dialectic, too, envisioned the imminent proletarian revolution, which would, after the "raw communist" stage, bring about a "higher communism" or perhaps a "beyond communist" stage, which would be a classless society, a society of total equality, of no division of labor, a society without rulers. But since history is a "history of class struggles" for Marx, the ultimate communist stage would be the final one, so that, in effect, history would then come to an end.
Critics of Marx, from Bakunin to Machajski to Milovan Djilas, have of course pointed out, both prophetically and in retrospect, that the proletarian revolution, whichever its stage, would not eliminate classes, but, on the contrary, would set up a new ruling class and a new ruled. There would be no equality, but another inequality of power and inevitably of wealth: the oligarchic elite, the vanguard, as rulers, and the rest of society as the ruled.
In order to round out his system, Marx was interested in the dialectical workings of the past, the passages from oriental despotism or the "Asiatic mode of production" to the ancient world, thence to feudalism, and from feudalism to capitalism. But his main interest, understandably, was in demonstrating the precise mechanism by which capitalism was supposed to give way, imminently, to the proletarian revolution. After working out this broad system, the rest of Marx's life was largely devoted to demonstrating and developing these alleged mechanisms.
[From Man, Economy, and State, with Power and Market]
Up to this point we have discussed the case in which the owners of land and labor, i.e., of the original factors, restrict their possible consumption and invest their factors in a production process, which, after a certain time, produces a consumers' good to be sold to consumers for money. Now let us consider a situation in which the owners of the factors do not own the final product. How could this come about? Let us first forget about the various stages of the production process and assume for the moment that all the stages can be lumped together as one. An individual or a group of individuals acting jointly can then, at present, offer to pay money to the owners of land and labor, thus buying the services of their factors. The factors then work and produce the product, which, under the terms of their agreement, belongs to the new class of product owners. These product owners have purchased the services of the land and labor factors as the latter have been contributing to production; they then sell the final product to the consumers.
What has been the contribution of these product owners, or "capitalists," to the production process? It is this: the saving and restriction of consumption, instead of being done by the owners of land and labor, has been done by the capitalists. The capitalists originally saved, say, 95 ounces of gold which they could have then spent on consumers' goods. They refrained from doing so, however, and, instead, advanced the money to the original owners of the factors. They paid the latter for their services while they were working, thus advancing them money before the product was actually produced and sold to the consumers. The capitalists, therefore, made an essential contribution to production. They relieved the owners of the original factors from the necessity of sacrificing present goods and waiting for future goods. Instead, the capitalists have supplied present goods from their own savings (i.e., money with which to buy present goods) to the owners of the original factors. In return for this supply of present goods, the latter contribute their productive services to the capitalists, who become the owners of the product. More precisely, the capitalists become the owners of the capital structure, of the whole structure of capital goods as they are produced. Keeping to our assumption that one capitalist or group of capitalists owns all the stages of any good's production, the capitalists continue to advance present goods to owners of factors as the "year" goes on. As the period of time continues, highest-order capital goods are first produced, are then transformed into lower-order capital goods, etc., and ultimately into the final product. At any given time, this whole structure is owned by the capitalists. When one capitalist owns the whole structure, these capital goods, it must be stressed, do him no good whatever. Thus, suppose that a capitalist has already advanced 80 ounces over a period of many months to owners of labor and land in a line of production. He has in his ownership, as a result, a mass of fifth-, fourth-, and third-order capital goods. None of these capital goods is of any use to him, however, until the goods can be further worked on and the final product obtained and sold to the consumer.
Popular literature attributes enormous "power" to the capitalist and considers his owning a mass of capital goods as of enormous significance, giving him a great advantage over other people in the economy. We see, however, that this is far from the case; indeed, the opposite may well be true. For the capitalist has already saved from possible consumption and hired the services of factors to produce his capital goods. The owners of these factors have the money already for which they otherwise would have had to save and wait (and bear uncertainty), while the capitalist has only a mass of capital goods, a mass that will prove worthless to him unless it can be further worked on and the product sold to the consumers.
When the capitalist purchases factor services, what is the precise exchange that takes place? The capitalist gives money (a present good) in exchange for receiving factor services (labor and land), which work to supply him with capital goods. They supply him, in other words, with future goods. The capital goods for which he pays are way stations on the route to the final product — the consumers' good. At the time when land and labor are hired to produce capital goods, therefore, these capital goods, and therefore the services of the land and labor, are future goods; they represent the embodiment of the expected yield of a good in the future — a good that can then be consumed. The capitalist who buys the services of land and labor in year one to work on a product that will eventually become a consumers' good ready for sale in year two is advancing money (a present good) in exchange for a future good — for the present anticipation of a yield of money in the future from the sale of the final product. A present good is being exchanged for an expected future good.
Under the conditions of our example, we are assuming that the capitalists own no original factors, in contrast to the first case, in which the products were jointly owned by the owners of these factors. In our case, the capitalists originally owned money, with which they purchased the services of land and labor in order to produce capital goods, which are finally transformed by land and labor into consumers' goods. In this example we have assumed that the capitalists do not at any time own any of the cooperating labor or land factors. In actual life, of course, there may be and are capitalists who both work in some managerial capacity in the production process and also own the land on which they operate. Analytically, however, it is necessary to isolate these various functions. We may call those capitalists who own only the capital goods and the final product before sale "pure capitalists."
Let us now add another temporary restriction to our analysis — namely, that all producers' goods and services are only hired, never bought outright. This is a convenient assumption that will be maintained long after the assumption of specific factors is dropped. We here assume that the pure capitalists never purchase as a whole a factor that in itself could yield several units of service. They can only hire the services of factors per unit of time. This situation is directly analogous to the conditions described in chapter 4, section 7 above, in which consumers bought or "rented" the unit services of goods rather than the goods as a whole. In a free economy, of course, this hiring or renting must always occur in the case of labor services. The laborer, being a free man, cannot be bought; i.e., he cannot be paid a cash value for his total future anticipated services, after which he is at the permanent command of his buyer. This would be a condition of slavery, and even "voluntary slavery," as we have seen, cannot be enforced on the free market because of the inalienability of personal will. A laborer cannot be bought, then, but his services can be bought over a period of time; i.e., he can be rented or hired.
It is said that the most advantageous of all branches of trade is that which supplies manufactured commodities in exchange for raw materials. For these raw materials are the aliment and support of national labor.
Hence the conclusion is drawn that the best law of customs is that which gives the greatest possible facility to the importation of raw materials, and which throws most obstacles in the way of importing finished goods.
There is no fallacy in political economy more widely disseminated than this. It is cherished not only by the protectionist school but also, and above all, by the school that dubs itself Liberal; and it is unfortunate that it should be so, for what can be more injurious to a good cause than that it should be at the same time vigorously attacked and feebly defended?
Commercial liberty is likely to have the fate of liberty in general; it will only find a place in the statute book after it has taken possession of men's minds and convictions. But if it be true that a reform, in order to be solidly established, should be generally understood, it follows that nothing can so much retard reform as that which misleads public opinion. And what is more calculated to mislead public opinion than works that, in advocating freedom, invoke aid from the doctrines of monopoly?
Some years ago three of the great towns of France — Lyons, Bordeaux, and Havre — united in a movement against the restrictive regime. All Europe was stirred on seeing raised what they took for the banner of liberty. Alas! it proved to be also the banner of monopoly — of a monopoly a little more niggardly and much more absurd than that of which they seemed to desire the overthrow. By the aid of the fallacy that I have just endeavored to expose, the petitioners did nothing more than reproduce the doctrine of protection to national industry, tacking to it an additional inconsistency.
It was, in fact, nothing else than the system of prohibition. Just listen to Mr. de Saint-Cricq:
"Labor constitutes the wealth of a nation, because labor alone creates those material objects which our wants demand; and universal ease and comfort consist in the abundance of these things." So much for the principle.
"But this abundance must be produced by national labor. If it were the result of foreign labor, national labor would be immediately brought to a stand." Here lies the error. (See the preceding chapter.)
"What course should an agricultural and manufacturing country take under such circumstances? Reserve its markets for the products of its own soil and of its own industry." Such is the end and design.
"And for that purpose restrain by duties, and, if necessary, prohibit importation of the products of the soil and industry of other nations." Such are the means.
Let us compare this system with that which the Bordeaux petition advocates.
Commodities are there divided into three classes:
"The first includes provisions, and raw materials upon which no human labor has been bestowed. In principle, a wise economy would demand that this class should be free of duties." Here we have no labor, no protection.
"The second consists of products that have, to some extent, been prepared. This preparation warrants such products being charged with a certain amount of duty." Here protection begins, because here, according to the petitioners, begins national labor.
"The third comprises goods and products in their finished and perfect state. These contribute nothing to national labor, and we regard this class as the most taxable." Here labor, and protection along with it, reach their maximum.
We thus see that the petitioners profess their belief in the doctrine that foreign labor is injurious to national labor; and this is the error of the prohibitive system.
They demand that the home market should be reserved for home industry. That is the design of the system of prohibition.
They demand that foreign labor should be subjected to restrictions and taxes. These are the means employed by the system of prohibition. What difference, then, can we possibly discover between the Bordeaux petitioners and the Corypheus of restriction? One difference, and one only: the greater or less extension given to the word labor.
Mr. de Saint-Cricq extends it to everything, and so he wishes to protect all.
"Labor constitutes all the wealth of a people," he says; "to protect agricultural industry, and all agricultural industry; to protect manufacturing industry, and all manufacturing industry, is the cry which should never cease to be heard in this Chamber."
The Bordeaux petitioners take no labor into account but that of the manufacturers; and for that reason they would admit them to the benefits of protection.
"Raw materials are commodities upon which no human labor has been bestowed. In principle, we should not tax them. Manufactured products can no longer serve the cause of national industry, and we regard them as the best subjects for taxation."
It is not our business in this place to inquire whether protection to national industry is reasonable. Mr. de Saint-Cricq and the Bordeaux gentlemen are at one upon this point, and, as we have shown in the preceding chapters, we on this subject differ from both.
Our present business is to discover whether it is by Mr. de Saint-Cricq, or by the Bordeaux petitioners, that the word labor is used in a correct sense.
Now, in this view of the question, we think that Mr. de Saint-Cricq has very much the best of it; and to prove this we may suppose them to hold some such dialogue as the following:
MR. DE SAINT-CRICQ: You grant that national labor should be protected. You grant that the products of no foreign labor can be introduced into our market without superseding a corresponding amount of our national labor. Only you contend that there are a multiplicity of products possessed of value (for they sell), but upon which no human labor has been bestowed (virgin material). And you enumerate, among other things, wheat, flour, meat, cattle, tallow, salt, iron, copper, lead, coal, wool, hides, seeds, etc.
If you will only prove to me that the value of these things is not due to labor, I will grant that it is useless to protect them.
But, on the other hand, if I demonstrate to you that there is as much labor worked up in 100 francs worth of wool as in 100 francs worth of textile fabrics, you will allow that the one is as worthy of protection as the other.
Now, why is this sack of wool worth 100 francs? Is it not because that is its cost price? And what does its cost price represent but the aggregate wages of all the labor and profits of all the capital which have contributed to the production of the commodity?
THE BORDEAUX PETITIONERS: Well, perhaps as regards wool you may be right. But take the case of a sack of corn, a bar of iron, a hundredweight of coal — are these commodities produced by labor? Are they not created by nature?
MR. DE SAINT-CRICQ: Undoubtedly nature creates the elements of all these things, but it is labor that produces the value. I was wrong myself in saying that labor created material objects, and that unfortunate form of expression has led me into other errors. It does not belong to man to create, to make anything out of nothing, be he agriculturist or manufacturer; and if by production is meant creation, all our labor must be marked down as unproductive, and yours, as merchants, more unproductive than all others, excepting perhaps my own.
The agriculturist, then, cannot pretend to have created wheat but he has created value; I mean to say, he has, by his labor and that of his servants, laborers, reapers, etc., transformed into wheat substances which had no resemblance to it whatever. The miller who converts the wheat into flour, the baker who converts the flour into bread, do the same thing.
In order that man may be enabled to clothe himself a multitude of operations are necessary. Prior to all intervention of human labor the true raw materials of cloth are the air, the water, the heat, the gases, the light, the salts, that enter into its composition. These are the raw materials upon which, strictly speaking, no human labor has been employed. They are virgin materials; and since they have no value, I should never dream of protecting them. But the first application of labor converts these substances into grass and fodder, a second into wool, a third into yarn, a fourth into a woven fabric, a fifth into clothing. Who can assert that the whole of these operations, from the first furrow laid open by the plough to the last stitch of the tailor's needle, do not resolve themselves into labor?
And it is because these operations are spread over several branches of industry, in order to accelerate and facilitate the accomplishment of the ultimate object, which is to furnish clothing to those who have need of it, that you desire, by an arbitrary distinction, to rank the importance of such works in the order in which they succeed each other, so that the first of the series shall not merit even the name of labor, and that the last, being labor par excellence, shall be worthy of the favors of protection?
THE PETITIONERS: Yes, we begin to see that wheat, like wool, is not exactly a product of which it can be said that no human labor has been bestowed upon it; but the agriculturist has not, at least, like the manufacturer, done everything himself or by means of his workmen; nature has assisted him, and if there is labor worked up in wheat it is not the simple product of labor.
MR. DE SAINT-CRICQ: But its value resolves itself exclusively into labor. I am happy that nature concurs in the material formation of grain. I could even wish that it were entirely her work; but you must allow that I have constrained this assistance of nature by my labor, and when I sell you my wheat you will remark this: That it is not for the labor of nature that I ask you to pay, but for my own.
But, as you state the case, manufactured commodities are no longer the exclusive products of labor. Is the manufacturer not beholden to nature in his processes? Does he not avail himself of the assistance of the steam-engine, of the pressure of the atmosphere, just as, with the assistance of the plough, I avail myself of its humidity? Has he created the laws of gravitation, of the transmission of forces, of affinity?
THE PETITIONERS: Well, this is the case of the wool over again; but coal is assuredly the work, the exclusive work, of nature. It is indeed a product upon which no human labor has ever been bestowed.
MR. DE SAINT-CRICQ: Yes, nature has undoubtedly created the coal, but labor has imparted value to it. For the millions of years during which it was buried 100 fathoms under ground, unknown to everybody, it was destitute of value. It was necessary to search for it — that is labor; it was necessary to send it to market — that is additional labor. Then the price you pay for it in the market is nothing else than the remuneration of the labor of mining and transport. I do not particularize the parts of the remuneration falling to the lessee, the capitalist, etc., for several reasons: First, because, on looking at the thing more closely, you will see that the remuneration always resolves itself into the reimbursement of advances or the payment of previous labor. Second, because, under the term labor, I include not only the wages of the workmen, but the legitimate recompense of everything that co-operates in the work of production. Third (and above all), because the production of manufactured products is, like that of raw materials, burdened with auxiliary remunerations other than the mere expense of manual labor; and, moreover, this objection, frivolous in itself, would apply as much to the most delicate processes of manufacture, as to the rudest operations of agriculture.
Thus far we see that Mr. de Saint-Cricq has the best of the argument; that the value of raw materials, like that of manufactured commodities, represents the cost of production, that is to say, the labor worked up in them; that it is not possible to conceive of a product possessing value, that has had no human labor bestowed on it; that the distinction made by the petitioners is futile in theory; that, as the basis of an unequal distribution of favors, it would be iniquitous in practice, since the result would be that one-third of our countrymen, who happened to be engaged in manufactures, would obtain the advantages of monopoly, on the alleged ground that they produce by labor, while the other two-thirds — namely, the agricultural population — would be abandoned to competition under the pretext that they produce without labor.
The rejoinder to this, I am quite sure, will be that a nation derives more advantages from importing what are called raw materials, whether produced by labor or not, and exporting manufactured commodities. This will be repeated and insisted on, and it is an opinion very widely accredited.
"The more abundant raw materials are," says the Bordeaux petition, "the more are manufactures promoted and multiplied."
"Raw materials," says the same document in another place, "open up an unlimited field of work for the inhabitants of the countries into which they are imported."
"Raw materials," says the Havre petition, "constituting as they do the elements of labor, must be submitted to a different treatment, and be gradually admitted at the lowest rate of duty."
The same petition expresses a wish that manufactured products should be admitted, not gradually, but after an indefinite lapse of time, not at the lowest rate of duty, but at a duty of 20 percent.
"Among other articles, the low price and abundance of which are a necessity," says the Lyons petition, "manufacturers include all raw materials."
All this is founded on an illusion.
We have seen that all value represents labor. Now, it is quite true that manufacturing labor increases tenfold, sometimes a hundredfold, the value of the raw material; that is to say, it yields ten times, a hundred times, more profit to the nation. Hence men are led to reason thus: The production of a hundredweight of iron brings in a gain of only 15 shillings to workmen of all classes. The conversion of this hundredweight of iron into the mainsprings of watches raises their earnings to £500; and will anyone venture to say that a nation has not a greater interest to secure for its labor a gain of £500 than a gain of 15 shillings? We do not exchange a hundredweight of un-wrought iron for a hundredweight of watchsprings, nor a hundredweight of unwashed wool for a hundredweight of cashmere shawls; but we exchange a certain value of one of these materials for an equal value of another. Now, to exchange equal value for equal value is to exchange equal labor for equal labor. It is not true, then, that a nation that sells five pounds' worth of wrought fabrics or watch-springs gains more than a nation that sells five pounds' worth of wool or iron.
In a country where no law can be voted, where no tax can be imposed, but with the consent of those whose dealings the law is to regulate, and whose pockets the tax is to affect, the public cannot be robbed without first being imposed on and misled. Our ignorance is the raw material of every extortion from which we suffer, and we may be certain beforehand that every fallacy is the precursor of an act of plunder. My good friends! when you detect a fallacy in a petition, button up your wallet-pocket, for you may be sure that this is the mark aimed at. Let us see, then, what is the real object secretly aimed at by the shipowners of Bordeaux and Havre, and the manufacturers of Lyons, and which is concealed under the distinction they attempt to draw between agricultural and manufactured commodities.
"It is principally this first class (that which comprises raw materials, upon which no human labor has been bestowed) which affords," say the Bordeaux petitioners, "the principal support to our merchant shipping.… In principle, a wise economy would not tax this class.… The second (commodities partly wrought up) may be taxed to a certain extent. The third (commodities which call for no more exertion of labor) we regard as the fittest subjects of taxation."
The Havre petitioners "consider that it is indispensable to reduce gradually the duty on raw materials to the lowest rate, in order that our manufacturers may gradually find employment for the shipping interest, which furnishes them with the first and indispensable materials of labor."
The manufacturers could not remain behindhand in politeness toward the shipowners. So the Lyons petition asks for the free introduction of raw materials, "in order to prove," as they express it, "that the interests of the manufacturing are not always opposed to those of the maritime towns."
No; but then the interests of both, understood as the petitioners understand them, are in direct opposition to the interests of agriculture and of consumers.
Well, gentlemen, we have come at length to see what you are aiming at, and the object of your subtle economical distinctions. You desire that the law should restrain the transport of finished goods across the ocean, in order that the more costly conveyance of raw and rough materials, bulky, and mixed up with refuse, should afford greater scope for your merchant shipping, and more largely employ your marine resources. This is what you call a wise economy.
On the same principle, why do you not ask that the pines of Russia should be brought to you with their branches, bark, and roots; the silver of Mexico in its mineral state; the hides of Buenos Aires sticking to the bones of the putrefying carcasses from which they have been torn?
I expect that railway shareholders, the moment they are in a majority in the Chambers, will proceed to make a law forbidding the manufacture of the brandy that is consumed in Paris. And why not? Would not a law enforcing the conveyance of ten casks of wine for every cask of brandy afford Parisian industry the indispensable materials of its labor, and give employment to our locomotive resources?
How long will men shut their eyes to this simple truth?
Manufactures, shipping, labor — all have for end the general, the public good; to create useless industries, to favor superfluous conveyances, to support a greater amount of labor than is necessary, not for the good of the public, but at the expense of the public — is to realize a true petitio principii. It is not labor that is desirable for its own sake; it is consumption. All labor without a commensurate result is a loss. You may as well pay sailors for skipping pebbles on the surface of the water as pay them for transporting useless refuse. Thus, we arrive at the result to which all economic fallacies, numerous as they are, conduct us, namely, confounding the means with the end, and developing the one at the expense of the other.
This lecture by Peter Klein was presented at the 2012 Mises University in Auburn, Alabama. Includes an introduction by Mark Thornton.
Tim Jackson, a professor of sustainable development at the University of Surrey, suggests that greater productivity may have reached its "natural limits", writes David Gordon.
This audio Mises Daily is narrated by Harold Fritsche.
[This article is adapted from a section of Chapter 14, specifically pp. 613–18, of the author's Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996).]
The Marxian doctrine of the alleged arbitrary power of employers over wages appears plausible because there are two obvious facts that it relies on, facts which do not actually support it, but which appear to support it. These facts can be described as "worker need" and "employer greed." The average worker must work in order to live, and he must find work fairly quickly, because his savings cannot sustain him for long. And if necessary — if he had no alternative — he would be willing to work for as little as minimum physical subsistence. At the same time, self-interest makes employers, like any other buyers, prefer to pay less rather than more — to pay lower wages rather than higher wages. People put these two facts together and conclude that if employers were free, wages would be driven down by the force of the employers' self-interest — as though by a giant plunger pushing down in an empty cylinder — and that no resistance to the fall in wages would be encountered until the point of minimum subsistence was reached. At that point, it is held, workers would refuse to work because starvation without the strain of labor would be preferable to starvation with the strain of labor.
What must be realized is that while it is true that workers would be willing to work for minimum subsistence if necessary, and that self-interest makes employers prefer to pay less rather than more, both of these facts are irrelevant to the wages the workers actually have to accept in the labor market.
Let us start with "worker need." To understand why a worker's willingness to work for subsistence if necessary is irrelevant to the wages he actually has to work for, consider the analogous case of the owner of a late-model car who decides to accept a job offer, and to live, in the heart of New York City. If this car owner cannot afford several hundred dollars a month to pay the cost of keeping his car in a garage, and if he cannot devote several prime working hours every week to driving around, hunting for places to park his car on the street, he will be willing, if he can find no better offer, to give his car away for free — indeed, to pay someone to come and take it off his hands. Yet the fact that he is willing to do this is absolutely irrelevant to the price he actually must accept for his car. That price is determined on the basis of the utility and scarcity of used cars — by the demand for and supply of such cars. Indeed, so long as the number of used cars offered for sale remained the same, and the demand for used cars remained the same, it would not matter even if every seller of such a car were willing to give his car away for free, or willing even to pay to have it taken off his hands. None of them would have to accept a zero or negative price or any price that is significantly different from the price he presently can receive.
This point is illustrated in terms of the simple supply and demand diagram presented in Figure 14–1.
On the vertical axis, I depict the price of used cars, designated by P. On the horizontal axis, I depict the quantity of used cars, designated by Q, that sellers are prepared to sell and the buyers to buy at any given price. The willingness of sellers to sell some definite, given quantity of used cars at any price from zero on up (or, indeed, from less than zero by the cost of having the cars taken off their hands) is depicted by a vertical line drawn through that quantity. The vertical line SS denotes the fact that sellers are willing to sell the specific quantity A of used cars at any price from something less than zero on up to as much as they can get for their cars. The fact that they are willing to sell for zero or a negative price has nothing whatever to do with the actual price they receive, which in this case is the very positive price P1. The actual price they receive in this case is determined by the limitation of the supply of used cars, together with the demand for used cars. In Figure 14–1, it is determined at point E, which represents the intersection of the vertical supply line with the demand curve. The price that corresponds to that juncture of supply and demand is P1. The fact that the sellers are all willing if necessary to accept a price less than P1 is, as I say, simply irrelevant to the price they actually must accept. The price the sellers receive in a case of this kind is not determined by the terms on which they are willing to sell. Rather, it is determined by the competition of the buyers for the limited supply offered for sale. (This, of course, is the kind of case Böhm-Bawerk had in mind when he declared that "price is actually limited and determined by the valuations on the part of the buyers exclusively."See Eugen von Böhm-Bawerk, Capital and Interest, 3 vols., trans. George D. Huncke and Hans F. Sennholz (South Holland, Ill.: Libertarian Press, 1959), 2:245.)
Essentially the same diagram, Figure 14–2, depicts the case of labor. Instead of showing price on the vertical axis, I show wages, designated by W. Instead of the supply line being vertical to the point of the sellers being willing to pay to have their good taken off their hands, I assume that no supply whatever is offered below the point of "minimum subsistence," M. This is depicted by a horizontal line drawn from M and parallel to the horizontal axis. Thus, the supply curve in this case has a horizontal portion at "minimum subsistence" before becoming vertical. These are the only differences between Figures 14–1 and 14–2.
Figure 14–2 makes clear that the fact that the workers are willing to work for as little as minimum subsistence is no more relevant to the wages they actually have to accept than was the fact in the previous example that the sellers of used cars were willing to give them away for free or pay to have them taken off their hands. For even though the workers are willing to work for as little as minimum subsistence, the wage they actually obtain in the conditions of the market is the incomparably higher wage W1, which is shown by the intersection — once again at point E — of the demand for labor with the limited supply of labor denoted by point A on the horizontal axis. Exactly like the value of used cars, or anything else that exists in a given, limited supply, the value of labor is determined on a foundation of its utility and scarcity, by demand and supply — more specifically, by the competition of buyers for the limited supply — not by any form of cost of production, least of all by any "cost of production of labor."
It also quickly becomes clear that "employer greed" is fully as irrelevant to the determination of wage rates as "worker need." This becomes apparent as soon as the case of the art auction is recalled that I presented in Chapter 6 in order to demonstrate the actual self-interest of buyers. There I assumed that there are two people at an art auction, both of whom want the same painting. One of these people, let us now call him Mr. Smith, is willing and able to bid as high as $2,000 for the painting. The other, let us now call him Mr. Jones, is willing and able to go no higher than $1,000.
Of course, Mr. Smith does not want to spend $2,000 for the painting. This figure is merely the limit of how high he will go if he has to. He would much prefer to obtain the painting for only $200, or better still, for only $20, or, best of all, for nothing at all. What we must recall here is precisely how low a bid Mr. Smith's rational self-interest allows him to persist in. Would it, for example, actually be to Mr. Smith's self-interest to persist in a bid of only $20, or $200?
It should be obvious that the answer to this question is decidedly no! This is because if Mr. Smith persists in such a low bid, the effect will be that he loses the painting to Mr. Jones, who is willing and able to bid more than $20 and more than $200. In fact, in the conditions of this case, Mr. Smith must lose the painting to the higher bidding of Mr. Jones, if he persists in bidding any sum under $1,000! If Mr. Smith is to obtain the painting, the conditions of the case require him to bid more than $1,000, because that is the sum required to exceed the maximum potential bid of Mr. Jones.
This case contains the fundamental principle that names the actual self-interest of buyers. That principle is that a buyer rationally desires to pay not the lowest price he can imagine, but the lowest price that is simultaneously too high for any other potential buyer of the good, who would otherwise obtain the good in his place.
This identical principle, of course, applies to the determination of wage rates.
The only difference between the labor market and the auction of a painting is the number of units involved. Instead of one painting with two potential buyers for it, there are many millions of workers who must sell their services, together with potential employers of all those workers and of untold millions more workers. This is because just as in the example of the art auction, the essential fact that is present in the labor market is that the potential quantity demanded exceeds the supply available. The potential quantity of labor demanded always far exceeds the quantity of labor that the workers are able, let alone willing, to perform.
For labor, it should be recalled, is scarce. It is the most fundamentally useful and scarce thing in the economic system: virtually everything else that is useful is its product and is limited in supply only by virtue of our lack of ability or willingness to expend more labor to produce a larger quantity of it. (This, of course, includes raw materials, which can always be produced in larger quantity by devoting more labor to the more intensive exploitation of land and mineral deposits that are already used in production, or by devoting labor to the exploitation of land and mineral deposits not presently exploited.) As I have shown, for all practical purposes there is no limit to our need and desire for goods or, therefore, for the performance of the labor required to produce them. In having, for example, a need and desire to be able to spend incomes five or ten times the incomes we presently spend, we have an implicit need and desire for the performance of five or ten times the labor we presently perform, for that is what would be required in the present state of technology and the productivity of labor to supply us with such increases in the supply of goods. Moreover, almost all of us would welcome the full-time personal services of at least several other people. Thus, on both grounds labor is scarce, for the maximum amount of labor available to satisfy the needs and desires of the average member of the economic system can never exceed the labor of just one person, and, indeed, in actual practice, falls far short of that amount because of the existence of large numbers of people, notably young children and elderly parents, who are incapable of performing labor and must live as dependents on the labor of others.
The consequence of the scarcity of labor is that wage rates in a free market can fall no lower than corresponds to the point of full employment. At that point the scarcity of labor is felt, and any further fall in wage rates would be against the self-interests of employers because then a labor shortage would ensue. Thus, if somehow wage rates did fall below the point corresponding to full employment, it would be to the self-interest of employers to bid them back up again.
These facts can be shown in the same supply and demand diagram I used to show the irrelevance to wage determination of workers being willing to work for subsistence. Thus, Figure 14–3 shows that if wage rates were below their market equilibrium of W1, which takes place at the point of full employment, denoted by E — if, for example, they were at the lower level of W2 — a labor shortage would exist. The quantity of labor demanded at the wage rate of W2 is B. But the quantity of labor available — whose employment constitutes full employment — is the smaller amount A. Thus, at the lower wage, the quantity of labor demanded exceeds the supply available by the horizontal distance AB.
The shortage exists because the lower wage of W2 enables employers to afford labor who would not have been able to afford it at the wage of W1, or it enables employers who would have been able to afford some labor at the wage of W1 to now afford a larger quantity of labor. To whatever extent such employers employ labor that they otherwise could not have employed, that much less labor remains to be employed by other employers, who are willing and able to pay the higher wage of W1. For the sake of simplicity, we can assume that at the artificially low wage of W2 the entire quantity AB of labor is employed by employers who otherwise could not have afforded to employ that labor. The effect of this is to leave an equivalently reduced quantity of labor available for those employers who could have afforded the market wage of W1. The labor available to those employers is reduced by AC, which is precisely equal to AB. This is the inescapable result of the existence of a given quantity of labor and some of it being taken off the market by some employers at the expense of other employers. What the one set gains, the other must lose. Thus, because the wage is W2 rather than W1, the employers who could have afforded the market wage of W1 and obtained the full quantity of labor A are now able to employ only the smaller quantity of labor C, because labor has been taken off the market by employers who depend on the artificially low wage of W2.
The employers who could have afforded the market wage of W1 are in identically the same position as the bidder at the art auction who is about to see the painting he wants go to another bidder not able or willing to pay as much. The way to think of the situation is that there are two groups of bidders for quantity AB of labor: those willing and able to pay the market wage of W1, or an even higher wage — one as high as W3 — and those willing and able to pay only a wage that is below W1 — a wage that must be as low as W2. In Figure 14–3, the position of these two groups is indicated by two zones on the demand curve: an upper zone HE and a lower zone EL. The wage of W1 is required for the employers in the upper zone to be able to outbid the employers in the lower zone.
The question is: Is it to the rational self-interest of the employers willing and able to pay a wage of W1, or higher, to lose the labor they want to other employers not able or willing to pay a wage as high as W1? The obvious answer is no. And the consequence is that if, somehow, the wage were to fall below W1, the self-interest of employers who are willing and able to pay W1 or more, and who stood to lose some of their workers if they did not do so, would lead them to bid wage rates back up to W1. The rational self-interest of employers, like the rational self-interest of any other buyers, does not lead them to pay the lowest wage (price) they can imagine, but the lowest wage that is simultaneously too high for other potential employers of the same labor who are not able or willing to pay as much and who would otherwise be enabled to employ that labor in their place.
The principle that it is against the self-interest of employers to allow wage rates to fall to the point of creating a labor shortage is illustrated by the conditions which prevail when the government imposes such a shortage by virtue of a policy of price and wage controls. In such conditions, employers actually conspire with the wage earners to evade the controls and to raise wage rates. They do so by such means as awarding artificial promotions, which allow them to pay higher wages within the framework of the wage controls.
The payment of higher wages in the face of a labor shortage is to the self-interest of employers because it is the necessary means of gaining and keeping the labor they want to employ. In overbidding the competition of other potential employers for labor, it attracts workers to come to work for them and it removes any incentive for their present workers to leave their employ. This is because it eliminates the artificial demand for labor by the employers who depend on a below-market wage in order to be able to afford labor. It is, as I say, identically the same in principle as the bidder who wants the painting at an auction raising his bid to prevent the loss of the painting to another bidder not able or willing to pay as much. The higher bid is to his self-interest because it knocks out the competition. In the conditions of a labor shortage, which necessarily materializes if wage rates go below the point corresponding to full employment, the payment of higher wages provides exactly the same benefit to employers.
On the basis of the preceding discussion, it should be clear that average money wage rates are determined neither by worker need nor by employer greed, but, basically, by the quantity of money in the economic system and thus the aggregate monetary demand for labor, on the one side, and by the number of workers willing and able to work, on the other — that is, by the ratio of the demand for labor to the supply of labor. It should also be clear that in a free labor market, money wage rates can fall no lower than corresponds to the point of full employment.
Two points should be realized in connection with the principle that it is against the self-interest of employers to allow wage rates to fall below the point that corresponds to full employment. First, the operation of the principle does not require that full employment be established throughout the economic system before wage rates cease to fall. On the contrary, the principle applies to each occupation and, still more narrowly, to each occupation within each geographical area. For example, the wage rates of carpenters in Des Moines can fall no further than corresponds to the point of full employment of carpenters in Des Moines. Any further fall would create a shortage of such carpenters and thus would be prevented or quickly reversed, even though there might still be major unemployment in other occupations or in other geographical areas.
Second, the operation of the principle need not be feared as possibly serving to bring about the establishment of subsistence wages through the back door, so to speak. By this, I mean that so long as unemployment exists, there is room for wage rates to fall without the creation of a labor shortage. And in a free market, wage rates would in fact fall in such circumstances. This is because in such circumstances, the self-interest of the employers, and also of the unemployed, would operate to drive them down. It should not be thought, however, that the fall in wage rates in these circumstances meant that the conditions of supply and demand were capable of accomplishing the human misery that Marxism attributes to the alleged arbitrary power of businessmen and capitalists.
It should be recalled that we saw in Chapter 13 that a drop in wage rates to the full employment point does not imply any drop in the average worker's standard of living. That is, it does not imply any reduction in the goods and services he can actually buy — any reduction in his so called real wages — because the elimination of unemployment that the fall in wage rates brings about means more production and a fall in costs of production, both of which mean lower prices. Indeed, we saw that it is likely that real wages actually rise with the elimination of unemployment, even in the short run, because not only do prices fall as much as, or even more than, wages, but also the burden of supporting the unemployed is eliminated, with the result that disposable, take-home pay drops less than gross wages and less than prices. When these facts are kept in mind, it is clear that insofar as market conditions require a fall in wage rates, they are, if anything, at the same time operating to raise the average worker's standard of living further above subsistence, not drive it down toward subsistence.
The Law of ReturnsWe have concluded that the value of each unit of any good is equal to its marginal utility at any point in time, and that this value is determined by the relation between the actor's scale of wants and the stock of goods available. We know that there are two types of goods: consumers' goods, which directly serve human wants, and producers' goods, which aid in the process of production eventually to produce consumers' goods. It is clear that the utility of a consumers' good is the end directly served. The utility of a producers' good is its contribution in producing consumers' goods. With value imputed backward from ends to consumers' goods through the various orders of producers' goods, the utility of any producers' good is its contribution to its product — the lower-stage producers' good or the consumers' good.
As has been discussed above, the very fact of the necessity of producing consumers' goods implies a scarcity of factors of production. If factors of production at each stage were not scarce, then there would be unlimited quantities available of factors of the next lower stage. Similarly, it was concluded that at each stage of production, the product must be produced by more than one scarce higher-order factor of production. If only one factor were necessary for the process, then the process itself would not be necessary, and consumers' goods would be available in unlimited abundance. Thus, at each stage of production, the produced goods must have been produced with the aid of more than one factor. These factors cooperate in the production process and are termed complementary factors.
Factors of production are available as units of a homogeneous supply, just as are consumers' goods. On what principles will an actor evaluate a unit of a factor of production? He will evaluate a unit of supply on the basis of the least importantly valued product which he would have to forgo were he deprived of the unit factor. In other words, he will evaluate each unit of a factor as equal to the satisfactions provided by its marginal unit — in this case, the utility of its marginal product. The marginal product is the product forgone by a loss of the marginal unit, and its value is determined either by its marginal product in the next stage of production, or, if it is a consumers' good, by the utility of the end it satisfies. Thus, the value assigned to a unit of a factor of production is equal to the value of its marginal product, or its marginal productivity.
Since man wishes to satisfy as many of his ends as possible, and in the shortest possible time, it follows that he will strive for the maximum product from given units of factors at each stage of production. As long as the goods are composed of homogeneous units, their quantity can be measured in terms of these units, and the actor can know when they are in greater or lesser supply. Thus, whereas value and utility cannot be measured or subject to addition, subtraction, etc., quantities of homogeneous units of a supply can be measured. A man knows how many horses or cows he has, and he knows that four horses are twice the quantity of two horses.
Assume that a product P (which can be a producers' good or a consumers' good) is produced by three complementary factors, X, Y, and Z. These are all higher-order producers' goods. Since supplies of goods are quantitatively definable, and since in nature quantitative causes lead to quantitatively observable effects, we are always in a position to say that: a quantities of X, combined with b quantities of Y, and c quantities of Z, lead to p quantities of the product P.
Now let us assume that we hold the quantitative amounts b and c unchanged. The amounts a and therefore p are free to vary. The value of a yielding the maximum p/a, i.e., the maximum average return of product to the facto, is called the optimum amount of X. The law of returns states that with the quantity of complementary factors held constant, there always exists some optimum amount of the varying factor. As the amount of the varying factor decreases or increases from the optimum, pa, the average unit product declines. The quantitative extent of that decline depends on the concrete conditions of each case. As the supply of the varying factor increases, just below this optimum, the average return of product to the varying factor is increasing; after the optimum it is decreasing. These may be called states of increasing returns and decreasing returns to the factor, with the maximum return at the optimum point.
The law that such an optimum must exist can be proved by contemplating the implications of the contrary. If there were no optimum, the average product would increase indefinitely as the quantity of the factor X increased. (It could not increase indefinitely as the quantity decreases, since the product will be zero when the quantity of the factor is zero.) But if pa can always be increased merely by increasing a, this means that any desired quantity of P could be secured by merely increasing the supply of X. This would mean that the proportionate supply of factors Y and Z can be ever so small; any decrease in their supply can always be compensated to increase production by increasing the supply of X. This would signify that factor X is perfectly substitutable for factors Y and Z and that the scarcity of the latter factors would not be a matter of concern to the actor so long as factor X was available in abundance. But a lack of concern for their scarcity means that Y and Z would no longer be scarce factors. Only one scarce factor, X, would remain. But we have seen that there must be more than one factor at each stage of production. Accordingly, the very existence of various factors of production implies that the average return of product to each factor must have some maximum, or optimum, value.
In some cases, the optimum amount of a factor may be the only amount that can effectively cooperate in the production process. Thus, by a known chemical formula, it may require precisely two parts of hydrogen and one part of oxygen to produce one unit of water. If the supply of oxygen is fixed at one unit, then any supply of hydrogen under two parts will produce no product at all, and all parts beyond two of hydrogen will be quite useless. Not only will the combination of two hydrogen and one oxygen be the optimum combination, but it will be the only amount of hydrogen that will be at all useful in the production process.
The relationship between average product and marginal product to a varying factor may be seen in the hypothetical example illustrated in table 1. Here is a hypothetical picture of the returns to a varying factor, with other factors fixed. The average unit product increases until it reaches a peak of eight at five units of X. This is the optimum point for the varying factor. The marginal product is the increase in total product provided by the marginal unit. At any given supply of units of factor X, a loss of one unit will entail a loss of total product equal to the marginal product.
Table 1FACTORYb UNITSFACTORXa UNITSTOTALPRODUCTp UNITSAVERAGEUNITPRODUCTp/aMARGINALPRODUCTΔp/Δa33333333012345670410183040454904567.587.57…468121054 Thus, if the supply of X is increased from three units to four units, total product is increased from 18 to 30 units, and this increase is the marginal product of X with a supply of four units. Similarly, if the supply is cut from four units to three units, the total product must be cut from 30 to 18 units, and thus the marginal product is 12.
It is evident that the amount of X that will yield the optimum of average product is not necessarily the amount that maximizes the marginal product of the factor. Often the marginal product reaches its peak before the average product. The relationship that always holds mathematically between the average and the marginal product of a factor is that as the average product increases (increasing returns), the marginal product is greater than the average product. Conversely, as the average product declines (diminishing returns), the marginal product is less than the average product.For algebraic proof, see George J. Stigler, The Theory of Price (New York: Macmillan & Co., 1946), pp. 44–45.
It follows that when the average product is at a maximum, it equals the marginal product.
It is clear that, with one varying factor, it is easy for the actor to set the proportion of factors to yield the optimum return for the factor. But how can the actor set an optimum combination of factors if all of them can be varied in their supply? If one combination of quantities of X, Y, and Z yields an optimum return for X, and another combination yields an optimum return for Y, etc., how is the actor to determine which combination to choose? Since he cannot quantitatively compare units of X with units of Y or Z, how can he determine the optimum proportion of factors? This is a fundamental problem for human action, and its methods of solution will be treated in subsequent chapters.
Convertibility and ValuationFactors of production are valued in accordance with their anticipated contribution in the eventual production of consumers' goods. Factors, however, differ in the degree of their specifity, i.e., the variety of consumers' goods in the production of which they can be of service. Certain goods are completely specific — are useful in producing only one consumers' good. Thus, when, in past ages, extracts from the mandrake weed were considered useful in healing ills, the mandrake weed was a completely specific factor of production — it was useful purely for this purpose. When the ideas of people changed, and the mandrake was considered worthless, the weed lost its value completely. Other producers' goods may be relatively nonspecific and capable of being used in a wide variety of employments. They could never be perfectly nonspecific — equally useful in all production of consumers' goods — for in that case they would be general conditions of welfare available in unlimited abundance for all purposes. There would be no need to economize them. Scarce factors, however, including the relatively nonspecific ones, must be employed in their most urgent uses. Just as a supply of consumers' goods will go first toward satisfying the most urgent wants, then to the next most urgent wants, etc., so a supply of factors will be allocated by actors first to the most urgent uses in producing consumers' goods, then to the next most urgent uses, etc. The loss of a unit of a supply of a factor will entail the loss of the least urgent of the presently satisfied uses.
The less specific a factor is, the more convertible it is from one use to another. The mandrake weed lost its value because it could not be converted to other uses. Factors such as iron or wood, however, are convertible into a wide variety of uses. If one type of consumers' good falls into disuse, iron output can be shifted from that to another line of production. On the other hand, once the iron ore has been transformed into a machine, it becomes less easily convertible and often completely specific to the product. When factors lose a large part of their value as a result of a decline in the value of the consumers' good, they will, if possible, be converted to another use of greater value. If, despite the decline in the value of the product, there is no better use to which the factor can be converted, it will stay in that line of product or cease being used altogether if the consumers' good no longer has value.
For example, suppose that cigars suddenly lose their value as consumers' goods; they are no longer desired. Those cigar machines which are not usable in any other capacity will become, valueless. Tobacco leaves, however, will lose some of their value, but may be convertible to uses such as cigarette production with little loss of value. (A loss of all desire for tobacco, however, will result in a far wider loss in the value of the factors, although part of the land may be salvaged by shifting from tobacco to the production of cotton.)
Suppose, on the other hand, that some time after cigars lose their value this commodity returns to public favor and regains its former value. The cigar machines, which had been rendered valueless, now recoup their great loss in value. On the other hand, the tobacco leaves, land, etc., which had shifted from cigars to other uses will reshift into the production of cigars. These factors will gain in value, but their gain, as was their previous loss, will be less than the gain of the completely specific factor. These are examples of a general law that a change in the value of the product causes a greater change in the value of the specific factors than in that of the relatively nonspecific factors.
To further illustrate the relation between convertibility and valuation, let us assume that complementary factors 10X, 5Y, and 8Z produce a supply of 20P. First, suppose that each of these factors is completely specific and that none of the supply of the factors can be replaced by other units. Then, if the supply of one of the factors is lost (say 10X), the entire product is lost, and the other factors become valueless. In that case, the supply of that factor which must be given up or lost equals in value the value of the entire product — 20P, while the other factors have a zero value. An example of production with purely specific factors is a pair of shoes; the prospect of a loss of one shoe is valued at the value of the entire pair, while the other shoe becomes valueless in case of a loss. Thus, jointly, factors 10X, 5Y, and 8Z produce a product that is valued, say, as rank 11 on the actor's value scale. Lose the supply of one of the factors, and the other complementary factors become completely valueless.
Now, let us assume, secondly, that each of the factors is nonspecific: that 10X can be used in another line of production that will yield a product, say, ranked 21st on the value scale; that 5Y in another use will yield a product ranked 15th on the actor's value scale; and that 8Z can be used to yield a product ranked 30th. In that case, the loss of 10X would mean that instead of satisfying a want of rank 11, the units of Y and Z would be shifted to their next most valuable use, and wants ranked 15th and 30th would be satisfied instead. We know that the actor preferred the satisfaction of a want ranked 11th to the satisfaction of wants ranked 15th and 30th; otherwise the factors would not have been engaged in producing P in the first place. But now the loss of value is far from total, since the other factors can still yield a return in other uses.
Convertible factors will be allocated among different lines of production according to the same principles as consumers' goods are allocated among the ends they can serve. Each unit of supply will be allocated to satisfy the most urgent of the not yet satisfied wants, i.e., where the value of its marginal product is the highest. A loss of a unit of the factor will deprive the actor of only the least important of the presently satisfied uses, i.e., that use in which the value of the marginal product is the lowest. This choice is analogous to that involved in previous examples comparing the marginal utility of one good with the marginal utility of another. This lowest-ranked marginal product may be considered the value of the marginal product of any unit of the factor, with all uses taken into account. Thus, in the above case, suppose that X is a convertible factor in a myriad of different uses. If one unit of X has a marginal product of say, 3P, a marginal product in another use of 2Q, 5R, etc., the actor ranks the values of these marginal products of X on his value scale. Suppose that he ranks them in this order: 4S, 3P, 2Q, 5R. In that case, suppose he is faced with the loss of one unit of X. He will give up the use of a unit of X in production of R, where the marginal product is ranked lowest. Even if the loss takes place in the production of P, he will not give up 3P, but shift a unit of X from the less valuable use R and give up 5R. Thus, just as the actor gave up the use of a horse in pleasure riding and not in wagon-pulling by shifting from the former to the latter use, so the actor who (for example) loses a cord of wood intended for building a house will give up a cord intended for a service less valuable to him — say, building a sled. Thus, the value of the marginal product of a unit of a factor will be equal to its value in its marginal use, i.e., that use served by the stock of the factor whose marginal product is ranked lowest on his value scale.
We now can see further why, in cases where products are made with specific and convertible factors, the general law holds that the value of convertible factors changes less than that of specific factors in response to a change in the value of P or in the conditions of its production. The value of a unit of a convertible factor is set, not by the conditions of its employment in one type of product, but by the value of its marginal product when all its uses are taken into consideration. Since a specific factor is usable in only one line of production, its unit value is set as equal to the value of the marginal product in that line of production alone. Hence, in the process of valuation, the specific factors are far more responsive to conditions in any given process of production than are the nonspecific factors.For further reading on this subject, see Böhm-Bawerk, Positive Theory of Capital, pp. 170–88; and Hayek, Counter-Revolution of Science, pp. 32–33.
As with the problem of optimum proportions, the process of value imputation from consumers' good to factors raises a great many problems which will be discussed in later chapters. Since one product cannot be measured against other products, and units of different factors cannot be compared with one another, how can value be imputed when, as in a modern economy, the structure of production is very complex, with myriads of products and with convertible and inconvertible factors? It will be seen that value imputation is easy for isolated Crusoe-type actors, but that special conditions are needed to enable the value-imputing process, as well as the factor-allocating process, to take place in a complex economy. In particular, the various units of products and factors (not the values, of course) must be made commensurable and comparable.
Labor versus LeisureSetting aside the problem of allocating production along the most desired lines and of measuring one product against another, it is evident that every man desires to maximize his production of consumers' goods per unit of time. He tries to satisfy as many of his important ends as possible, and at the earliest possible time. But in order to increase the production of his consumers' goods, he must relieve the scarcity of the scarce factors of production; he must increase the available supply of these scarce factors. The nature-given factors are limited by his environment and therefore cannot be increased. This leaves him with the choice of increasing his supply of capital goods or of increasing his expenditure of labor.
It might be asserted that another way of increasing his production is to improve his technical knowledge of how to produce the desired goods — to improve his recipes. A recipe, however, can only set outer limits on his increases in production; the actual increases can be accomplished solely by an increase in the supply of productive factors. Thus, suppose that Robinson Crusoe lands, without equipment, on a desert island. He may be a competent engineer and have full knowledge of the necessary processes involved in constructing a mansion for himself. But without the necessary supply of factors available, this knowledge could not suffice to construct the mansion.
One method, then, by which man may increase his production per unit of time is by increasing his expenditure of labor. In the first place, however, the possibilities for this expansion are strictly limited — by the number of people in existence at any time and by the number of hours in the day. Secondly, it is limited by the ability of each laborer, and this ability tends to vary. And, finally, there is a third limitation on the supply of labor: whether or not the work is directly satisfying in itself, labor always involves the forgoing of leisure, a desirable good.This is the first proposition in this chapter that has not been deduced from the axiom of action. It is a subsidiary assumption, based on empirical observation of actual human behavior. It is not deducible from human action because its contrary is conceivable, although not generally existing. On the other hand, the assumptions above of quantitative relations of cause and effect were logically implicit in the action axiom, since knowledge of definite cause-and-effect relations is necessary to any decision to act.
We can conceive of a world in which leisure is not desired and labor is merely a useful scarce factor to be economized. In such a world, the total supply of available labor would be equal to the total quantity of labor that men would be capable of expending. Everyone would be eager to work to the maximum of capacity, since increased work would lead to increased production of desired consumers' goods. All time not required for maintaining and preserving the capacity to work would be spent in labor.Cf. Mises, Human Action, p. 131. Such a situation could conceivably exist, and an economic analysis could be worked out on that basis. We know from empirical observation, however, that such a situation is very rare for human action. For almost all actors, leisure is a consumers' good, to be weighed in the balance against the prospect of acquiring other consumers' goods, including possible satisfaction from the effort itself. The more a man labors, the less leisure he can enjoy. Increased labor therefore reduces the available supply of leisure and the utility that it affords. Consequently, "people work only when they value the return of labor higher than the decrease in satisfaction brought about by the curtailment of leisure."Ibid., p. 132. It is possible that included in this "return" of satisfaction yielded by labor may be satisfaction in the labor itself, in the voluntary expenditure of energy on a productive task. When such satisfactions from labor do not exist, then simply the expected value of the product yielded by the effort will be weighed against the disutility involved in giving up leisure — the utility of the leisure forgone. Where labor does provide intrinsic satisfactions, the utility of the product yielded will include the utility provided by the effort itself. As the quantity of effort increases, however, the utility of the satisfactions provided by labor itself declines, and the utility of the successive units of the final product declines as well. Both the marginal utility of the final product and the marginal utility of labor-satisfaction decline with an increase in their quantity, because both goods follow the universal law of marginal utility.
In considering an expenditure of his labor, man not only takes into account which are the most valuable ends it can serve (as he does with all other factors), these ends possibly including the satisfaction derived from productive labor itself, but he also weighs the prospect of abstaining from the expenditure of labor in order to obtain the consumers' good, leisure. Leisure, like any other good, is subject to the law of marginal utility. The first unit of leisure satisfies a most urgently felt desire; the next unit serves a less highly valued end; the third unit a still less highly valued end, etc. The marginal utility of leisure decreases as the supply increases, and this utility is equal to the value of the end that would have to be forgone with the loss of the unit of leisure. But in that case, the marginal disutility of work (in terms of leisure forgone) increases with every increase in the amount of labor performed.
In some cases, labor itself may be positively disagreeable, not only because of the leisure forgone, but also because of specific conditions attached to the particular labor that the actor finds disagreeable. In these cases, the marginal disutility of labor includes both the disutility due to these conditions and the disutility due to leisure forgone. The painful aspects of labor, like the forgoing of leisure, are endured for the sake of the yield of the final product. The addition of the element of disagreeableness in certain types of labor may reinforce and certainly does not counteract the increasing marginal disutility imposed by the cumulation of leisure forgone as the time spent in labor increases.
Thus, for each person and type of labor performed, the balancing of the marginal utility of the product of prospective units of effort as against the marginal disutility of effort will include the satisfaction or dissatisfaction with the work itself, in addition to the evaluation of the final product and of the leisure forgone. The labor itself may provide positive satisfaction, positive pain or dissatisfaction, or it may be neutral. In cases where the labor itself provides positive satisfactions, however, these are intertwined with and cannot be separated from the prospect of obtaining the final product. Deprived of the final product, man will consider his labor senseless and useless, and the labor itself will no longer bring positive satisfactions. Those activities which are engaged in purely for their own sake are not labor but are pure play, consumers' goods in themselves. Play, as a consumers' good, is subject to the law of marginal utility as are all goods, and the time spent in play will be balanced against the utility to be derived from other obtainable goods.Leisure is the amount of time not spent in labor, and play may be considered as one of the forms that leisure may take in yielding satisfaction. On labor and play, cf. Frank A. Fetter, Economic Principles (New York: The Century Co., 1915), pp. 171–77, 191, 197–206.
In the expenditure of any hour of labor, therefore, man weighs the disutility of the labor involved (including the leisure forgone plus any dissatisfaction stemming from the work itself) against the utility of the contribution he will make in that hour to the production of desired goods (including future goods and any pleasure in the work itself), i.e., with the value of his marginal product. In each hour he will expend his effort toward producing that good whose marginal product is highest on his value scale. If he must give up an hour of labor, he will give up a unit of that good whose marginal utility is lowest on his value scale. At each point he will balance the utility of the product on his value scale against the disutility of further work. We know that a man's marginal utility of goods provided by effort will decline as his expenditure of effort increases. On the other hand, with each new expenditure of effort, the marginal disutility of the effort continues to increase. Therefore, a man will expend his labor as long as the marginal utility of the return exceeds the marginal disutility of the labor effort. A man will stop work when the marginal disutility of labor is greater than the marginal utility of the increased goods provided by the effort.Cf. L. Albert Hahn, Common Sense Economics (New York: Abelard-Schuman, 1956), pp. 1 ff.
Then, as his consumption of leisure increases, the marginal utility of leisure will decline, while the marginal utility of the goods forgone increases, until finally the utility of the marginal products forgone becomes greater than the marginal utility of leisure, and the actor will resume labor again.
This analysis of the laws of labor effort has been deduced from the implications of the action axiom and the assumption of leisure as a consumers' good.
This article is excerpted from Man, Economy, and State (1962), chapter 1.
[Man, Economy, and State (1962)]
- The Concept of ActionThe distinctive and crucial feature in the study of man is the concept of action.For further reading on this topic, the best source is the epochal work of Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949), pp. 1–143, and passim. Human action is defined simply as purposeful behavior. It is therefore sharply distinguishable from those observed movements which, from the point of view of man, are not purposeful. These include all the observed movements of inorganic matter and those types of human behavior that are purely reflex, that are simply involuntary responses to certain stimuli. Human action, on the other hand, can be meaningfully interpreted by other men, for it is governed by a certain purpose that the actor has in view.Cf. ibid., p. 11; F.A. Hayek, "The Facts of the Social Sciences," in Individualism and Economic Order (Chicago: University of Chicago Press, 1948), pp. 57–76; Hayek, The Counter-Revolution of Science (Glencoe, Ill.: The Free Press, 1952), pp. 25–35; and Edith T. Penrose, "Biological Analogies in the Theory of the Firm," American Economic Review, December, 1952, pp. 804–19, especially 818–19. The purpose of a man's act is his end; the desire to achieve this end is the man's motive for instituting the action.
All human beings act by virtue of their existence and their nature as human beings.Cf. Aristotle, Ethica Nicomachea, Bk. I, especially ch. vii. We could not conceive of human beings who do not act purposefully, who have no ends in view that they desire and attempt to attain. Things that did not act, that did not behave purposefully, would no longer be classified as human.
It is this fundamental truth — this axiom of human action — that forms the key to our study. The entire realm of praxeology and its best developed subdivision, economics, is based on an analysis of the necessary logical implications of this concept.This chapter consists solely of a development of the logical implications of the existence of human action. Future chapters — the further parts of the structure — are developed with the help of a very small number of subsidiary assumptions. Cf. Appendix below and Murray N. Rothbard, "Praxeology: Reply to Mr. Schuller," American Economic Review, December, 1951, pp. 943–46; and "In Defense of 'Extreme Apriorism,'" Southern Economic Journal, January, 1957, pp. 314–20. The fact that men act by virtue of their being human is indisputable and incontrovertible. To assume the contrary would be an absurdity. The contrary — the absence of motivated behavior — would apply only to plants and inorganic matter.There is no need to enter here into the difficult problem of animal behavior, from the lower organisms to the higher primates, which might be considered as on a borderline between purely reflexive and motivated behavior. At any rate, men can understand (as distinguished from merely observe) such behavior only in so far as they can impute to the animals motives that they can understand.
- First Implications of the ConceptThe first truth to be discovered about human action is that it can be undertaken only by individual "actors." Only individuals have ends and can act to attain them. There are no such things as ends of or actions by "groups," "collectives," or "States," which do not take place as actions by various specific individuals. "Societies" or "groups" have no independent existence aside from the actions of their individual members. Thus, to say that "governments" act is merely a metaphor; actually, certain individuals are in a certain relationship with other individuals and act in a way that they and the other individuals recognize as "governmental."To say that only individuals act is not to deny that they are influenced in their desires and actions by the acts of other individuals, who might be fellow members of various societies or groups. We do not at all assume, as some critics of economics have charged, that individuals are "atoms" isolated from one another. The metaphor must not be taken to mean that the collective institution itself has any reality apart from the acts of various individuals. Similarly, an individual may contract to act as an agent in representing another individual or on behalf of his family. Still, only individuals can desire and act. The existence of an institution such as government becomes meaningful only through influencing the actions of those individuals who are and those who are not considered as members.Cf. Hayek, Counter-Revolution of Science, p. 34. Also cf. Mises, Human Action, p. 42.
In order to institute action, it is not sufficient that the individual man have unachieved ends that he would like to fulfill. He must also expect that certain modes of behavior will enable him to attain his ends. A man may have a desire for sunshine, but if he realizes that he can do nothing to achieve it, he does not act on this desire. He must have certain ideas about how to achieve his ends. Action thus consists of the behavior of individuals directed towards ends in ways that they believe will accomplish their purpose. Action requires an image of a desired end and "technological ideas" or plans on how to arrive at this end.
Men find themselves in a certain environment, or situation. It is this situation that the individual decides to change in some way in order to achieve his ends. But man can work only with the numerous elements that he finds in his environment, by rearranging them in order to bring about the satisfaction of his ends. With reference to any given act, the environment external to the individual may be divided into two parts: those elements which he believes he cannot control and must leave unchanged, and those which he can alter (or rather, thinks he can alter) to arrive at his ends. The former may be termed the general conditions of the action; the latter, the means used. Thus, the individual actor is faced with an environment that he would like to change in order to attain his ends. To act, he must have technological ideas about how to use some of the elements of the environment as means, as pathways, to arrive at his ends. Every act must therefore involve the employment of means by individual actors to attempt to arrive at certain desired ends. In the external environment, the general conditions cannot be the objects of any human action; only the means can be employed in action.Cf. Talcott Parsons, The Structure of Social Action (Glencoe, Ill.: The Free Press, 1949), pp. 44 ff.
All human life must take place in time. Human reason cannot even conceive of an existence or of action that does not take place through time. At a time when a human being decides to act in order to attain an end, his goal, or end, can be finally and completely attained only at some point in the future. If the desired ends could all be attained instantaneously in the present, then man's ends would all be attained and there would be no reason for him to act; and we have seen that action is necessary to the nature of man. Therefore, an actor chooses means from his environment, in accordance with his ideas, to arrive at an expected end, completely attainable only at some point in the future. For any given action, we can distinguish among three periods of time involved: the period before the action, the time absorbed by the action, and the period after the action has been completed. All action aims at rendering conditions at some time in the future more satisfactory for the actor than they would have been without the intervention of the action.
A man's time is always scarce. He is not immortal; his time on earth is limited. Each day of his life has only 24 hours in which he can attain his ends. Furthermore, all actions must take place through time. Therefore time is a means that man must use to arrive at his ends. It is a means that is omnipresent in all human action.
Action takes place by choosing which ends shall be satisfied by the employment of means. Time is scarce for man only because whichever ends he chooses to satisfy, there are others that must remain unsatisfied. When we must use a means so that some ends remain unsatisfied, the necessity for a choice among ends arises. For example, Jones is engaged in watching a baseball game on television. He is faced with the choice of spending the next hour in: (a) continuing to watch the baseball game, (b) playing bridge, or (c) going for a drive. He would like to do all three of these things, but his means (time) is insufficient. As a result, he must choose; one end can be satisfied, but the others must go unfulfilled. Suppose that he decides on course A. This is a clear indication that he has ranked the satisfaction of end A higher than the satisfaction of ends B or C.
From this example of action, many implications can be deduced. In the first place, all means are scarce, i.e., limited with respect to the ends that they could possibly serve. If the means are in unlimited abundance, then they need not serve as the object of attention of any human action. For example, air in most situations is in unlimited abundance. It is therefore not a means and is not employed as a means to the fulfillment of ends. It need not be allocated, as time is, to the satisfaction of the more important ends, since it is sufficiently abundant for all human requirements. Air, then, though indispensable, is not a means, but a general condition of human action and human welfare.
Secondly, these scarce means must be allocated by the actor to serve certain ends and leave other ends unsatisfied. This act of choice may be called economizing the means to serve the most desired ends. Time, for example, must be economized by the actor to serve the most desired ends. The actor may be interpreted as ranking his alternative ends in accordance with their value to him. This scaling of ends may be described as assigning ranks of value to the ends by the actor, or as a process of valuation. Thus, suppose that Jones ranked his alternative ends for the use of an hour of time as follows:
(First)1. Continuing to watch the baseball game(Second)2. Going for a drive(Third)3. Playing bridge This was his scale of values or scale of preferences. The supply of means (time) available was sufficient for the attainment of only one of these ends, and the fact that he chose the baseball game shows that he ranked that highest (or first). Suppose now that he is allocating two hours of his time and can spend an hour on each pursuit. If he spends one hour on the game and then a second hour on the drive, this indicates that his ranking of preferences is as above. The lowest-ranking end — playing bridge — goes unfulfilled. Thus, the larger the supply of means available, the more ends can be satisfied and the lower the rank of the ends that must remain unsatisfied.
Another lesson to be derived is that action does not necessarily mean that the individual is "active" as opposed to "passive," in the colloquial sense. Action does not necessarily mean that an individual must stop doing what he has been doing and do something else. He also acts, as in the above case, who chooses to continue in his previous course, even though the opportunity to change was open to him. Continuing to watch the game is just as much action as going for a drive.
Furthermore, action does not at all mean that the individual must take a great deal of time in deliberating on a decision to act. The individual may make a decision to act hastily, or after great deliberation, according to his desired choice. He may decide on an action coolly or heatedly; none of these courses affects the fact that action is being taken.Some writers have unfoundedly believed that praxeology and economics assume that all action is cool, calculating, and deliberate.
Another fundamental implication derived from the existence of human action is the uncertainty of the future. This must be true because the contrary would completely negate the possibility of action. If man knew future events completely, he would never act, since no act of his could change the situation. Thus, the fact of action signifies that the future is uncertain to the actors. This uncertainty about future events stems from two basic sources: the unpredictability of human acts of choice, and insufficient knowledge about natural phenomena. Man does not know enough about natural phenomena to predict all their future developments, and he cannot know the content of future human choices. All human choices are continually changing as a result of changing valuations and changing ideas about the most appropriate means of arriving at ends. This does not mean, of course, that people do not try their best to estimate future developments. Indeed, any actor, when employing means, estimates that he will thus arrive at his desired goal. But he never has certain knowledge of the future. All his actions are of necessity speculations based on his judgment of the course of future events. The omnipresence of uncertainty introduces the ever-present possibility of error in human action. The actor may find, after he has completed his action, that the means have been inappropriate to the attainment of his end.
To sum up what we have learned thus far about human action: The distinguishing characteristic of human beings is that all humans act. Action is purposeful behavior directed toward the attainment of ends in some future period which will involve the fulfillment of wants otherwise remaining unsatisfied. Action involves the expectation of a less imperfectly satisfied state as a result of the action. The individual actor chooses to employ elements in his environment as means to the expected achievement of his ends, economizing them by directing them toward his most valued ends (leaving his least valued ones unsatisfied), and in the ways that his reason tells him are most appropriate to attain these ends. His method — his chosen means — may or may not turn out to be inappropriate.
- Further Implications: The MeansThe means to satisfy man's wants are called goods. These goods are all the objects of economizing action.The common distinction between "economic goods" and "free goods" (such as air) is erroneous. As explained above, air is not a means, but a general condition of human welfare, and is not the object of action. Such goods may all be classified in either of two categories: (a) they are immediately and directly serviceable in the satisfaction of the actor's wants, or (b) they may be transformable into directly serviceable goods only at some point in the future — i.e., are indirectly serviceable means. The former are called consumption goods or consumers' goods or goods of the first order. The latter are called producers' goods or factors of production or goods of higher order.
Let us trace the relations among these goods by considering a typical human end: the eating of a ham sandwich. Having a desire for a ham sandwich, a man decides that this is a want that should be satisfied and proceeds to act upon his judgment of the methods by which a ham sandwich can be assembled. The consumers' good is the ham sandwich at the point of being eaten. It is obvious that there is a scarcity of this consumers' good as there is for all direct means; otherwise it would always be available, like air, and would not be the object of action. But if the consumers' good is scarce and not obviously available, how can it be made available? The answer is that man must rearrange various elements of his environment in order to produce the ham sandwich at the desired place — the consumers' good. In other words, man must use various indirect means as cooperating factors of production to arrive at the direct means. This necessary process involved in all action is called production; it is the use by man of available elements of his environment as indirect means — as cooperating factors — to arrive eventually at a consumers' good that he can use directly to arrive at his end.
Let us consider the pattern of some of the numerous cooperating factors that are involved in a modern developed economy to produce one ham sandwich as a consumers' good for the use of one consumer. Typically, in order to produce a ham sandwich for Jones in his armchair, it is necessary for his wife to expend energy in unwrapping the bread, slicing the ham, placing the ham between bread slices, and carrying it to Jones. All this work may be called the labor of the housewife. The cooperating factors that are directly necessary to arrive at the consumers' good are, then: the housewife's labor, bread in the kitchen, ham in the kitchen, and a knife to slice the ham. Also needed is the land on which to have room to live and carry on these activities. Furthermore, this process must, of course, take time, which is another indispensable cooperating factor. The above factors may be called first-order producers' goods, since, in this case, these cooperate in the production of the consumers' good. Many of the first-order producers' goods, however, are also unavailable in nature and must be produced themselves, with the help of other producers' goods. Thus, bread in the kitchen must be produced with the cooperation of the following factors: bread-in-retail-shop and housewife's labor in carrying it (plus the ever-present land-as-standing-room, and time). In this procedure, these factors are second-order producers' goods, since they cooperate in producing first-order goods. Higher-order factors are those cooperating in the production of factors of lower order.
Thus, any process (or structure) of production may be analyzed as occurring in different stages. In the earlier or "higher" stages, producers' goods must be produced that will later cooperate in producing other producers' goods that will finally cooperate in producing the desired consumers' good. Hence, in a developed economy, the structure of production of a given consumers' good might be a very complex one and involve numerous stages.
Important general conclusions can, however, be drawn that apply to all processes of production. In the first place, each stage of production takes time. Secondly, the factors of production may all be divided into two classes: those that are themselves produced, and those that are found already available in nature — in man's environment. The latter may be used as indirect means without having been previously produced; the former must first be produced with the aid of factors in order to aid in the later (or "lower") stages of production. The former are the produced factors of production; the latter are the original factors of production. The original factors may, in turn, be divided into two classes: the expenditure of human energy, and the use of nonhuman elements provided by nature. The first is called labor; the latter is nature or land.The term "land" is likely to be misleading in this connection because it is not used in the popular sense of the word. It includes such natural resources as water, oil, and minerals. Thus, the classes of factors of production are labor, land, and the produced factors, which are termed capital goods.
Labor and land, in one form or another, enter into each stage of production. Labor helps to transform seeds into wheat, wheat into flour, pigs into ham, flour into bread, etc. Not only is labor present at every stage of production, but so also is nature. Land must be available to provide room at every stage of the process, and time, as has been stated above, is required for each stage. Furthermore, if we wish to trace each stage of production far enough back to original sources, we must arrive at a point where only labor and nature existed and there were no capital goods. This must be true by logical implication, since all capital goods must have been produced at earlier stages with the aid of labor. If we could trace each production process far enough back in time, we must be able to arrive at the point — the earliest stage — where man combined his forces with nature unaided by produced factors of production. Fortunately, it is not necessary for human actors to perform this task, since action uses materials available in the present to arrive at desired goals in the future, and there is no need to be concerned with development in the past.
There is another unique type of factor of production that is indispensable in every stage of every production process. This is the "technological idea" of how to proceed from one stage to another and finally to arrive at the desired consumers' good. This is but an application of the analysis above, namely, that for any action, there must be some plan or idea of the actor about how to use things as means, as definite pathways, to desired ends. Without such plans or ideas, there would be no action. These plans may be called recipes; they are ideas of recipes that the actor uses to arrive at his goal. A recipe must be present at each stage of each production process from which the actor proceeds to a later stage. The actor must have a recipe for transforming iron into steel, wheat into flour, bread and ham into sandwiches, etc.
The distinguishing feature of a recipe is that, once learned, it generally does not have to be learned again. It can be noted and remembered. Remembered, it no longer has to be produced; it remains with the actor as an unlimited factor of production that never wears out or needs to be economized by human action. It becomes a general condition of human welfare in the same way as air.We shall not deal at this point with the complications involved in the original learning of any recipe by the actor, which is the object of human action.
It should be clear that the end of the production process — the consumers' good — is valued because it is a direct means of satisfying man's ends. The consumers' good is consumed, and this act of consumption constitutes the satisfying of human wants. This consumers' good may be a material object like bread or an immaterial one like friendship. Its important quality is not whether it is material or not, but whether it is valued by man as a means of satisfying his wants. This function of a consumers' good is called its service in ministering to human wants. Thus, the material bread is valued not for itself, but for its service in satisfying wants; just as an immaterial thing, such as music or medical care, is obviously valued for such service. All these services are "consumed" to satisfy wants. "Economic" is by no means equivalent to "material."
It is also clear that the factors of production — the various higher-order producers' goods — are valued solely because of their anticipated usefulness in helping to produce future consumers' goods or to produce lower-order producers' goods that will help to bring about consumers' goods. The valuation of factors of production is derived from actors' evaluation of their products (lower stages), all of which eventually derive their valuation from the end result — the consumers' good.Cf. Carl Menger, Principles of Economics (Glencoe, Ill.: The Free Press, 1950), pp. 51–67.
Furthermore, the omnipresent fact of the scarcity of consumers' goods must be reflected back in the sphere of the factors of production. The scarcity of consumers' goods must imply a scarcity of their factors. If the factors were unlimited, then the consumers' goods would also be unlimited, which cannot be the case. This does not exclude the possibility that some factors, such as recipes, may be unlimited and therefore general conditions of welfare rather than scarce indirect means. But other factors at each stage of production must be in scarce supply, and this must account for the scarcity of the end product. Man's endless search for ways to satisfy his wants — i.e., to increase his production of consumers' goods — takes two forms: increasing his available supply of factors of production and improving his recipes.
Although it has seemed evident that there are several cooperating factors at each stage of production, it is important to realize that for each consumers' good there must always be more than one scarce factor of production. This is implied in the very existence of human action. It is impossible to conceive of a situation where only one factor of production produces a consumers' good or even advances a consumers' good from its previous stage of production. Thus, if the sandwich in the armchair did not require the cooperating factors at the previous stage (labor of preparation, carrying, bread, ham, time, etc.), then it would always be in the status of a consumers' good — sandwich-in-the-armchair. To simplify the example, let us suppose the sandwich already is prepared and in the kitchen. Then, to produce a consumers' good from this stage forward requires the following factors: (1) the sandwich; (2) carrying it to the armchair; (3) time; (4) the land available. If we assume that it required only one factor — the sandwich — then we would have to assume that the sandwich was magically and instantaneously moved from kitchen to armchair without effort. But in this case, the consumers' good would not have to be produced at all, and we would be in the impossible assumption of paradise. Similarly, at each stage of the productive process, the good must have been produced by at least more than one (higher-order) scarce cooperating factor; otherwise this stage of production could not exist at all.
- Further Implications: TimeTime is omnipresent in human action as a means that must be economized. Every action is related to time as follows:
Figure 1 … A is the period before the beginning of the action; A is the point in time at which the action begins; AB is the period during which the action occurs; B is the point at which the action ends; and B … is the period after the end of the action.
AB is defined as the period of production — the period from the beginning of the action to the time when the consumers' good is available. This period may be divided into various stages, each itself taking a period of time. The time expended during the period of production consists of the time during which labor energy is expended (or working time) and maturing time, i.e., time required without the necessity of concurrent expenditure of labor. An obvious example is the case of agriculture. There might be six months between the time the soil is tilled and the time the harvest is reaped. The total time during which labor must be expended may be three weeks, while the remaining time of over five months consists of the time during which the crop must mature and ripen by the processes of nature. Another example of a lengthy maturing time is the aging of wine to improve its quality.
Clearly, each consumers' good has its own period of production. The differences between the time involved in the periods of production of the various goods may be, and are, innumerable.
One important point that must be emphasized when considering action and the period of production is that acting man does not trace back past production processes to their original sources. In the previous section, we traced back consumers' goods and producers' goods to their original sources, demonstrating that all capital goods were originally produced solely by labor and nature. Acting man, however, is not interested in past processes, but only in using presently available means to achieve anticipated future ends. At any point in time, when he begins the action (say A), he has available to him: labor, nature-given elements, and previously produced capital goods. He begins the action at A expecting to reach his end at B. For him, the period of production is AB, since he is not concerned with the amount of time spent in past production of his capital goods or in the methods by which they were produced.For each actor, then, the period of production is equivalent to his waiting time — the time that he must expect to wait for his end after the commencement of his action. Thus, the farmer about to use his soil to grow crops for the coming season does not worry about whether or to what extent his soil is an original, nature-given factor or is the result of the improvements of previous land-clearers and farmers. He is not concerned about the previous time spent by these past improvers. He is concerned only with the capital (and other) goods in the present and the future. This is the necessary result of the fact that action occurs in the present and is aimed at the future. Thus, acting man considers and values the factors of production available in the present in accordance with their anticipated services in the future production of consumers' goods, and never in accordance with what has happened to the factors in the past.
A fundamental and constant truth about human action is that man prefers his end to be achieved in the shortest possible time. Given the specific satisfaction, the sooner it arrives, the better. This results from the fact that time is always scarce, and a means to be economized. The sooner any end is attained, the better. Thus, with any given end to be attained, the shorter the period of action, i.e., production, the more preferable for the actor. This is the universal fact of time preference. At any point of time, and for any action, the actor most prefers to have his end attained in the immediate present. Next best for him is the immediate future, and the further in the future the attainment of the end appears to be, the less preferable it is. The less waiting time, the more preferable it is for him.Time preference may be called the preference for present satisfaction over future satisfaction or present good over future good, provided it is remembered that it is the same satisfaction (or "good") that is being compared over the periods of time. Thus, a common type of objection to the assertion of universal time preference is that, in the wintertime, a man will prefer the delivery of ice the next summer (future) to delivery of ice in the present. This, however, confuses the concept "good" with the material properties of a thing, whereas it actually refers to subjective satisfactions. Since ice-in-the-summer provides different (and greater) satisfactions than ice-in-the-winter, they are not the same, but different goods. In this case, it is different satisfactions that are being compared, despite the fact that the physical property of the thing may be the same.
Time enters into human action not only in relation to the waiting time in production, but also in the length of time in which the consumers' good will satisfy the wants of the consumer. Some consumers' goods will satisfy his wants, i.e., attain his ends, for a short period of time, others for a longer period. They can be consumed for shorter or longer periods. This may be included in the diagram of any action, as shown in figure 2. This length of time, BC, is the duration of serviceableness of the consumers' good. It is the length of the time the end served by the consumers' good continues to be attained. This duration of serviceableness differs for each consumers' good. It may be four hours for the ham sandwich, after which period of time the actor desires other food or another sandwich. The builder of a house may expect to use it to serve his wants for ten years. Obviously, the expected durative power of the consumers' good to serve his end will enter into the actor's plans.It has become the custom to designate consumer goods with a longer duration of serviceableness as durable goods, and those of shorter duration as nondurable goods. Obviously, however, there are innumerable degrees of durability, and such a separation can only be unscientific and arbitrary.
Figure 2 Period of Production and ConsumptionClearly, all other things being equal, the actor will prefer a consumers' good of greater durability to one of lesser, since the former will render more total service. On the other hand, if the actor values the total service rendered by two consumers' goods equally, he will, because of time preference, choose the less durable good since he will acquire its total services sooner than the other. He will have to wait less for the total services of the less durable good.
The concepts of period of production and duration of serviceableness are present in all human action. There is also a third time period that enters into action. Each person has a general time horizon, stretching from the present into the future, for which he plans various types of action. Whereas period of production and duration of serviceableness refer to specific consumers' goods and differ with each consumers' good, the period of provision (the time horizon) is the length of future time for which each actor plans to satisfy his wants. The period of provision, therefore, includes planned action for a considerable variety of consumers' goods, each with its own period of production and duration. This period of provision differs from actor to actor in accordance with his choice. Some people live from day to day, taking no heed of later periods of time; others plan not only for the duration of their own lives, but for their children as well.
[On Freedom and Free Enterprise (1956)]
When asked to contribute an essay to Professor Mises's Festschrift, I was at first inclined to dip my pen in the well of humility and then lay it aside unused. On what economic theme has Professor Mises himself failed to write with a superiority to anything I could offer? Yet honor is due him. So I trust that friends of this great and patient teacher will tolerate an essay's imperfections for the sake of the spirit of an offering.
Professor Mises's main renown is as an economist. Yet to me he is a charitable person even more than an economist. His charity is not of the fashionable kind that ladles out economic pleasantries from a caldron filled with socialist loot obtained by theft. His is not even primarily of the material sort at all but is, instead, in the form of his inspiring mind and spirit. In my opinion there can be no greater charity than this, for it endures beyond any material form of benevolence.
In this essay I shall be dealing, however, with one aspect of economic charity — a form inferior to charity of the mind and the spirit. People spend vast sums trying to do good with economic alms in forms which, to me, seem open to serious question. In their haste to do good and to bask in the glow of immediate glory as purveyors of alms, they are being exceedingly wasteful of the means of benevolence. The methods they use would come to appear unbenevolent, I believe, if they would view them by the test of alternatives in the longer perspective of economic science. That is the thought I should like to explore here, in honor of Professor Mises.
A certain Talmudical philosopher once offered us this apothegm:
The noblest charity is to prevent a man from accepting charity, and the best alms are to show and enable a man to dispense with alms.Paraphrased by Mary Baker Eddy from Moses Maimonides in his Code of Jewish Law, Chapter X, paragraph 7.
A profound observation! It deserves to be kept in mind constantly as we fumble along in attempts to do good to others.
The greatest charity of all, in the light of this apothegm, would be to assist a person toward becoming wholly self-reliant within nature's limitations, and therefore totally free. The nonmaterial, noneconomic things of the mind and spirit are supreme to this end and therefore comprise the greatest charity. Bread and raiment and abode are trivial indeed as compared with these, in the furtherance of human progress.
The greatest aids to self-reliance are educational, broadly speaking — the tools for pursuing the eternal embryo of truth. The root of progress is a sincere love of truth per se. Devotion to truth in the abstract must surpass love for any specific belief one holds at the moment, if the pursuit is to continue rather than to bog down in stagnant dogma. Exploratory shoots can then sprout from these roots in the form of specific "truths" — more accurately, mere beliefs — however dimly and even erroneously they may be seen at any moment. Among these sprouting shoots will be some sound ones capable of bearing the economic fruits and other passing joys of our daily living.
With things of the mind and spirit duly recognized as the greatest charity of all, this essay will explore one aspect of economic charity. When the word "charity" is used hereinafter, I shall be referring to charity in its economic form according to one definition given in the Oxford Dictionary — material benevolence, sometimes called alms or munificence or philanthropy.Some will resist my use of the word "charity" in connection with the object of my acclaim. They will point to the earlier meaning of the word, which refers to a mental attitude of brotherly love and compassion. Yet standard works on the meanings of words reveal no substitute that seems lacking in the same sort of difficulty. All have multiple meanings, and are generally given as synonyms for one another. In fact, the word "charity" has come to refer increasingly to some form of almsgiving rather than to its earlier meaning. So I decided to hazard its use for want of anything better, in the hope that most of those who will be reading this essay will be charitable enough to try to glean my meaning and intent.
The social fashion of our age is the attempt to do good to others in a confused profusion of economic transfusions. Other times have been less afflicted in this respect for the simple reason that they could not afford as much waste as we can. For them, sheer survival of self and family absorbed nearly all their effort.
The charitable endeavors characteristic of our time are, in my opinion, often futile for their intended purpose. In fact, they may even be harmful to the recipient by making him less self-reliant than before. According to the Talmudical definition of the noblest charity, whatever reduces self-reliance is negative charity.
I believe there is another use for this vast amount of time and energy that would support a positive charity, fruitful beyond the fondest dreams of most persons. The prevailing notion is that such a use is wholly selfish. But its charitable aspect can be seen by testing it step by step against certain requisites of true charity.
The Nature of CharityTrue economic charity has three characteristics:
Charity requires the transfer of ownership from one person to another of something having economic worth. The receiver must get a clear title to it, or it cannot be charity. The giver must have had clear title to it, or the giving is like a gift of stolen property — which is not an act of charity. Private ownership at both ends of the transfer, never public ownership, is therefore required.
The transfer must be voluntary with both parties. If forced upon the receiver against his will, it is not charity. If taken from the source against the prior owner's will, it is theft rather than an act of charity.
True charity requires anonymity. This is difficult to attain, to be sure. But if the conditions of the transfer result in a personal obligation in any form or degree, it is a grant of credit and not an act of charity. Devices other than anonymity usually fail to prevent the creation of a personal obligation.
It is a temptation to list as a fourth requirement that the gift shall, in the long run, be beneficial to the recipient. This aspect is important, but it tests the wisdom of the giving and not its charity.
The third requirement of charity — anonymity — is in harmony with the biblical admonition that one who gives alms should not sound his trumpet before him as do the hypocrites.Matthew 6:2. If the act is motivated by vainglory, it is not charity; it is then merely salve for the ego of the giver. If the giver expects repayment in any form or degree, other than in unselfish personal satisfaction, it is something other than charity.
These are strict requirements for true charity and most "charitable" activities would fail to qualify.
Enslavement through "Charity"Unfortunately a common purpose of acts of "charity" is to entice somebody to become obligated to the giver. The way it works is this: Under guise of a gift or personal favor, an unspecified quid pro quo is assumed. "Some day you can do something for me." Perhaps it is some business favor in that wide arena where an unfree market allows special privileges to be traded. Such acts obligate the receiver for an amount not agreed upon in advance. There is no specific quid pro quo as with a loan or an outright trade. So the act of "charity" really becomes a debt that can never be repaid with precision because the amount of repayment is not known by both parties by prior agreement.
An attempt to repay such an obligation almost never satisfies both parties. A residual obligation, one way or the other, becomes suspended in uncertainty forever. That is why anonymity is required if this pernicious feature is to be avoided. Credit should be correctly labeled as credit and trade should be called trade.
The process just described is really a means by which one person permanently obligates himself to another. It is really a moderated form of enslavement.
Plutarch must have had this in mind when he said, "The real destroyer of the Liberties of any people is he who spreads among them bounties, donations, and largesses." Plutarch's other comments make it amply clear that he was not opposed to real charity. But he was opposed to the sham of charity that feeds the vainglory of the giver and enslaves the recipient.
Aesop's fables — presumably written by a wise slave who had astutely observed these processes — repeatedly pointed out the dangers of enslavement under guise of charity.
False charity destroys security. Having once allowed one's self to become permanently obligated to another by debts that can never be repaid, the recipient loses his self-reliance and becomes insecure. As St. Thomas Aquinas expressed it, "There is no security for us so long as we depend on the will of another man."Acton, Essays on Freedom and Power, p. 64.
Just as one person can allow himself to become enslaved to another by a debt that cannot be repaid, so can persons within a group allow themselves to become enslaved to the group. National socialism is a common form, where the state becomes the dispenser of loot collected by force. The recipients lose their self-reliance in the process and come to feel indebted forever to the collective for their very lives. They have by then become enslaved.
There is not space here to trace in full the ideological ancestry of mass enslavement in this way, but the influence of Rousseau and Marx should be mentioned in passing.Thomas Davidson, Rousseau and Education According to Nature (1898); also, Leopold Schwarzschild, The Red Prussian, the Life and Legend of Karl Marx (1947). Rousseau, though he pleaded for "back to nature" in the education of Emile, was untrusting of natural self-reliance in economic and social affairs. So in his Social Contract he revived Plato's cult of reliance upon the state and became, according to Janet, the uncontested founder of modern communism.P. Janet, Les Origines du Socialisme Contemporain, (1883), p. 119. Then Marx later built further upon the same concept when he said that man is merely a complex of social relations, and that he is responsible to society for his real existence. For if one really owes his existence to society because his life depends upon society, he then owes servitude to the state or to some other collectivity of society. That is how men like Rousseau and Marx, with their mass programs of social dependency and socialized "charity," have helped socialize masses of humanity into dependency, insecurity, and slavery.
Enslavement on either a personal or mass basis could not happen if charity were to be kept in pure form, supplementing free exchange and voluntary credit arrangements between persons.
Common Forms of Charitable ActivityOf the various forms of economic charity in which we commonly indulge, the simplest would seem to be something such as buying a vagrant a cup of coffee or giving him a dime for the purpose.
Most of the colossal amount of activity which today goes by the name of charity is of this type, where the intent of the giver is to provide something for direct consumption or relief of a destitute recipient. But little giving is direct from the giver to the object of need — often the sufferer from some physical ailment or the victim of devastation from "acts of God." Most is given to some organization which acts as an intermediary.
If one will tabulate requests of all types during a year, it will become evident how numerous are the forms of request for charitable assistance. A few solicitors still stand on street corners with their tin cups. But most solicitation stems from intricately organized endeavors to wrest funds from would-be givers, frequently with the aid of the fund-raising profession. Often goodly neighbors are enlisted as unpaid solicitors to knock at one's door, and the giving in many instances is really little more than the cost of peacefully evicting a well-intentioned trespasser.
In doubting that much of this sort of thing is charity at all — at least not the wisest form of charity — I am not questioning the right of anybody to support anything voluntarily with his own means. I am merely questioning his wisdom and suggesting a better alternative. His glow of self-satisfaction over having given in the usual way is no more assurance of its wisdom than any other misguided but well-intentioned act. One can grow in wisdom only as he is willing to review acts he previously judged to be wise.
Tools as a Form of CharityBoth fact and logic seem to me to support the view that savings invested in privately owned economic tools of production amount to an act of charity. And further, I believe it to be — as a type — the greatest economic charity of all.
By economic tools of production I mean, of course, things with exchange value — trucks, factories, railroads, stores — which assist human effort in the production of other items of economic worth.
Does saving and investment in these tools qualify as charity? Does it meet the three tests of an act of charity?
The first test is whether there has been a transfer of privately owned things having economic worth. It is true that when one saves and invests in a tool which he uses in production, although he retains title to the tool, most of the extra production which the tool makes possible passes on to others, as we shall see. For that reason the first requisite of an act of charity seems to be met as a certain consequence of saving and investment in tools. It is this feature of the creation of privately owned capital which is its charitable aspect.
The second test of charity is that the transfer of economic benefits shall be voluntary. Did anybody steal anything? Was anybody coerced? So long as the tools are privately owned and their use functions in a free market, the process has to be voluntary for everybody involved. But state ownership or control of tools, as is common in Russia, violates this requirement.
The third test of charity is anonymity. The charitable feature of savings and tools arises from the extra production that flows from it as a consequence and which goes in large degree to others than the one who saved and invested in the tool — to others than the owner of the tool. It is anonymous because the beneficiaries do not know its source. Most of them do not even know how they are benefiting from it at all. They do not know this because they have been victimized by a thorough saturation with the surplus value theory. They even think of themselves as being victimized by these capitalists who own the tools they are using.
One can easily test from his own experience the anonymity of the charity that flows from savings and investment in tools. If one will list all the economic items he consumes or enjoys in a day, the test is to try in each instance to name specifically all the persons whose savings and investment made the item possible. Most of us, I dare say, could not name even one person responsible for an item we use and enjoy. This illustrates the anonymity of the millions of unknown persons responsible for the things we enjoy.
So savings and the tools of production meet all three tests of charity, and thus qualify as charity. How many of the things we commonly call "charities" can equally qualify by these three tests?
The Productive Power of ToolsA large part of the high level of economic living we now enjoy in the United States arises from the use of tools.
The average person in the United States has available for consumption upwards of ten times that of persons in the less prosperous half of the world. The reason for their poverty is a lack of savings invested in tools of production. In all their history over the ages they have accumulated little beyond the most primitive and simple tools, such as crude plows and hoes.
Harder work by us is not the reason why we can enjoy ten times as much economic welfare as they do. Persons in the United States work no harder, if as hard, as do the poorer half of the world's population. Even including mental work along with sheer muscular effort, both of which contribute to output, I doubt if we work any harder — overall.
Nor does innate intelligence seem to explain the difference. We probably have no more geniuses per thousand population than they do.
Lacking any of our accumulation of tools, our output per worker probably would be even lower than that of the poorer half of the world at the present time; even their production is aided considerably by their simple tools. Comparison of their output with ours suggests that without any tools whatsoever our output would be reduced to perhaps one-twentieth of what it now is. To say it another way, perhaps 95 percent of our present output in the United States is made possible by the presence of our tools. These tools are available because in the past some wise people saved and invested in tools.
Who Gets the Output Due to Tools?The next question is, Who gets this great increase in production? Evidence shows that a large part of it goes to others than those who did the saving and who hold the titles of ownership to the tools. It goes mostly to those who use the tools.
It has been estimated that only about 15 percent of the national income in the United States goes to the owners of capital as current income.F. A. Harper, The Crisis of the Free Market, 1945, p. 66. This is the amount of dividends, interest, rents, and royalties together with their equivalents in owner-operated businesses. The other 85 percent of the national income is paid currently for work, as distinguished from pay to owners for savings they have invested in tools. This figure for current work includes both wages paid to employees and its equivalent to those self-employed.
The question at once arises as to why so small a proportion of the product goes for capital, when capital is so highly productive? If we were to assume that those who save and invest in tools are entitled to the full increase in output that comes from the use of these tools as an aid to manual labor, it would appear from the evidence already given that justice would decree a division about like this: 95 percent for the owners and 5 percent for the users.
And so we may summarize:
To theTool OwnersTo theTool UsersTotalIf full production increasewere to go to the owners
955100Actual division in the UnitedStates at present
1585100Division according to Marx'ssurplus value theory
0100100Presuming these figures to be accurate, one must conclude that the saver-investor is receiving less than one-sixth of the return which his saving and investing has made possible — 15 received from the 95 produced. The other five-sixths of the increase goes to the users of the tools, enhancing their pay seventeen times — 85 received and 5 produced.
A person is lucky if by chance he happens to have been born in the United States where he can share directly in the bounty tools create. By having been born here he is enabled to work with tools that are now available because others have saved in the past. His income from current effort will, by these figures, be enhanced 17 times (85 versus 5) because of these tools. Had he been born where no tools had been accumulated whatsoever but would have to work as hard or even harder than in the United States, he would be getting only 1/17th as much for his labors.
This bounty to the users of tools is what I call the greatest economic charity.
Surplus-Value Theory ReviewedThese facts are significant in appraising Marx's surplus value theory. Marx said, in effect, that the 15 percent which goes to the owners of the tools is surplus value because the user of the tool — according to Marx — deserves the full 100 percent.
It is from the productive power of tools as aids to the manual efforts of man that something which might be called a surplus value arises. This surplus, as has been indicated, has raised US production from a level of 5 to a level of 100. So a counter claim to that of Marx would be that the full increase of 95 (100 minus 5) — the amount of surplus value created by the tools — should go to the one whose savings created the tools. But who really gets this surplus value of 95? The owner gets 15 and the user gets 80. Not a bad deal for the user!
Surplus value of a different sort arises in every instance of voluntary exchange in a free market. If one farmer trades a bushel of wheat to a merchant for a shirt, it is because the farmer prefers the shirt to the wheat and the merchant prefers the wheat to the shirt. The trade creates a surplus value for each of the participants, but the amounts of surplus value thus created are not subject to measurement by any device we now know or can contemplate. They are compensating in direction but not necessarily in amount, because the amount is entirely a matter of subjective appraisal. Being unknown in amount by both parties and probably not even thought of in these terms at all, no sense of residual obligation is created. This makes the process closely akin to anonymity. The center of interest of this discussion, however, is surplus value of the type created by tools as an act of economic charity. Therefore the phenomenon of surplus value created by exchange will not be dealt with further here.
In a free economy the process of deciding the division of the surplus value created by the use of tools occurs in the free market. We must accept the decree of private ownership and free exchange as having fairly decided the division, whatever the answer. Yet the answer given in the free market reveals that private capitalists — the "selfish owners," as those who save and invest are so often called — are really the greatest charity-givers of all.
It is also interesting to note the magnitude of charity arising from private capital in relation to "religious and welfare activities" contributions. About 2 billion dollars are given to religious and welfare activities in the United States each year. This is less than 1 percent of the amount of charity which the users of tools receive in their pay envelopes, according to this concept, in the same length of time.
Bread vs. Seed GrainI would certainly not scorn the giving of bread to a starving person in need. Nor would I scorn any other endeavors of a charitable nature by agencies which conduct recurrent campaigns for funds and materials for needy persons, so long as the offering is voluntary with one's own means. But I would emphasize strongly that the urgency of the plight of the needy can blind one to the possibilities of this greatest charity of all.
Those who benefit from the charity that flows from the creation of tools are the persons engaged in productive labor. This makes an excellent claim to worthiness, for as Samuel Johnson once said, "You are much surer that you are doing good when you pay money to those who work, as the recompense of their labor, than when you give money merely in charity."James Boswell, The Life of Samuel Johnson, Charles E. Lauriat Company, Boston, 1925-Vol. II, p. 636.
If we will but pause long enough to view with wider perspective the consequences of some of our customary acts of presumed charity, we can see their short-sightedness. Perhaps we should view with some question even the giving of grain to a starving person, if the same grain could better serve as seed for a harvest that would keep 20 persons from starving later. Savings, when used wisely by private enterprise to produce capital tools of venture, serve as economic seed in a like manner. The use of it as seed becomes an act of charity with a high leverage. But its creation requires enough patience and restraint from demands for immediate consumption so that the tools will be created. One must have foresight and economic insight enough to see beyond the exceedingly conspicuous and tempting need for present consumption.
When a neighbor knocks at one's door for a contribution to some charity, it may seem selfish to wonder if perhaps greater good could not be done by buying a share of new investment stock instead. But such an alternative is worth pondering, even with the perspective of charity in mind.
Many foundations have been established to engage in charity with the accumulated profits from the use of tools created in an earlier day. It may be a novel idea to suggest that greater charity might have been the consequence if these funds had been reinvested in new tools rather than to be used for direct-consumption charity, wherever that has been the policy. Use of foundation funds for the purpose of research and discovery is, of course, another matter because it is the creation of a form of tool and therefore highly charitable in its effects.
The one point I wish to make above all others is that, whereas a crust of bread may save a man from starving for a short while, the creation and use of tools are the only effective means by which people can be pulled completely out of the mire of poverty and placed on the solid base of sustained plenty. One cannot heal all the sick, relieve all the poor, comfort all in distress, nor father all the fatherless. And so it is important that in one's efforts to do good he lend his limited support where it will bear the most fruit on a long-time basis — after he is gone and after his own direct efforts have ceased.
The Incentive FactorThere must be some incentive if there is to be saving and investment in tools. This is best done by private ownership. The nature of man being what it is, the prospect of some rewards under private ownership surpasses all other incentives. A carrot will entice the donkey better than a whip will drive him.
The label of charity on anything having as a motive any personal gain at all will probably be questioned by many. They will say that, unless 100 percent of it is relinquished, none is truly charity. But I would pose some questions in reply. Does the fact that a person gives only 10 percent of his yearly income, not 100 percent, deny any of his gifts being charity? Does the fact that a charitable agency uses part of its income for organizational expenses deny any of it as being charity?
He who would serve his fellow men by charity can best do so by saving and investing in tools. Even though he may benefit himself a little, in the process, he unavoidably and anonymously benefits others by many times as much.
One who would be wholly self-sacrificing in the matter is free to refrain from any personal benefits in consumption at all, if he wishes. He can do this by reinvesting his profits in more tools. He can use that small part of the product of the tools which the free market allocates to him in the form of owner-reward to extend this greatest charity, foregoing all personal gain beyond the title to tools which are wholly benefiting others.
Beating Communism at Its Own PurposeHas socialism-communism anything to offer to compare with this? Can their proposals benefit mankind in any such way, even though the capitalist may get a little out of it for himself? Do they have any such benefits to offer the commonweal in a parade of progress, benefiting his children and his children's children on a continuing basis?
No. A socialist-communist regime, instead of being truly charitable, kills off this greatest charity of all. Taxes for "public welfare" kill the goose that lays this golden egg of charity. As taxes increase more and more and the chance for reward disappears, savings and venture are discouraged more and more. As rewards become thinner, the players turn away from the game. Original hopes of a charitable plenty turn into a poverty enforced by orders and police measures.
There is always the danger that when one has grasped the idea of the productive power of tools he will propose confiscating funds from private citizens in order to build more tools. But this denies the very process of charity. One person cannot be truly charitable with funds which he steals from another, any more than church collections can be increased by having the members of the congregation pick each other's pockets every Sunday. If tried, the source will dry up because those attending will learn to keep their pockets empty or else stay away from church.
True charity must remain purely private rather than public and socialized. It must be voluntary. That is the nature of the greatest economic charity of all — savings invested in privately owned tools of production.
ConclusionThe intent of this essay has been to bring into focus the conflict between two views toward economic charity, and to give a basis for choice between them.
An analogy may illustrate the difference. According to one view, sharing a crust of bread is advocated as the method of charity. The other advocates savings and tools for the production of additional loaves of bread, which is the greatest economic charity.
The two views are in conflict because the two methods are mutually exclusive in absorbing one's time and means in all the choices he makes day by day. These cannot be twice used.
The reason for the difference in view really stems from different concepts about the nature of the economic world. The former view stems from the belief that the total of economic goods is a constant. The latter view is built on the belief that expansion in production is possible without any necessary limit.
The difference between the two views is like the difference between a two- and three-dimensional perspective of production. The two-dimensional size is fixed at any instant of time, but the third dimension and therefore the size of the total is expandable without limit by savings and tools.
If the total of economic goods were fixed, it might seem humane to spend all one's time dividing it into pieces and carrying them here and there. If man is assumed to be selfish, voluntary methods would seem inadequate and centralized control of supplies and their distribution would seem to be necessary — if only there could be any assurance of finding unselfish men to rule.
All the history of mankind denies that there is a fixed total of economic goods. History further reveals that savings and expansion of tools constitute the only way to any appreciable increase. Christ seemed to be telling us this in the story of the talents, 2,000 years ago.Matthew 25. Were we to grasp fully the meaning of this story, concepts about what is the best form of economic charity would undergo a revolutionary change.
The greatest economic charity is that which enables persons to become independent of alms and therefore most self-reliant and secure under freedom. Only when that happens — when persons advance from the brink of starvation — is time released for devotion to things of the mind and spirit, which comprise the supremely great charity.
This article is excerpted from On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises (1956).
Government is in the last resort the employment of armed men, of policemen, gendarmes, soldiers, prison guards, and hangmen, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
[A Theory of Socialism and Capitalism (1989; 2007)]
The previous chapters have demonstrated that neither an economic nor a moral case for socialism can be made. Socialism is economically and morally inferior to capitalism. The last chapter examined why socialism is nonetheless a viable social system, and analyzed the socio-psychological characteristics of the state — the institution embodying socialism. Its existence, stability, and growth rest on aggression and on public support of this aggression which the state manages to effect.
This it does, for one thing, through a policy of popular discrimination — a policy, that is, of bribing some people into tolerating and supporting the continual exploitation of others by granting them favors — and secondly, through a policy of popular participation in the making of policy, i.e., by corrupting the public and persuading it to play the game of aggression by giving prospective power wielders the consoling opportunity to enact their particular exploitative schemes at one of the subsequent policy changes.
We shall now return to economics, and analyze the workings of a capitalist system of production — a market economy — as the alternative to socialism, thereby constructively bringing my argument against socialism full circle. While the final chapter will be devoted to the question of how capitalism solves the problem of the production of so-called "public goods," this chapter will explain what might be termed the normal functioning of capitalist production and contrast it with the normal working of a system of state or social production. We will then turn to what is generally believed to be a special problem allegedly showing a peculiar economic deficiency in a pure capitalist production system: the so-called problem of monopolistic production.
Ignoring for the moment the special problems of monopolistic and public-goods production, we will demonstrate why capitalism is economically superior as compared to its alternative for three structural reasons. First, only capitalism can rationally, i.e., in terms of consumer evaluations, allocate means of production; second, only capitalism can ensure that, with the quality of the people and the allocation of resources being given, the quality of the output produced reaches its optimal level as judged again in terms of consumer evaluations; and third, assuming a given allocation of production factors and quality of output, and judged again in terms of consumer evaluations, only a market system can guarantee that the value of production factors is efficiently conserved over time.Cf. on this also Chapter 3 above and Chapter 10 below.
As long as it produces for a market, i.e., for exchange with other people or businesses, and subject as it is to the rule of nonaggression against the property of natural owners, every ordinary business will use its resources for the production of such goods and such amounts of these goods which, in anticipation, promise a return from sales that surpasses as far as possible the costs which are involved in using these resources. If this were not so, a business would use its resources for the production of different amounts of such goods or of different goods altogether. And every such business has to decide repeatedly whether a given allocation or use of its means of production should be upheld and reproduced, or if, due to a change in demand or the anticipation of such a change, a reallocation to different uses is in order.
The question of whether or not resources have been used in the most value-productive (the most profitable) way, or if a given reallocation was the most economic one, can, of course, only be decided in a more or less distant future under any conceivable economic or social system, because invariably time is needed to produce a product and bring it onto the market. However, and this is decisive, for every business there is an objective criterion for deciding the extent to which its previous allocational decisions were right or wrong. Bookkeeping informs us — and in principle anyone who wanted to do so could check and verify this information — whether or not and to what extent a given allocation of factors of production was economically rational, not only for the business in total but for each of its subunits, insofar as market prices exist for the production factors used in it.
Since the profit-loss criterion is an ex post criterion, and must necessarily be so under any production system because of the time factor involved in production, it cannot be of any help when deciding on future ex ante allocations. Nevertheless, from the consumers' point of view it is possible to conceive of the process of resource allocation and reallocation as rational, because every allocational decision is constantly tested against the profit-loss criterion. Every business that fails to meet this criterion is in the short or long run doomed to shrink in size or be driven out of the market entirely, and only those enterprises that successfully manage to meet the profit-loss criterion can stay in operation or possibly grow and prosper.
To be sure, then, the institutionalization of this criterion does not insure (and no other criterion ever could) that all individual business decisions will always turn out to be rational in terms of consumer evaluations. However, by eliminating bad forecasters and strengthening the position of consistently successful ones, it does insure that the structural changes of the whole production system which take place overtime can be described as constant movements toward a more rational use of resources and as a never-ending process of directing and redirecting factors of production out of less value-productive lines of production into lines which are valued more highly by the consumer.On the function of profit and loss cf. L. v. Mises, Human Action, Chicago, 1966, Chapter 15; and "Profit and Loss," in: the same, Planning for Freedom, South Holland, 1974; M. N. Rothbard, Man, Economy and State, Los Angeles, 1970, Chapter 8.
The situation is entirely different and arbitrariness from the point of view of the consumer (for whom, it should be recalled, production is undertaken) replaces rationality as soon as the state enters the picture. Because it is different from ordinary businesses in that it is allowed to acquire income by noncontractual means, the state is not forced to avoid losses if it wants to stay in business as are all other producers. Rather, since it is allowed to impose taxes and/or regulations on people, the state is in a position to determine unilaterally whether or not, to what extent, and for what length of time to subsidize its own productive operations. It can also unilaterally choose which prospective competitor is allowed to compete with the state or possibly outcompete it.
Essentially this means that the state becomes independent of cost-profit considerations. But if it is no longer forced to test continually any of its various uses of resources against this criterion, i.e., if it no longer need successfully adjust its resource allocations to the changes in demand of consumers in order to survive as a producer, then the sequence of allocational decisions as a whole must be regarded as an arbitrary, irrational process of decision making. A mechanism of selection forcing those allocational "mutations" which consistently ignore or exhibit a maladjustment to consumer demand out of operation simply no longer exists.On the economics of government cf., esp. M. N. Rothbard, Power and Market, Kansas City, 1977, Chapter 5. To say that the process of resource allocation becomes arbitrary in the absence of the effective functioning of the profit-loss criterion does not mean that the decisions which somehow have to be made are not subject to any kind of constraint and hence are pure whim. They are not, and any such decision faces certain constraints imposed on the decision maker.
If, for instance, the allocation of production factors is decided democratically, then it evidently must appeal to the majority. But if a decision is constrained in this way or if it is made autocratically, respecting the state of public opinion as seen by the autocrat, then it is still arbitrary from the point of view of voluntarily buying or not-buying consumers.Regarding democratically controlled allocations, various deficiencies have become quite evident. For instance J. Buchanan and R. Wagner write (The Consequences of Mr. Keynes, London, 1978, p. 19), "Market competition is continuous; at each purchase, a buyer is able to select among competing sellers. Political competition is intermittent; a decision is binding generally for a fixed number of years. Market competition allows several competitors to survive simultaneously…. Political competition leads to an all-or-nothing outcome…. in market competition the buyer can be reasonably certain as to just what it is that he will receive from his purchase. In political competition, the buyer is in effect purchasing the services of an agent, whom he cannot bind…. Moreover, because a politician needs to secure the cooperation of a majority of politicians, the meaning of a vote for a politician is less clear than that of a ‘vote' for a private firm." (Cf. on this also J. Buchanan, "Individual Choice in Voting and the Market," in: the same, Fiscal Theory and Political Economy, Chapel Hill, 1962; for a more general treatment of the problem J. Buchanan and G. Tullock, The Calculus of Consent, Ann Arbor, 1962.) What has commonly been overlooked, though — especially by those who try to make a virtue of the fact that a democracy gives equal voting power to everyone, whereas consumer sovereignty allows for unequal "votes" — is the most important deficiency of all: that under a system of consumer sovereignty people might cast unequal votes but, in any case, they exercise control exclusively over things which they acquired through original appropriation or contract and hence are forced to act morally. Under a democracy of production everyone is assumed to have something to say regarding things one did not so acquire, and hence one is permanently invited thereby not only to create legal instability with all its negative effects on the process of capital formation, but, moreover, to act immorally. Cf. on this also L. v. Mises, Socialism, Indianapolis, 1981, Chapter 31; also cf. Chapter 8 above. Hence, the allocation of resources, whatever it is and however it changes over time, embodies a wasteful use of scarce means. Freed from the necessity of making profits in order to survive as a consumer-serving institution, the state necessarily substitutes allocational chaos for rationality. M. Rothbard nicely summarizes the problem as follows:
How can it (i.e. the government, the state) know whether to build road A or road B, whether to invest in a road or in a school — in fact, how much to spend for all its activities? There is no rational way that it can allocate funds or even decide how much to have. When there is a shortage of teachers or schoolrooms or police or streets, the government and its supporters have only one answer: more money. Why is this answer never offered on the free market? The reason is that money must be withdrawn from some other uses in consumption or investment … and this withdrawal must be justified. This justification is provided by the test of profit and loss: the indication that the most urgent wants of the consumers are being satisfied. If an enterprise or product is earning high profits for its owners and these profits are expected to continue, more money will be forthcoming; if not, and losses are being incurred, money will flow out of the industry. The profit-and-loss-test serves as the critical guide for directing the flow of productive services. No such guide exists for the government, which has no rational way to decide how much money to spend, either in total, or in each specific line. The more money it spends, the more service it can supply — but where to stop?On the economics of government cf., esp. M. N. Rothbard, Power and Market, Kansas City, 1977, Chapter 5.
Besides the misallocation of factors of production that results from the decision to grant the state the special right to appropriate revenue in a noncontractual way, state production implies a reduction in the quality of the output of whatever it decides to produce. Again, an ordinary profit-oriented business can only maintain a given size or possibly grow if it can sell its products at a price and in such quantity that allow it to recover at least the costs involved in production and is hopefully higher. Since the demand for the goods or services produced depends either on their relative quality or on their price — this being one of many criteria of quality — as perceived by potential buyers, the producers must constantly be concerned about "perceived product quality" or "cheapness of product." A firm is dependent exclusively on voluntary consumer purchases for its continued existence, so there is no arbitrarily defined standard of quality for a capitalist enterprise (including so-called scientific or technological standards of quality) set by an alleged expert or committee of experts. For it there is only the quality as perceived and judged by the consumers.
Once again, this criterion does not guarantee that there are no low-quality or overpriced products or services offered on the market because production takes time and the sales test comes only after the products have appeared on the market. And this would have to be so under any system of goods production. Nonetheless, the fact that every capitalist enterprise must undergo this sales test and pass it to avoid being eliminated from the market guarantees a sovereign position to the consumers and their evaluations. Only if product quality is constantly improved and adjusted to consumer tastes can a business stay in operation and prosper.
The story is quite different as soon as the production of goods is undertaken by the state. Once future revenue becomes independent of cost-covering sales — as is typically the case when the state produces a good — there is no longer a reason for such a producer to be concerned about product quality in the same way that a sales-dependent institution would have to be. If the producer's future income can be secured, regardless of whether according to consumer evaluations the products or services produced are worth their money, why undertake special efforts to improve anything?
More precisely, even if one assumes that the employees of the state as a productive enterprise with the right to impose taxes and to regulate unilaterally the competitiveness of its potential rivals are, on the average, just as much interested or uninterested in work as those working in a profit-dependent enterprise,This is a very generous assumption, to be sure, as it is fairly certain that the so-called public sector of production attracts a different type of person from the very outset and boasts an unusually high number of inefficient, lazy, and incompetent people. and if one further assumes that both groups of employees and workers are on the average equally interested or uninterested in an increase or decrease in their income, then the quality of products, measured in terms of consumer demand and revealed in actual purchases, must be lower in a state enterprise than in private business, because the income of the state employees would be far less dependent on product quality. Accordingly, they would tend to devote relatively less effort to producing quality products and more of their time and effort would go into doing what they, but not necessarily the consumer, happen to like.Cf. L. v. Mises, Bureaucracy, New Haven, 1944; Rothbard, Power and Market, Kansas City, 1977, pp. 172ff; and For A New Liberty New York, 1978, Chapter 10; also M. and R. Friedman, iThe Tyranny of the Status Quoc, New York, 1984, pp. 35-51.
Only if the people working for the state were superhumans or angels, while everyone else was simply an ordinary, inferior human being, could the result be any different. Yet the same result, i.e., the inferiority of product quality of any state-produced goods, would again ensue if the human race in the aggregate would somehow improve: if they were working in a state enterprise even angels would produce a lower-quality output than their angel colleagues in private business, if work implied even the slightest disutility for them.
Finally, in addition to the facts that only a market system can ensure a rational allocation of scarce resources, and that only capitalist enterprises can guarantee an output of products that can be said to be of optimal quality, there is a third structural reason for the economic superiority, indeed unsurpassability, of a capitalist system of production. Only through the operation of market forces is it possible to utilize resources efficiently over time in any given allocation, i.e., to avoid overutilization as well as underutilization. This problem has already been addressed with reference to Russian style socialism in chapter 3.
What are the institutional constraints on an ordinary profit-oriented enterprise in its decisions about the degree of exploitation or conservation of its resources in the particular line of production in which they happen to be used? Evidently, the owner of such an enterprise would own the production factors or resources as well as the products produced with them. Thus, his income (used here in a wide sense of the term) consists of two parts: the income that is received from the sales of the products produced after various operating costs have been subtracted; and the value that is embodied in the factors of production which could be translated into current income should the owner decide to sell them.
Institutionalizing a capitalist system — a social order based on private property — thus implies establishing an incentive structure under which people would try to maximize their income in both of these dimensions. What exactly does this mean?On the following cf. L. v. Mises, Human Action, Chicago, 1966, Chapter 23.6; M.N. Rothbard, Man Economy and State, Los Angeles, 1970, Chapter 7, esp. 7.4-6; Every act of production evidently affects both mentioned income dimensions. On one hand, production is undertaken to reach an income return from sales. On the other hand, as long as the factors of production are exhaustible, i.e., as long as they are scarce and not free goods, every production act implies a deterioration of the value of the production factors. Assuming that private ownership exists, this produces a situation in which every business constantly tries not to let the marginal costs of production (i.e., the drop in value of the resources that results from their usage) to become greater than the marginal revenue product, and where with the help of bookkeeping an instrument for checking the success or failure of these attempts exists.
If a producer were not to succeed in this task and the drop in the value of capital were higher than the increase in the income returns from sales, the owner's total income (in the wider sense of the term) would be reduced. Thus, private ownership is an institutional device for safeguarding an existing stock of capital from being overexploited or if it is, for punishing an owner for letting this happen through losses in income. This helps make it possible for values produced to be higher than values destroyed during production. In particular, private ownership is an institution in which an incentive is established to efficiently adjust the degree of conserving or consuming a given stock of capital in a particular line of production to anticipated price changes.
If, for instance, the future price of oil were expected to rise above its current level, then the value of the capital bound up in oil production would immediately rise as would the marginal cost involved in producing the marginal product. Hence, the enterprise would immediately be impelled to reduce production and increase conservation accordingly, because the marginal revenue product on the present market was still at the unchanged lower level. On the other hand, if in the future oil prices were expected to fall below their present level, this would result in an immediate drop in the respective capital values and in marginal costs, and hence the enterprise would immediately begin to utilize its capital stock more intensively since prices on the present market would still be relatively higher. And to be sure, both of these reactions are exactly what is desirable from the point of view of the consumers.
If the way in which a capitalist production system works is compared with the situation that becomes institutionalized whenever the state takes care of the means of production, striking differences emerge. This is true especially when the state is a modern parliamentary democracy. In this case, the managers of an enterprise may have the right to receive the returns from sales (after subtracting operation costs), but, and this is decisive, they do not have the right to appropriate privately the receipts from a possible sale of the production factors.
Under this constellation, the incentive to use a given stock of capital economically over time is drastically reduced. Why? Because if one has the right to privately appropriate the income return from product sales but does not have the right to appropriate the gains or losses in capital value that result from a given degree of usage of this capital, then there is an incentive structure institutionalized not of maximizing total income — i.e., total social wealth in terms of consumer evaluations — but rather of maximizing income returns from sales at the expense of losses in capital value.
Why, for instance, should a government official reduce the degree of exploitation of a given stock of capital and resort to a policy of conservation when prices for the goods produced are expected to rise in the future? Evidently, the advantage of such a conservationist policy (the higher capital value resulting from it) could not be reaped privately. On the other hand, by resorting to such a policy one's income returns from sales would be reduced, whereas they would not be reduced if one forgot about conserving.
In short, to conserve would mean to have none of the advantages and all of the disadvantages. Hence, if the state managers are not superhumans but ordinary people concerned with their own advantages, one must conclude that it is an absolutely necessary consequence of any state production that a given stock of capital will be overutilized and the living standards of consumers impaired in comparison to the situation under capitalism.
Now it is fairly certain that someone will argue that while one would not doubt what has been stated so far, things would in fact be different and the deficiency of a pure market system would come to light as soon as one paid attention to the special case of monopolistic production. And by necessity, monopolistic production would have to arise under capitalism, at least in the long run. Not only Marxist critics but orthodox economic theorists as well make much of this alleged counterargument.On this and the following cf. L. v. Mises, Socialism, Indianapolis, 1981, part 3.2. In answer to this challenge four points will be made in turn.
First, available historical evidence shows that contrary to these critics' thesis, there is no tendency toward increased monopoly under an unhampered market system. In addition, there are theoretical reasons that would lead one to doubt that such a tendency could ever prevail on a free market. Third, even if such a process of increasing monopolization should come to bear, for whatever reason, it would be harmless from the point of view of consumers provided that free entry into the market were indeed ensured. And fourth, the concept of monopoly prices as distinguished from and contrasted to competitive prices is illusory in a capitalist economy.
Regarding historical evidence, if the thesis of the critics of capitalism were true, then one would have to expect a more pronounced tendency toward monopolization under relatively freer, unhampered, unregulated laissez-faire capitalism than under a relatively more heavily regulated system of "welfare" or "social" capitalism. However, history provides evidence of precisely the opposite result. There is general agreement regarding the assessment of the historical period from 1867 to World War I as being a relatively more capitalist period in history of the United States, and of the subsequent period being one of comparatively more and increasing business regulations and welfare legislation.
However, if one looks into the matter one finds that there was not only less development toward monopolization and concentration of business taking place in the first period than in the second but also that during the first period a constant trend towards more severe competition with continually falling prices for almost all goods could be observed.Thus states J. W. McGuire, Business and Society, New York, 1963, pp. 38-39: "From 1865 to 1897, declining prices year after year made it difficult for businessmen to plan for the future. In many areas new railroad links had resulted in a nationalization of the market east of the Mississippi, and even small concerns in small towns were forced to compete with other, often larger firms located at a distance. At the same time there were remarkable advances in technology and productivity. In short it was a wonderful era for the consumer and a frightful age for the producers especially as competition became more and more severe." And this tendency was only brought to a halt and reversed when in the course of time the market system became more and more obstructed and destroyed by state intervention. Increasing monopolization only set in when leading businessmen became more successful at persuading the government to interfere with this fierce system of competition and pass regulatory legislation, imposing a system of "orderly" competition to protect existing large firms from the so-called cutthroat competition continually springing up around them.Cf. on this G. Kolko, The Triumph of Conservatism, Chicago, 1967; and Railroads and Regulation, Princeton, 1965; J. Weinstein, The Corporate Ideal in the Liberal State, Boston, 1968; M. N. Rothbard and R. Radosh (eds.), A New History of Leviathan, New York, 1972. G. Kolko, a left-winger and thus certainly a trustworthy witness, at least for the critics from the Left, sums up his research into this question as follows:
There was during this [first] period a dominant trend toward growing competition. Competition was unacceptable to many key business and financial leaders, and the merger movement was to a large extent a reflection of voluntary, unsuccessful business effects to bring irresistible trends under control … As new competitors sprang up, and as economic power was diffused throughout an expanding nation, it became apparent to many important businessmen that only the national government could [control and stabilize] the economy.… Ironically, contrary to the consensus of historians, it was not the existence of monopoly which caused the government to intervene in the economy, but the lack of it.G. Kolko, The Triumph of Conservatism, Chicago, 1967, pp.4-5; cf. also the investigations of M. Olson, The Logic of Collective Action, Cambridge, 1965, to the effect that mass organizations (in particular labor unions), too, are not market phenomena but owe their existence to legislative action.
In addition, these findings, which stand in clear contradiction to much of the common wisdom on the matter, are backed by theoretical considerations.On the following cf. L. v. Mises, Socialism, Indianapolis, 1981, part 3.2; and Human Action, Chicago, 1966, Chapters 25-26; M. N. Rothbard, Man, Economy and State, Los Angeles, 1970, pp.544ff; pp.585ff; and "Ludwig von Mises and Economic Calculation under Socialism," in: L. Moss (ed.), The Economics of Ludwig von Mises, Kansas City, 1976, pp. 75-76. Monopolization means that some specific factor of production is withdrawn from the market sphere. There is no trading of the factor, but there is only the owner of this factor engaging in restraint of trade. Now if this is so, then no market price exists for this monopolized production factor. But if there is no market price for it, then the owner of the factor can also no longer assess the monetary costs involved in withholding it from the market and in using it as he happens to use it. In other words, he can no longer calculate his profits and make sure, even if only ex post facto, that he is indeed earning the highest possible profits from his investments.
Thus, provided that the entrepreneur is really interested in making the highest possible profit (something, to be sure, which is always assumed by his critics), he would have to offer the monopolized production factors on the market continually to be sure that he was indeed using them in the most profitable way and that there was no other more lucrative way to use them, so as to make it more profitable for him to sell the factor than keep it. Hence, it seems, one would reach the paradoxical result that in order to maximize his profits, the monopolist must have a permanent interest in discontinuing his position as the owner of a production factor withheld from the market and, instead, desire its inclusion in the market sphere.
Furthermore, with every additional act of monopolization the problem for the owner of monopolized production factors — i.e., that because of the impossibility of economic calculation, he can no longer make sure that those factors are indeed used in the most profitable way — becomes ever more acute. This is so, in particular, because realistically one must assume that the monopolist is not only not omniscient but that his knowledge regarding future competing goods and services by the consumers in future markets becomes more and more limited as the process of monopolization advances. As production factors are withdrawn from the market, and as the circle of consumers served by the goods produced with these factors widens, it will be less likely that the monopolist, unable to make use of economic calculation, can remain in command of all the relevant information needed to detect the most profitable uses for his production factors.
Instead, it becomes more likely in the course of such a process of monopolization, that other people or groups of people, given their desire to make profits by engaging in production, will perceive more lucrative ways of employing the monopolized factors.Cf. F. A. Hayek, Individualism and Economic Order, Chicago, 1948, esp. Chapter 9; I. Kirzner, Competition and Entrepreneurship, Chicago, 1973. Not necessarily because they are better entrepreneurs, but simply because they <>occupy different positions in space and time and thus become increasingly aware of entrepreneurial opportunities which become more and more difficult and costly for the monopolist to detect with every new step toward monopolization. Hence, the likelihood that the monopolist will be persuaded to sell his monopolized factors to other producers — nota bene: for the purpose of thereby increasing his profits — increases with every additional step toward monopolization.Regarding large-scale ownership, in particular of land, Mises observes that it is normally only brought about and upheld by nonmarket forces: by coercive violence and a state-enforced legal system outlawing or hampering the selling of land. "Nowhere and at no time has the large scale ownership of land come into being through the working of economic forces in the market. Founded by violence, it has been upheld by violence and that alone. As soon as the latifundia are drawn into the sphere of market transactions they begin to crumble, until at last they disappear completely…. That in a market economy it is difficult even now to uphold the latifundia, is shown by the endeavors to create legislation institutions like the ‘Fideikommiss' and related legal institutions such as the English ‘entail'…. Never was the ownership of the means of production more closely concentrated than at the time of Pliny, when half the province of Africa was owned by six people, or in the day of the Merovingian, when the church possessed the greater part of all French soil. And in no part of the world is there less large-scale land ownership than in capitalist North America," Socialism, Indianapolis, 1981, pp.325–326.
Now, let us assume that what historical evidence as well as theory proves to be unlikely happens anyway, for whatever reason. And let us assume straightaway the most extreme case conceivable: there is only one single business, one supermonopolist so to speak, that provides all the goods and services available on the market, and that is the sole employer of everyone. What does this state of affairs imply regarding consumer satisfaction, provided, of course, as assumed, that the supermonopolist has acquired his position and upholds it without the use of aggression? For one thing, it evidently means that no one has any valid claims against the owner of this firm; his enterprise is indeed fully and legitimately his own. And for another thing it means that there is no infringement on anyone's right to boycott any possible exchange. No one is forced to work for the monopolist or buy anything from him, and everyone can do with his earnings from labor services whatever he wants. He can consume or save them, use them for productive or nonproductive purposes, or associate with others and combine their funds for any sort of joint venture.
But if this were so, then the existence of a monopoly would only allow one to say this: the monopolist clearly could not see any chance of improving his income by selling all or part of his means of production, otherwise he would do so. And no one else could see any chance of improving his income by bidding away factors from the monopolist or by becoming a capitalist producer himself through original saving, through transforming existing nonproductively used private wealth into productive capital, or through combining funds with others, otherwise it would be done.
But then, if no one saw any chance of improving his income without resorting to aggression, it would evidently be absurd to see anything wrong with such a supermonopoly. Should it indeed ever come into existence within the framework of a market economy, it would only prove that this self-same supermonopolist was indeed providing consumers with the most urgently wanted goods and services in the most efficient way.
Yet the question of monopoly prices remains.Cf. on the following in M. N. Rothbard, Man, Economy and State, Los Angeles, 1970, Chapter 10, esp. pp.586ff; also W. Block, "Austrian Monopoly Theory. A Critique," in: Journal of Libertarian Studies, 1977. Doesn't a monopoly price imply a suboptimal supply of goods to consumers, and isn't there then an important exception from the generally superior economic working of capitalism to be found here? In a way this question has already been answered by the above explanation that even a supermonopolist establishing itself in the market cannot be considered harmful for consumers. But in any case, the theory that monopoly prices are (allegedly) categorically different from competitive prices has been presented in different, technical language and hence deserves special treatment. The result of this analysis, which is hardly surprising now, only reinforces what has already been discovered: monopoly does not constitute a special problem forcing anyone to make qualifying amendments to the general rule of a market economy being necessarily more efficient than any socialist or statist system. What is the definition of "monopoly price" and, in contrast to it, of "competitive price" according to economic orthodoxy (which in the matter under investigation includes the so-called Austrian school of economics as represented by L. v. Mises)? The following definition is typical:
Monopoly is a prerequisite for the emergence of monopoly prices, but it is not the only prerequisite. There is a further condition required, namely a certain shape of the demand curve. The mere existence of monopoly does not mean anything in this regard. The publisher of a copyrighted book is a monopolist. But he may not be able to sell a single copy, no matter how low the price he asks. Not every price at which a monopolist sells a monopolized commodity is a monopoly price. Monopoly prices are only prices at which it is more advantageous for the monopolist to restrict the total amount to be sold than to expand its sales to the limit which a competitive market would allow.L.v. Mises, Human Action, Chicago, 1966, p.359; cf. also any current textbook, such as P. Samuelson, Economics, New York, 1976, p.500.
However plausible this distinction might seem, it will be argued that neither the producer himself nor any neutral outside observer could ever decide if the prices actually obtained on the market were monopoly or competitive prices, based on the criterion "restricted versus unrestricted supply' as offered in the above definition. In order to understand this, suppose a monopolist producer in the sense of "a sole producer of a given good" exists. The question of whether or not a given good is different from or homogeneous to other goods produced by other firms is not one that can be decided based on a comparative analysis of such goods in physical or chemical terms ex ante, but will always have to be decided ex post facto, on future markets, by the different or equal treatment and evaluations that these goods receive from the buying public. Thus every producer, no matter what his product is, can be considered a potential monopolist in this sense of the term, at the point of decision making.
What, then, is the decision with which he and every producer is faced? He must decide how much of the good in question to produce in order to maximize his monetary income (with other, nonmonetary income considerations assumed to be given). To be able to do this he must decide how the demand curve for the product concerned will be shaped when the products reach the market, and he must take into consideration the various production costs of producing various amounts of the good to be produced. This done, he will establish the amount to be produced at that point where returns from sales, i.e., the amount of goods sold times price, minus production costs involved in producing that amount, will reach a maximum. Let us assume this happens and the monopolist also happens to be correct in his evaluation of the future demand curve in that the price he seeks for his products indeed clears the market.
Now the question is, is this market price a monopoly or a competitive price? As M. Rothbard realized in his pathbreaking but much-neglected analysis of the monopoly problem, there is no way of knowing. Was the amount of the good produced "restricted" in order to take advantage of inelastic demand and was a monopoly price thus reaped, or was the price reached a competitive one established in order to sell an amount of goods that was expanded "to the limit that a competitive market would allow"? There is no way to decide the matter.Cf. M. N. Rothbard, Man, Economy and State, Los Angeles, 1970, Chapter 10, esp. pp.604-614. Clearly, every producer will always try to set the quantity produced at a level above which demand would become elastic and would hence yield lower total returns to him because of reduced prices paid. He thus engages in restrictive practices.
At the same time, based on his estimate of the shape of future demand curves, every producer will always try to expand his production of any good up to the point at which the marginal cost of production (that is, the opportunity cost of not producing a unit of an alternative good with the help of scarce production factors now bound up in the process of producing another unit of x) equals the price per unit of x that one expects to be able to charge at the respective level of supply. Both restriction and expansion are part of profit maximizing and market-price formation, and neither of these two aspects can be separated from the other to make a valid distinction between monopolistic and competitive action.
Now, suppose that at the next point of decision making the monopolist decides to reduce the output of the good produced from a previously higher to a new lower level, and assume that he indeed succeeds in securing higher total returns now than at the earlier point in time. Wouldn't this be a clear instance of a monopoly price? Again, the answer must be no. And this time the reason would be the indistinguishability of this reallocational "restriction" from a "normal" reallocation that takes account of changes in demand. Every event that can be interpreted in one way can also be interpreted in the other, and no means for deciding the matter exist, for once again both are essentially two aspects of one and the same thing: of action, of choosing.
The same result, i.e., a restriction in supply coupled not only with higher prices but with prices high enough to increase total revenue from sales, would be brought about if the monopolist who, for example, produces a unique kind of apples faces an increase in the demand for his apples (an upward shift in the demand curve) and simultaneously an even higher increase in demand (an even more drastic upward shift of the demand curve) for oranges. In this situation he would reap greater returns from a reduced output of apples, too, because the previous market price for his apples would have become a subcompetitive price in the meantime. And if he indeed wanted to maximize his profits, instead of simply expanding apple production according to the increased demand, he now would have to use some of the factors previously used for the production of apples for the production of oranges, because in the meantime changes in the system of relative prices would have occurred.
However, what if the monopolist who restricts apple production does not engage in producing oranges with the now available factors, but instead does nothing with them? Again, all that this would indicate is that besides the increase in demand for apples, in the meantime an even greater increase in the demand for yet another good — leisure (more precisely, the demand for leisure by the monopolist who is also a consumer)-had taken place. The explanation for the restricted apple supply is thus found in the relative price changes of leisure (instead of oranges) as compared with other goods.
Neither from the perspective of the monopolist himself nor from that of any outside observer could restrictive action then be distinguished conceptually from normal reallocations which simply follow anticipated changes in demand. Whenever the monopolist engages in restrictive activities which are followed by higher prices, by definition he must use the released factors for another more highly valued purpose, thereby indicating that he adjusts to changes in relative demand. As M. Rothbard sums up,
We cannot use "restriction of production" as the test of monopoly vs. competitive price. A movement from a sub-competitive to a competitive price also involves a restriction of production of this good, coupled, of course, with an expansion of production in other lines by the released factors. There is no way whatever to distinguish such a restriction and corollary expansion from the alleged "monopoly price" situation. If the restriction is accompanied by increased leisure for the owner of the labor factor rather than increased production of some other good on the market, it is still the expansion of the yield of a consumer good — leisure. There is still no way of determining whether the "restriction" resulted in a "monopoly" or a "competitive" price or to what extent the motive of increased leisure was involved. To define a monopoly price as a price attained by selling a smaller quantity of a product at a higher price is therefore meaningless, since the same definition applies to the "competitive" price as compared with a subcompetitive price.M. N. Rothbard, Man, Economy and State, Los Angeles, 1970, p.607.
The analysis of the monopoly question, then, provides no reason whatsoever to modify the description given above of the way a pure market economy normally works and its superiority over any sort of socialist or statist system of production. Not only is a process of monopolization highly unlikely to occur, empirically as well as theoretically, but even if it did, from the point of view of the consumers it would be harmless. Within the framework of a market system a restrictive monopolistic price could not be distinguished from a normal price hike stemming from higher demand and changes in relative prices. And as every restrictive action is simultaneously expansionary, to say that the curtailment of production in one production line coupled with an increase in total revenue implies a misallocation of production factors and an exploitation of consumers is simply nonsense. The misunderstanding involved in such reasoning has been accurately revealed in the following passage from one of L. v. Mises's later works in which he implicitly refutes his own above-cited orthodox position regarding the monopoly-price problem. He states,
An entrepreneur at whose disposal are 100 units of capital employs, for instance, 50 units for the production of p and 50 units for the production of q. If both lines are profitable, it is odd to blame him for not having employed more, e.g., 75 units, for the production of p. He could increase the production of p only by curtailing correspondingly the production of q. But with regard to q the same fault could be found with the grumblers. If one blames the entrepreneur for not having produced more p, one must blame him also for not having produced more q. This means: one blames the entrepreneur for the fact that there is scarcity of factors of production and that the earth is not a land of Cockaigne.L.v. Mises, "Profit and Loss," in: Planning for Freedom, South Holland, 1974, p.116.
The monopoly problem as a special problem of markets requiring state action to be resolved does not exist.In fact, historically, governmental anti-trust policy has almost exclusively been a practice of providing less successful competitors with the legal tools needed to hamper the operation of their more successful rivals. For an impressive assembly of case studies to this effect cf. D. Armentano, Antitrust and Monopoly, New York, 1982; also Y. Brozen, Is Government the Source of Monopoly? And Other Essays, San Francisco, 1980. In fact, only when the state enters the scene does a real, nonillusory problem of monopoly and monopoly prices emerge. The state is the only enterprise whose prices and business practices can be conceptually distinguished from all other prices and practices, and whose prices and practices can be called 'too high' or 'exploitative' in a completely objective, nonarbitrary way. These are prices and practices which consumers are not voluntarily willing to pay and accept, but which instead are forced upon them through threats of violence. And only for so privileged an institution as the state is it also normal to expect and to find a permanent process of increasing monopolization and concentration.
As compared to all other enterprises, which are subject to the control of voluntarily buying or not-buying consumers, the enterprise "state" is an organization that can tax people and need not wait until they accept the tax, and can impose regulations on the use people make of their property without gaining their consent for doing so. This evidently gives the state, as compared to all other institutions, a tremendous advantage in the competition for scarce resources. If one only assumes that the representatives of the state are as equally driven by the profit motive as anyone else, it follows from this privileged position that the organization "state" must have a relatively more pronounced tendency toward growth than any other organization. And indeed, while there was no evidence for the thesis that a market system would bring about a tendency toward monopolistic growth, the thesis that a statist system would do so is amply supported by historical experience.
This article is excerpted from A Theory of Socialism and Capitalism, chapter 9, "Capitalist Production and the Problem of Monopoly" (1989; 2007).
"The wealth of the 1 percent provides the standard of living of the 99 percent."The protesters in the Occupy Wall Street movement and its numerous clones elsewhere in the country and around the world chant that 1 percent of the population owns all the wealth and lives at the expense of the remaining 99 percent. The obvious solution that they imply is for the 99 percent to seize the wealth of the 1 percent and use it for their benefit rather than allowing it to continue to be used for the benefit of the 1 percent, who are allegedly undeserving greedy capitalist exploiters. In other words, the implicit program of the protesters is that of socialism and the redistribution of wealth.
Putting aside the hyperbole in the movement's claim, it is true that a relatively small minority of people does own the far greater part of the wealth of the country. The figures "1 percent" and "99 percent," however exaggerated, serve to place that fact in the strongest possible light.
What the protesters do not realize is that the wealth of the 1 percent provides the standard of living of the 99 percent.
The protesters have no awareness of this, because they see the world through an intellectual lens that is inappropriate to life under capitalism and its market economy. They see a world, still present in some places, and present everywhere a few centuries ago, of self-sufficient farm families, each producing for its own consumption and having no essential connection to markets.
In such a world, if one sees a farmer's field, or his barn, or plow, or draft animals, and asks who do these means of production serve, the answer is the farmer and his family, and no one else. In such a world, apart from the receipt of occasional charity from the owners, those who are not owners of means of production cannot benefit from means of production unless and until they themselves somehow become owners of means of production. They cannot benefit from other people's means of production except by inheriting them or by seizing them.
In the world of the protesters, means of production have the same essential status as consumers' goods, which as a rule are of benefit only to their owners. It is because of this that those who share the mentality of the protesters typically depict capitalists as fat men, whose plates are heaped high with food, while the masses of wage earners must live near starvation. According to this mentality, the redistribution of wealth is a matter merely of taking from the overflowing plates of the capitalists and giving to the starving workers.
Contrary to such beliefs, in the modern world in which we actually live, the wealth of the capitalists is simply not in the form of consumers' goods to any great extent. Not only is it overwhelmingly in the form of means of production, but those means of production are employed in the production of goods and services that are sold in the market. Totally unlike the conditions of self-sufficient farm families, the physical beneficiaries of the capitalists' means of production are all the members of the general consuming public who buy the capitalists' products.
For example, without owning so much as a single share of stock in General Motors or Exxon Mobil, everyone in a capitalist economy who buys the products of these firms benefits from their means of production: the buyer of a GM automobile benefits from the GM factory that produced that automobile; the buyer of Exxon's gasoline benefits from its oil wells, pipelines, and tanker trucks. Furthermore, everyone benefits from their means of production who buys the products of the customers of GM or Exxon, insofar as their means of production indirectly contribute to the products of their customers. For example, the patrons of grocery stores whose goods are delivered in trucks made by GM or fueled by diesel oil produced in Exxon's refineries are beneficiaries of the existence of GM's truck factories and Exxon's refineries. Even everyone who buys the products of the competitors of GM and Exxon, or of the customers of those competitors, benefits from the existence of GM's and Exxon's means of production. This is because GM's and Exxon's means of production result in a more abundant and thus lower-priced supply of the kind of goods the competitors sell.
"The physical beneficiaries of the capitalists' means of production are all the members of the general consuming public who buy the capitalists' products."In other words, all of us, 100 percent of us, benefit from the wealth of the hated capitalists. We benefit without ourselves being capitalists, or being capitalists to any great extent. The protesters are literally kept alive on the foundation of the wealth of the capitalists they hate. As just indicated, the oil fields and pipelines of the hated Exxon corporation provide the fuel that powers the tractors and trucks that are essential to the production and delivery of the food the protesters eat. The protesters and all other haters of capitalists hate the foundations of their own existence.
The benefit of the capitalists' means of production to non-owners of means of production extends not only to the buyers of the products of those means of production but also to the sellers of the labor that is employed to work with those means of production. The wealth of the capitalists, in other words, is the source both of the supply of products that non-owners of the means of production buy and of the demand for the labor that non-owners of the means of production sell. It follows that the larger the number and greater the wealth of the capitalists, the greater is both the supply of products and the demand for labor, and thus the lower are prices and the higher are wages, i.e., the higher is the standard of living of everyone. Nothing is more to the self-interest of the average person than to live in a society that is filled with multibillionaire capitalists and their corporations, all busy using their vast wealth to produce the products he buys and to compete for the labor he sells.
Nevertheless, the world the protesters yearn for is a world from which the billionaire capitalists and their corporations have been banished, replaced by small, poor producers, who would not be significantly richer than they themselves are, which is to say, impoverished. They expect that in a world of such producers, producers who lack the capital required to produce very much of anything, let alone carry on the mass production of the technologically advanced products of modern capitalism, they will somehow be economically better off than they are now. Obviously, the protesters could not be more deluded.
In addition to not realizing that the wealth of the so-called 1 percent is the foundation of the standard of living of the so-called 99 percent, what the protesters also do not realize is that the "greed" of those who seek to become part of the 1 percent, or to enlarge their position within it, is what serves progressively to improve the standard of living of the 99 percent.
Of course, this does not apply to wealth that has been acquired by such means as obtaining government subsidies or preventing competition through protective tariffs and other forms of government intervention. These are methods that are made possible to the extent that the government is permitted to depart from a policy of strict laissez-faire and thereby arbitrarily reward or punish firms.
Apart from such aberrations, the way that business fortunes are accumulated is by means of the high profits generated by the introduction of new and improved products and more efficient, lower-cost methods of production, followed by the heavy saving and reinvestment of those high profits.
"All of us, 100 percent of us, benefit from the wealth of the hated capitalists."For example, the $6 billion fortune of the late Steve Jobs was built on a foundation of Mr. Jobs having made it possible for Apple Computer to introduce such new and improved products as the iPod, the iPhone, and the iPad, and then heavily saving and reinvesting the share of the profits that came to him.
Two closely related points need to be stressed. First, the fortunes that are accumulated in this way generally serve in the larger-scale production of the very sort of products that provided the profits out of which their accumulation took place. Thus, for example, Jobs's billions serve largely in the production of Apple's products. Similarly, old Henry Ford's great personal fortune, earned on the foundation of introducing major improvements in the efficiency of automobile production, which brought down the price of a new automobile from about $10,000 at the beginning of the 20th Century to $300 in the mid 1920s, was used to make possible the production of millions of Ford automobiles.
Second, the high rates of profit earned on new and improved products and methods of production are temporary. As soon as the production of the new product or use of the new method of production becomes the norm in an industry, it no longer provides any exceptional profitability. Indeed, further improvements again and again render earlier improvements downright unprofitable. For example, the first generation of the iPhone, which was highly profitable just a few years ago, is or soon will be unprofitable, because further advances have rendered it obsolete.
As a result, the accumulation of great business fortunes generally requires the introduction of a series of improvements in products or methods of production. This is what is required to maintain a high rate of profit in the face of competition. For example, Intel's ability to maintain its high rate of profit over the years has depended on its ability to introduce one substantial improvement in its computer chips after another. The net effect has been that computer users have gotten the benefit of improvement after improvement not only at no rise but a drastic decline in the prices of computer chips. Insofar as high profits rest on low costs of production, competition drives prices down to correspond to the lower level of costs, which necessitates the achievement of still further cost reductions to maintain high profits.
The same outcome, of course, applies not only to Intel and microprocessors but also to the rest of the computer industry, where gigabytes of memory and terabytes of hard-drive data storage now sell at prices below the prices of megabytes of memory and hard-drive data storage just a couple of decades ago. Indeed, if one knows how to look, the principle of ever more and better products for less and less applies throughout the economic system. It is present in the production of food, clothing, and shelter as well as in the high-tech industries, and in virtually all industries in between.
"The protesters are literally kept alive on the foundation of the wealth of the capitalists they hate."It is present in these industries even though the government's inflation of the money supply has caused the prices of their products to rise sharply over the years. Despite this, when calculated in terms of the amount of labor the average person must expend in order to earn the wages needed to enable him to buy these products, their prices have sharply fallen.
This can be seen in the fact that today, the average worker works 40 hours per week, while a worker of a century or so ago worked 60 hours a week. For the 40 hours he works, the average worker of today receives the goods and services comprising the average standard of living of 2011, which includes such things as an automobile, refrigerator, air conditioner, central heating, more and better living space, more and better food and clothing, modern medicine and dentistry, motion pictures, a computer, cell phone, television set, washer-dryer, microwave oven, and so on. The average worker of 1911 either did not have these things at all or had much less of them and of poorer quality.
If we describe the goods and services received by the average worker of today for his 40 hours of labor as being 10 times as great as those received by the average worker of 1911 for his 60 hours of labor, then it follows that, expressed in terms of the amount of labor that needs to be performed today in order to be able to buy goods and services equivalent to the standard of living of 1911, prices have fallen to two-thirds of one-tenth of their level in 1911, i.e., to one-fifteenth of their level in 1911, which is to say, by 93 1/3 percent.
Capitalism — laissez-faire capitalism — is the ideal economic system. It is the embodiment of individual freedom and the pursuit of material self-interest. Its result is the progressive rise in the material well-being of all, manifested in lengthening life spans and ever-improving standards of living.
The economic stagnation and decline, the problems of mass unemployment and growing poverty experienced in the United States in recent years, are the result of violations of individual freedom and the pursuit of material self-interest. The government has enmeshed the economic system in a growing web of paralyzing rules and regulations that prohibit the production of goods and services that people want, while compelling the production of goods and services they don't want, and making the production of virtually everything more and more expensive than it needs to be. For example, prohibitions on the production of atomic power, oil, coal, and natural gas, make the cost of energy higher and in the face of less energy available for use in production, require the performance of more human labor to produce any given quantity of goods. This results in fewer goods being available to remunerate the performance of any given quantity of labor.
Uncontrolled government spending and its accompanying budget deficits and borrowing, along with the income, estate, and capital gains taxes, all levied on funds that otherwise would have been heavily saved and invested, drain capital from the economic system. They thus serve to prevent the increase in both the supply of goods and the demand for labor that more capital in the hands of business would have made possible. They have now gone far enough to have begun actually to reduce the supply of capital in the economic system in comparison with the past.
"It turns out that virtually all of the problems the Occupy Wall Street protesters complain about are the result of the enactment of policies that they support and in which they fervently believe."Capital accumulation is also impaired, and can ultimately be turned into capital decumulation, through the effects of additional government regulation in raising the costs of production and thus reducing its efficiency. This applies to practically all of the regulations imposed by the Environmental Protection Agency, the Occupational Safety and Health Administration, the Consumer Product Safety Commission, the National Labor Relations Board, the Food and Drug Administration, and the various other government agencies. The effect of their regulations is that for any given amount of labor performed in the economic system, there is less product than would otherwise be produced.
Now anything that serves to reduce the ability to produce in general serves also to reduce the ability to produce capital goods in particular. Because of such government interference, any given amount of labor and capital goods devoted to the production of capital goods results in a smaller output of capital goods, just as any given quantity of labor and capital goods devoted to the production of consumers' goods results in a smaller output of consumers' goods. At a minimum, the reduced supply of capital goods produced serves to reduce the rate of economic progress. A reduction in the supply of capital goods produced great enough to prevent the addition of any increment to the previously existing supply of capital goods, and thus to put an end to capital accumulation, brings economic progress to a complete halt. A still greater reduction, one that renders the supply of capital goods produced less than the supply being used up in production, constitutes capital decumulation and thus a decline in the economic system's ability to produce. As indicated, the United States already appears to be at this point.
The problem of capital decumulation has been greatly compounded as the result of massive credit expansion induced by the Federal Reserve System and its policy of easy money and artificially low interest rates. This policy led first to a great stock-market bubble and then a vast housing bubble, as large quantities of newly created money poured into the stock market and later the housing market. Between these two bubbles, trillions of dollars of capital were lost. In both instances, vast overconsumption occurred as people raced to buy such things as new automobiles, major appliances, vacations, and all kinds of luxury goods that they would not have believed they could afford in the absence of the effects of credit expansion, often incurring substantial debt in the process.
In the one case, it was the artificial rise in stock prices that misled people into believing that they could afford these things. In the other, it was the artificial rise in home prices that produced this result. The seeming wealth vanished with the fall in stock prices and then again, later, with the fall in housing prices. In the housing bubble, moreover, millions of homes were constructed for people who could not afford to pay for them. All of this represented a huge loss of capital and thus of the ability of business to produce and to employ labor. It is this loss of capital that is responsible for our present problem of mass unemployment.
Despite this loss of capital, unemployment could be eliminated. But given the loss of capital, what would be required to accomplish this is a fall in wage rates. This fall, however, is made virtually illegal as the result of the existence of minimum-wage laws and pro-union legislation. These laws prevent employers from offering the lower wage rates at which the unemployed would be reemployed.
Thus, however ironic it may be, it turns out that virtually all of the problems the Occupy Wall Street protesters complain about are the result of the enactment of policies that they support and in which they fervently believe. It is their mentality, the Marxism that permeates it, and the government policies that are the result, that are responsible for what they complain about. The protesters are, in effect, in the position of being unwitting flagellants. They are beating themselves left and right and as balm for their wounds they demand more whips and chains. They do not see this, because they have not learned to make the connection that in violating the freedom of businessmen and capitalists and seizing and consuming their wealth, i.e., using weapons of pain and suffering against this small hated group, they are destroying the basis of their own well-being.
However much the protesters might deserve to suffer as the result of the injury caused by the enactment of their very own ideas, it would be far better, if they woke up to the modern world and came to understand the actual nature of capitalism, and then directed their ire at the targets that deserve it. In that case, they might make some real contribution to economic well-being, including their own.
Economists since Adam Smith have understood the enormous potential for productivity due to the division of labor. Overall productivity increases dramatically by splitting a job into several separate tasks performed by different people, each focused on their specific task. Ricardo further developed this understanding and showed that even in situations where one person outperforms another in every one of these tasks, both are still better off each focusing on the task for which they have a comparative advantage.
A surgeon who is also tremendously adept at preparing for and assisting during surgery is therefore better off — and actually does society a service — when hiring a nurse. This is true even if the nurse is worse at both performing surgeries and assisting during such procedures, simply because by focusing on the relatively more productive task (in this case to perform surgery), the surgeon produces greater overall value — even though some of the profits pay the nurse. The result is that the physician earns more, the nurse gets a job and earns a wage, and the rest of society gains access to both more medical expertise and more doctors' appointments and treatment.
But it is equally true that this increased focus on more narrowly defined tasks creates a mutual dependence between the surgeon and the nurse. The surgeon can only operate on this many patients if the nurse assists during surgery. Likewise, the nurse cannot offer the service of assisting were there no one with surgical skills to perform the operation. Therefore, in order to provide the market with surgery efficiently it is necessary to have both a surgeon and a nurse — and they need to cooperate in the production process. This is the reason Ludwig von Mises emphasized the division of labor as social cooperation and argued that every civilized society is based on the prosperity as well as the mutual dependence caused by the division of labor.
Mises was right. The enormously complex network of products and services — not to mention the collaborative skills that are coordinated in order to produce them — shows that we are all quite dependent on others for our prosperity and wealth. But note that this state of dependence is necessary only if we find desirable the prosperity that comes with it. Everybody should have the right to renounce this market order and refrain from partaking in the division of labor, even if it ultimately means that those who choose to do so also have to opt out of everything that makes our lives comfortable and convenient.
In fact, everybody has to make this fundamental choice: we can either engage in the social division of labor and contribute to our own and society's overall prosperity, or turn our backs on civilization and live the nasty, brutish, and short life that awaits all "noble savages" that do not partake in social cooperation through the division of labor.
The Dependencies of Indirect ProductionEugen von Böhm-Bawerk showed how society, at least the parts that choose division of labor instead of barbarism, consistently develop more roundabout and productive production processes that consist of ever more stages and involve (are dependent on) more people. The roundaboutness or "length" of a production process denotes the number of tasks it includes, where each task is continuously more narrowly defined. The alternative to the division of labor is that the baker has a small field out back where he grows and harvests his wheat, has a mill where he grinds it into flour, and a self-built oven to bake the bread. A longer or more indirect production method, which Böhm-Bawerk talks about, amounts to a farmer specializing in the production of wheat, a miller to grind the wheat, and a baker to produce the dough and bake bread in an oven made by someone specializing in oven making.
In other words, the production process is "longer" because it includes farmers, millers, bakers, and oven makers. And they are all dependent on each other to find outlets for the products of their labor. But it is equally a matter of having access to the ingredients or inputs necessary in each productive task: the miller is dependent on the baker purchasing the flour but is also dependent on the farmer to produce the wheat to mill. In the same way, the baker is dependent on both the flour produced by the miller and the oven maker's oven to produce the bread that is sold to consumers.
The latter is what directs the whole production process. Everybody involved in the production of bread (or any other product or service) — directly or indirectly — is dependent on consumers' valuation of it. If it cannot be produced cheaply enough, nobody in the chain of productive tasks can sell their intermediate products. The whole economy aims to do this single thing: to produce goods that satisfy the needs and wants of consumers.
But if this is the case — and if division of labor makes the market more efficient (productive) in satisfying consumer wants — why don't we experience an even more intense division of labor? Why don't we see the baker's job divided into numerous separate tasks? With what we know about the division of labor, we should see more productive production processes where different people mix ingredients, work the dough, form loaves, bake, take the bread out of the oven, let cool, etc.
The limitation to the intensity of the division of labor lies in the extent of the market. In order to support increased division of labor, greater volume is needed — and workers must be provided with sufficient incentives to take part in such "extreme" specialization. Likewise, the mutual dependence that arises between the baker and the miller limits the possible divisions of labor.
It is simply impossible to offer the service of "forming loaves" out of dough in the existing market. The market for such a service is literally nonexistent, because this task is an obvious part of the baker's job in the current structure of the market. The market therefore provides resistance to actors' overutilization of specialization through the division of labor. On the one hand, anyone in the current market structure choosing to grow and harvest his own wheat, then mill it into flour, then make bread and deliver it to consumers will suffer relative inefficiency and will not stand the market test. On the other hand, one cannot specialize to such an extent that the task carried out is incompatible with existing tasks carried out by market actors. There has to already exist both producers of inputs for and users of the output of the task for which one wishes to specialize.
In the case of the person wishing to specialize in "forming loaves," there must already exist those working the dough who are willing to sell it before forming it into loaves (input) — and those working with putting the already-formed loaves in the oven to bake. In a market where the baker commonly carries out all of these tasks there is no entrepreneurial opportunity to specialize in offering this particular service.
The Driver of Market SpecializationThe question then is how the market evolves toward consistently higher levels of specialization and more roundabout ("longer") production processes. Remember that we are not talking about increased efficiency in terms of methods or execution here but the splitting up of a task into several separate tasks. Such change cannot be brought about through small, continuous steps in a certain direction, but splitting one task into many is a decisive leap toward a different way of producing goods or services to satisfy consumer wants. And every such leap needs a market base to be feasible and to the advantage of everyone. How are market actors induced to take such leaps forward?
This problem has not been analyzed in detail in economic theory. Rather, economists have assumed that the increased division of labor in the market comes about quite automatically — and that this process accelerates. But how? No single actor in the market has incentives to make such a change as to specialize in a previously unknown narrow task, because doing so necessarily means suffering enormous losses until there exist actors who perform compatible services prior to and after the specific task in the overall production process.
There have been certain attempts to explain this situation using transaction-cost reasoning. Due to high transaction costs in the market, the extent of the market available to each actor is limited; consequently, the continuous increase of the division of labor is hindered. But this type of reasoning does not answer how or why the market is characterized by constantly higher degrees of division of labor; it only labels yet another contributing factor to the self-regulating and seemingly stable specialization level in the market.
In reality, however, the market is not only characterized by increasing division of labor — but increasingly so! Production processes become ever more roundabout and indirect — and at an increasing speed; to then focus on what hinders the adoption of increasing divisions of labor hardly explains the overall trend.
Obviously, one would expect to find an explanation in the driving force of the market: the entrepreneur. But this is problematic, because specializing in "forming loaves" is by definition an entrepreneurial act, yet market incentives directly counteract pursuing such opportunities (as we saw above). It is equally problematic for an entrepreneur wishing to indulge in "loaf forming" to first attempt to bring about a market structure where such services are traded — and it would completely undermine the profit motive (if not completely wipe out the possibility of profits), the very purpose of the entrepreneur's actions. Working to change the whole market structure in order to create a market for "loaf forming" would be costly and have few benefits.
A solution may be found if we look at the bigger picture, however. Overly specialized production processes can be coordinated in the market even if the individual tasks are incompatible with the market structure if they are integrated. An entrepreneur who imagines a new structure of production, where for instance the baker's job is split into multiple tasks as above, can contract with several bakers to each specialize in single tasks.
If these employed bakers are brought together to carry out and jointly work out the details of cospecializing these tasks, as well as coordinate their actions in an efficient manner, then the entrepreneur and bakers can avoid incompatibility: there are no such limits to the specific process (chain of tasks) as are in the market, because all necessary parts in the mutual dependence of tasks are created simultaneously. In other words, the entrepreneur can create and put together not-yet-existing competencies in a production structure that also does not yet exist, where each task is highly specialized and overall production therefore highly productive. What used to be a baker's job is, on this island of specialization created by the entrepreneur, transformed into several highly efficient tasks.
The Role and Function of Firms in the MarketBut the question remains, How can this new, roundabout production process be brought about? The answer is that the limit to the division of labor, the "extent of the market," can be sidestepped through the economic function offered by the firm. According to this view, the firm provides a means for the entrepreneur to further exploit the market's vast wealth-creating powers — and thereby make all involved better off (including consumers). At the same time, existing interdependencies are dissolved as other entrepreneurs follow the money and attempt to mimic the successful production processes, thereby increasing volume and, eventually, creating a labor market for those who have specialized within the firm.
The self-reinforcing limits of the market structure that existed prior to the firm are thereby mercilessly done away with, and existing production processes are replaced with successful (profitable) longer and more indirect processes.
This structural renewal process constitutes a leap toward greater specialization, longer and more indirect production, new capital constellations, new and additional mutual dependencies, and enhanced social cooperation — resulting in greatly increased productivity and, consequently, prosperity.
This important role of the firm in the market process has not previously been identified in the literature. Instead of being a way of organizing (coordinating) production where transaction-cost theory says it is too costly, the firm here becomes a progressive tool for the entrepreneur to completely reshape the market — in spite of its limitations — by establishing new forms of production. The firm therefore takes a very central and extremely important role in the functioning of the market, while offering an explanation for how the market can constantly be improved, streamlined, and become more specialized, despite the limitations to such development in the existing market structure.
There are several important implications of this view of the firm. Stigler's (1951) thesis that factors are first developed within firms and then markets are created for trading those factors (rather than vice versa) is confirmed. And theoretically, it makes embracing a changing or dynamic view of the market necessary — static models and general equilibrium theories appear irrelevant with the firm as the entrepreneur's tool and specialization catalyst: the entrepreneur is awarded a central role and the market structure is continuously pushed toward greater productivity through the establishment of new firms. This theory also offers explanations to the driving force behind and the reasons for outsourcing as a natural component of the market process.
But the practical and political implications seem potentially of even greater significance for the state and our view of society. As the firm is shown to play such a central and important role for the development of overall social prosperity, any legal or arbitrary effect by regulation on the business environment may very well mean huge welfare losses as the successes and development of firms are hindered.
One must ask, however, why the firm has not already been given greater attention in economic research, and why there have been no serious attempts to discover and explain its role in a larger market contest. As I have mentioned in a previous article, Adam Smith discussed the division of labor within the firm — and so did Karl Marx. And in the 1920s, several economists attempted to explain the existence and function of firms in the market through focusing on the division of labor. But it seems the neoclassical revolution severely undermined these theories before they matured — and the Coasean transaction-cost theory, despite its lack of ability to explain many of the phenomena mentioned above, put an unfortunate end to all such attempts.
[The Theory of Idle Resources (2011)]
Pseudo idleness is a condition which is common and has many forms; and it constitutes a phenomenon of the greatest importance in any study of unemployment of labor or “surplus capacity” in material resources.
Pseudo idleness exists when the capital value of resources is greater than their scrap value, while their net hire value is nil.
One of the most common forms of “pseudo-idleness” is that which exists when resources are being retained in their specialized form (i.e., not being scrapped) because the productive service of carrying them through time is being performed. This condition exists when their capital value is greater than their net positive scrap value, while their immediate hire value is nil.
This last phrase may require some explanation. Resources must be reckoned as of “no hire value” even if they can be hired out but (a) the price obtainable is insufficient to cover depreciation and loss of specialization, and (b) there is a greater consequent loss or a smaller consequent gain to capital value. That is, we must conceive of a net hire value equal to gross hire value minus depreciation. For when depreciation is not covered, the supposed hire price in part covers the realization of resources as scrap.
Thus, suppose expectations concerning the revival of demand to remain unchanged, then, for a piece of equipment to be in “pseudo-idleness,” it is necessary that an entrepreneur should be unable to utilize it profitably while maintaining its physical efficiency. The proceeds of the complementary use must be insufficient to finance depreciation in order to bring it into the socially productive category which we call “pseudo idleness."
(1) As skill once acquired is seldom lost, pseudo idleness in labor due to feared loss of specialized skill is rare. "Pseudo idleness" in labor is important. But its manifestation differs from that in other resources because it arises very seldom from the existence of specialized skill. Moreover, it is not easy to apply the criterion which is so clear in the case of equipment, namely, that the capital value of the workers shall be greater than their positive net scrap value, while their immediate net hire value is nil.
There is no such thing as the scrapping of a human being's powers, and hence no conception analogous to scrap value in respect of skill. The improvement and specialization of a person do not resemble the specialization physically embodied in a machine. They are the result of environment and upbringing in which deliberate training and education are important. What has once been learned may often be remembered for life. An individual's specialization may be unutilized and may deteriorate (as a machine may depreciate) but it is never purposely destroyed.
For most types of skill, there is no reason to suppose that work in another job will cause the loss of skill or loss of adaptation to the main occupation faster than idleness. Nor can it often be necessary to destroy one skill in order to supplant another. In general, the skilled worker whose services are dispensed with is free to employ his acquired talents again, if circumstances should be once more propitious. Thus, when an unemployed linotype operator becomes a shop assistant, it is evidence of a much smaller loss of capital than is indicated when a linotype machine is completely scrapped and the steel turned into shop fittings. We cannot say that the specialization of a linotype operator is as good as "scrapped" because his wage rate in that trade has fallen below what he can earn as a shop assistant (without special training). He leaves the printing works for the counter; but if it is expected that the demand for printing will revive, there is nothing in his temporary shop employment which will prevent his specialization from being utilized later on. Labor is, therefore, usually in a very different position from plant and equipment.
(2) The destruction of skill.
But although rare, the acquisition of a new skill does sometimes happen to weaken one which already exists. To take an extreme case, displaced musicians employed on road making may have subtlety of touch destroyed. Where such loss of specialization is important, "pseudo idleness" may arise through it. The individual may refuse available temporary work because to accept it will cause him to lose skill or his adaptation to the tasks of his main profession faster than physical idleness. His condition ought, therefore, to be thought of as "pseudo idleness." He is paid for the condition, although his remuneration for the service of preserving his specialization from destruction is postponed until an opening for his special powers has been found in the labor market.
(3) Important cases of pseudo idleness arise when supplementary employments will destroy simple availability for more profitable employments. There is, however, a very important form in which "pseudo idleness" in labor occurs. Its presence may sometimes be manifested in the "casual-labor" condition, and it will be best if we consider it in connection with that problem. The essence of the idleness is again availability, in spite of specialized powers as usually understood not being a factor in the situation. "Labor reserves" exist because those forming them have no immediate hire value, this last phrase being interpreted in a rather special sense. The acceptance of supplementary employment will cause a more than countervailing decline in long-run expectations of earnings through the loss of availability for relatively more profitable employments. Availability is, as we have said, a form of specialization.
(4) Workers in pseudo idleness are paid to keep themselves attached to a trade. To consider the "reserve of labor" (as it has been called) which tends to become attached to certain occupations, let us for the moment ignore the possibilities: (a) of the labor reserve being the product of a wage rate fixed at above the true market rate; and (b) of casual work being preferred (in any sense) to regular employment by those engaged in it. If the reserve then exists, the idle workers are, in fact, paid to keep themselves attached to the trade. To the extent that any trade is known to be risky from the point of view of continuity of employment, so must an increment to compensate the workers for such idleness as is liable to be experienced be reckoned as forming part of the remuneration. This has been a commonplace of labor theory at least since the time of Adam Smith. But its significance requires further discussion.
(5) The payment for pseudo idleness in labor is not a retaining fee, but favorable "expectation of earnings." "There is no such thing as the scrapping of a human being’s powers, and hence no conception analogous to scrap value in respect of skill." To think realistically of a "reserve" of labor attached to any occupation, we must envisage this service of availability. In the case of a true labor "reserve" it is advantageous to pay for it during actual employment through the ruling wage rates. The irksomeness and cost of attracting labor from temporary occupations when it is wanted makes some payment for continuous availability economical. Under casual labor the increment is received by the workers, not in the form of a retaining fee as compensation for the value of their chance of temporary earnings elsewhere, but through the net estimated advantageousness to them of being attached to the occupation being more than they could command in other occupations.[1] The equilibrium is determined by equality of "expectation of earnings," which may be defined as the "wage rate multiplied by the chance of employment." From the workers' point of view, they remain "attached to" the casual trade (and in the extreme case refuse other casual work) because immediate availability at all times is a condition of their employment in their principal trade, owing to the methods of recruitment believed to be most economical in practice.
(6) If "floating labor," unattached to a particular trade, is a necessary consequence of productive technique, it is in pseudo idleness and remunerated through "expectation of earnings." "Labor reserves" based on such availability are of even greater importance, however, than the last paragraph would suggest. There are general as well as special (i.e., attached to particular trades) reserves. Exactly the same considerations apply to those who are "out of work" owing to what are usually called the "inevitable delays" met with in changing from one job to another — the class who, when idle, are not specially attached to any trade at all. The workers affected may be induced not to hide themselves in inferior occupations which might prevent them from being available for more valuable employments which the chance workings of a dynamic society will disclose sooner or later. And the element which remunerates them for this is the extra value of their services in the employments which they expect to find.
Perhaps the best example of the situation is that of the "floating labor" in the prewar United States which was unattached to any particular job. This could conceivably have been regarded as falling in part into the "pseudo idleness" category. The quantity of such idleness is likely to be least, in any given set of technical institutions, where competition can be most effectively secured. As Sir Sydney Chapman wrote in 1908, "to augment the quantity of displacement (of labor) is not to augment the quantity of lengthy unemployment, for the very forces which create the additional displacements induce the re-absorption of the labor displaced. And it is hardly likely that more competition will bring about a better disposition of the old percentage of the population normally employed without increasing it."[2]
But insofar as "floating labor" is a necessary consequence of modern technique it is a definitely productive condition and subject to remuneration. The "reserve" represents that disposition of resources which, given any set of labor market institutions, is the most productive employment. And for this reason the accompanying "reserve" must be regarded as a case of "pseudo idleness."
(7) The reality of remuneration for pseudo idleness may be simply demonstrated.
To suggest that these "inevitable delays" are "paid for" may at first seem most unrealistic; and a careless reader may well be indignant at such a suggestion. But its truth may be simply demonstrated. Improved institutions which reduced the delays of labor transference (commercially run employment exchanges, for instance) would undoubtedly cheapen labor. That is, the amount of productive effort obtainable from a given expenditure on wages would be greater. The saving achieved would represent an economy on the former payment for the availability (not the use in other senses) of a greater quantity. Reserves of labor in certain fields, or completely generalized reserves would be economized. The average period of actual employment for each worker would be longer; and in the light of the principle of equality of expectation of earnings, wage rates would not have to be so high in order to attract a given number of actual workers to any trade which needed their efforts.
(8) The typical poverty of casual workers does not affect the issue. Misconceptions are, however, still likely to arouse indignation when the reader considers the casual-labor question, for the workers concerned may in this case be desperately poor. But the fact that their average earnings in casual employment are often pitifully low must not be allowed to distort our judgment on this point.[3] The poverty typical of such workers is due to other causes. Casual labor simply happens to have been the haven into which those debarred or ousted from other trades by labor monopoly have found a permanent or temporary refuge. In spite of its containing only the dregs of employment opportunities, it has provided the sole considerable palliative to social injustice.
Immigrant workers from countries in which opportunities of employment are still less favorable may nevertheless have their inertia overcome by the relatively high earnings obtainable even in the worst labor markets of more favorably situated countries; and their competition may further depress rates of earnings of unskilled and casual labor. In books on the unemployment of labor there seems to have been a curious and perhaps significant reluctance even to mention, let alone bring into discussion, this very crucial fact. But occasionally it has been remarked upon. Thus, the Charity Organization Society Committee on Unskilled Labor pointed out in 1908 that "the skilled unions have limited the labor market in their trade. The inevitable result has been to maintain a continual glut in the low-skilled labor market."[4] It is usually held, however, that there is an obvious injustice in the casual-labor system.
(9) "Labor reserves" are purchased through wage rates, and cannot be "forced" unless employers' monopoly can destroy labor mobility. Yet "the requirement in each trade of reserves of labor to meet the fluctuations incidental even to years of prosperity"[5] is often regarded as an evil in itself. Some of the discussions of this question have even written in tones which imply that instead of being paid to be thus available, the workers are forced by "the employers" into a soul-destroying, cruel, and wasteful idleness.
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But unless that section of capitalists which benefits from the maintenance of "reserves" has some means others than payment of preventing the workers attached to the trade from obtaining alternative employment, we cannot see how it could be. No one has ever argued, as far as we know, that such a power has existed or been exploited.[6] The "reserves" of labor under casual employment are, in fact, paid for and to the interest of those workers who form them. The labor supplied is often necessarily cheap labor; and that being so, it may often pay to employ it extensively rather than intensively.
But if the standards of living which earnings can command from this field are deplorably low, it is the causes of the cheapness of the labor and not the methods by which it pays to utilize it which must be blamed. And the labor is cheap because other opportunities of employment are barred to those who provide it.
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This article is excerpted from The Theory of Idle Resources, chapters 3 and 4, "Pseudo-Idleness in Labor" (2011).
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Notes [1] Adam Smith brought in an additional suggestion to explain an element in the remuneration of casual employment. "What he earns," wrote Smith, "while he is employed, must not only maintain him while he is idle, but make him some compensation for those anxious and desponding moments which the thought of so precarious a situation must sometimes occasion" (Wealth of Nations, Cannan Edition, vol. I, p. 105. Italics added.). This is obviously an important factor determining the "net advantageousness" among those with a certain psychology and tradition. But among the poorest classes, the anxieties are probably more than countervailed by the "benefits" of recurrent "leisure" of the type discussed in chap. v, paras. 6 and 7. If Adam Smith's classical assertion concerning the influence of the risk burden does happen to be true of this class also, it does not in any way invalidate the analysis in the text.
[2] L. Brassey and S.J. Chapman, Work and Wages (London: Longmans, Green, 1904), vol. 11, p. 349.
[3] No one objects to casual work in a well-paid occupation like, say, that of barristers.
[4] Quoted in P. Alden and E. Hayward, The Unemployable and the Unemployed (London: Headley Brother, 1907), p. 78.
[5] W.H. Beveridge, Unemployment: A Problem of Industry (London: Longmans, Green, 1909), p. 13.
[6] J.S. Poyntz says (in Seasonal Trades, edited by S. Webb and A. Freeman [London: Constable, 1912], p. 60): "There are many trades where the employer undoubtedly finds it to his advantage to keep a large fringe of superfluous labor attached to his business in case of extra demand." But as this phenomenon is supposed to be specially prominent in the "sweated industries" where "employers" are notoriously uncombined, the allegation is obviously misconceived. "The army of men and women standing at (the employers') beck and call," says the same writer, "cost him nothing except for the actual hours that they are at work" (p. 7). This sort of confusion has probably been responsible for an immense amount of avoidable poverty.
IntroductionValue DerivationSavings and Capital GoodsThe Law of ReturnsIntroductionAccording to the Austrian business-cycle theory, monetary expansion leads to artificially low interest rates, which lead producers to act as if consumers wanted to save more than they really do. Thus, businesses overdedicate resources to longer chains of production and underdedicate resources to shorter chains. In effect this means malinvestment: overinvestment in goods like tractors, factories, and fuel — and underinvestment in goods like iPods and breakfast cereal.
This results in a perception of increased all-around prosperity, as investors revel in the increased monetary returns normally attendant on resources being freed up from consumption for investment, while consumers continue to enjoy (and use up) those same resources anyway. (This is the Austrian explanation for the enjoyable, but ultimately destructive, cyclical economic "boom.")
However, you can't have your cake and eat it too. And neither can you have your corn as ethanol and eat it as Corn Flakes too. As the rapping Hayek says, eventually the "grasping for resources reveals there's too few," (this revelation comes in the form of business losses) and resources are reallocated accordingly. Austrians say this reallocation period is the painful, but ultimately salutary, cyclical economic "bust" that inevitably follows the boom.
Superstar economist Paul Krugman doesn't buy it. In Slate, he wrote,
Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods — implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?
His argument seems to run as follows: Economic busts are characterized by increased unemployment. Why would a reallocation of resources from tractors, fuel, and factories to iPods and breakfast cereal lead to a rise in unemployment? The bust in the former should be attended by a boom in the latter. So why wouldn't employment just shift from one to the other? Why would it crash as calamitously as it does in a boom?
Krugman's "simple arithmetic" is actually too simple to frame the problem. "That simple equation — too much aggregation," as the rapping Hayek says. The only way a reallocation process would be as trouble-free as Krugman supposes would be if material resources and workers were perfectly nonspecific and convertible.
In effect, he treats "investment goods" and "consumption goods" as if they were two lumps of clay, and workers as if they had the simple job of massaging the clay. If that were accurate, there truly would be no problem! Just pinch some clay off of the "investment-goods" lump, squish it onto the "consumption-goods" lump, and transfer workers accordingly.
Of course material goods are not a homogeneous substance. As Jim Fedako wrote,
The standard view is that capital is clay, ready for the potter to reshape it in a moment's time. In contrast, the Austrian view takes the current structure of capital as a given, something that the entrepreneur must take into consideration when formulating his plans. If an entrepreneur wants to change the current structure of capital, he will wield dynamite and dozer, not water and wheel.
And neither are workers homogeneous. The liquidation of nonviable projects and the establishment of viable ones take time. And many workers will not be able to find a stable role in a radically overhauled structure of production until that structure has been established.
As Robert Murphy summed it up,
The elementary flaw in Krugman's objection is that he is ignoring the time structure of production. When workers get laid off in the industries that produce investment goods, they can't simply switch over to cranking out TVs and steak dinners. This is because the production of TVs and steak dinners relies on capital goods that must have already been produced.[1]
Elementary errors like the one made by Krugman stem from a deficient view of the structure of production. This is the most severe problem of most mainstream economists, and the one for which they most urgently need to learn from the Austrian School. This article will explain the elements of production theory that are applicable even for a one-man "Crusoe economy": value derivation, savings and capital goods, and the law of returns.
Value DerivationIn "Mises on Action," I explained the merits of imaginary constructions (thought experiments) in investigating economic principles: in particular, imaginary constructions involving an isolated individual (a Robinson Crusoe on his island). Let us again visit Crusoe on his island to investigate a one-man structure of production. The specialized terms in this section are italicized and linked to their definitions in the Mises Wiki.
Let us say Crusoe, after surviving his shipwreck, awakens on his island with two sources of uneasiness: a ravenous hunger and a bitter chill.
Crusoe sees two goods in front of him that also washed up on the beach from the shipwreck and that may satisfy his most pressing wants:
a smashed open can of green beans,
and a perfectly dry greatcoat.
These goods are consumers' goods because they are directly serviceable.
He sees behind him a great wave that in moments will hit the beach. The wave will probably soak the greatcoast and pull the can of green beans into the sea. Crusoe only has time to save one of the goods. He has to choose. And by making his choice, Crusoe by definition will demonstrate which good he values more highly.
Let us say he chooses the greatcoat. In that case, he demonstrates that he values the greatcoat more highly than the green beans, so his scale of values would be as follows:
Greatcoat
Green BeansCrusoe has made an autistic exchange: acquiring the greatcoat and giving up the green beans "in exchange" for it. The green beans constitute the opportunity cost of the action.
What determined the valuation of the greatcoat and the green beans? Because the goods are means for the alleviation of uneasiness, and not ends in and of themselves, Crusoe's choice is not, at bottom, a matter of green beans vs. greatcoat. It is a matter of hunger vs. cold; or, more precisely, the want satisfaction Crusoe expects the beans and the coat to provide with regard to his hunger and cold.
When actors decide between two means, they decide based on the extent to which each means accomplishes his ends. Value depends on usefulness or, more precisely, on marginal utility. So by demonstrating, through his choice, that the greatcoat has higher value than the green beans, he also demonstrates that the greatcoat has higher marginal utility than the green beans.
Let's make things a little more challenging for Crusoe. Let us say both goods are safe from the oncoming wave, but the can of green beans is actually sealed shut, and the greatcoat is locked up in a chest.
And now the following items are in danger of being lost to the wave:
a can opener
the key to the chest
For the sake of simplicity, let's say there will never be any way to open the can without the opener nor the chest without the key.
The can opener and the can of beans are producers' goods ("factors of production"), which, in combination with Crusoe's labor (also a factor of production) can produce the consumers' good of green beans that are ready to be eaten.
Similarly, the key and the unopened chest are producers' goods (factors of production) that, in combination with Crusoe's labor (also a factor of production), can produce the consumers' good of a ready-to-wear greatcoat.
Another way of labeling goods is to refer to consumers' goods as "goods of the first order," and to those producers' goods that directly produce consumers' goods as "goods of the second order." Producers' goods that produce "goods of the second order" are called "goods of the third order," and so on.
So the key and the can opener are goods of the second order; they can, respectively, help produce the ready-to-wear greatcoat and the ready-to-eat green beans, which are goods of the first order.
The key and the can opener are not important to Crusoe as ends in themselves, but as means for the acquisition of the greatcoat and green beans, which in turn are but means for the ends of the alleviation of cold and hunger. If the greatcoat has more utility for Crusoe than the green beans, the key (which is nothing more than a tool for the acquisition of the greatcoat) will have more utility and therefore be valued higher than the can opener (which is nothing more than a tool for the acquisition of the green beans). Accordingly, Crusoe would choose to save the key.
Thus we see an illustration of the principle that the utility/value of goods of the second order is derived from the utility/value of the goods of the first order (consumers' goods) that they help produce. In other words, value is imputed from the first-order good to the second-order good. This is a necessary implication of our understanding of the meaning of action and of any means-ends framework.
Now let's say both the key and the can opener are safe from the wave, but they are so bent out of shape that they are unusable. Now the goods that are in danger of being lost to the wave are:
a pair of needle-nose pliers that would only be suitable for repairing the key
a pair of large pliers that would only be suitable for repairing the can opener.
Since these goods can be used to produce goods of the second order (a ready-to-use key and a ready-to-use can opener), they are goods of the third order.
The needle-nose and large pliers are not important to Crusoe as ends in themselves, but as
means for the repair of the key and the can opener,
which in turn are but means for the acquisition of the greatcoat and the green beans,
which in turn are but means for the alleviation of cold and hunger.
If the greatcoat has more utility for Crusoe than the green beans, then obviously the key will have more utility than the can opener. And if that is the case, then obviously the needle-nose pliers will have more utility and therefore be valued more highly than the large pliers. Accordingly, Crusoe would choose to save the needle-nose pliers.
As we can see from this thought experiment, the utility/value of goods of the third order is derived from the utility/value of the goods of the second order that they directly help produce, which in turn is derived from the utility/value of the goods of the second order that the goods of the second order help produce.
"Physical production moves forward through time from higher- to lower-order goods. But value derivation moves, in the mind of man, backward through time, from lower- to higher-order goods."The utility and value of goods of the third order are ultimately derived from the goods of the first order they indirectly help produce. This reasoning can be extended to goods of any order, for any chain of production. Even the utility and value of goods of, say, the 243rd order are ultimately derived from the utility and value of the goods of the first order they indirectly help produce. This is a necessary implication of the truth that production is always for the sake of consumption.
Physical production moves forward through time from higher- to lower-order goods. But value derivation moves, in the mind of man, backward through time, from lower- to higher-order goods.
This view of the structure of production was pioneered by Carl Menger in his Principles of Economics, the book which Ludwig von Mises said "made an economist out of [him]."
Savings and Capital GoodsEvery order (2nd, 3rd, or 243rd) in a structure of production takes time. So extending a structure of production by adding orders of goods to it always involves extending the structure's period of production. How much a period of production can be extended is limited by time preference.
Other things being equal, satisfaction is preferred sooner rather than later. This universal feature of acting man is called "time preference." Time preference can even be seen in the behavior of children, as in the seminal "marshmallow experiment" conducted at Stanford University, on which the New Yorker reported,
In the late nineteen-sixties, Carolyn Weisz, a four-year-old with long brown hair, was invited into a "game room" at the Bing Nursery School, on the campus of Stanford University. The room was little more than a large closet, containing a desk and a chair. Carolyn was asked to sit down in the chair and pick a treat from a tray of marshmallows, cookies, and pretzel sticks. Carolyn chose the marshmallow. Although she's now forty-four, Carolyn still has a weakness for those air-puffed balls of corn syrup and gelatine. "I know I shouldn't like them," she says. "But they're just so delicious!" A researcher then made Carolyn an offer: she could either eat one marshmallow right away or, if she was willing to wait while he stepped out for a few minutes, she could have two marshmallows when he returned. He said that if she rang a bell on the desk while he was away he would come running back, and she could eat one marshmallow but would forfeit the second. Then he left the room.…
The Mises WikiMost of the children … struggled to resist the treat and held out for an average of less than three minutes. "A few kids ate the marshmallow right away," Walter Mischel, the Stanford professor of psychology in charge of the experiment, remembers. "They didn't even bother ringing the bell. Other kids would stare directly at the marshmallow and then ring the bell thirty seconds later." About thirty per cent of the children, however, were like Carolyn. They successfully delayed gratification until the researcher returned, some fifteen minutes later. These kids wrestled with temptation but found a way to resist.
In struggling with "temptation," these children were actually deliberating over an autistic exchange.[2] They were deciding over an exchange concerning two different goods: a present good (the one treat laid out before them) and a quantitatively greater future good (two treats in 15 minutes).
By virtue of their closeness in time, present goods always have a premium in relation to future goods, other things being equal. This premium is called time preference, and it varies from person to person. Another way of saying the same thing is that, by virtue of their remoteness in time, future goods always have a discount in relation to present goods, and this discount varies from person to person.
The children who did not wait, including Carolyn's brother Craig, exhibited a higher time preference than Carolyn and the other children who did wait. In other words, they placed a higher premium on "now," or a higher discount on "later."
Time preference is a fundamental factor in production. To see how, let's put Craig and Carolyn each in their own "Crusoe" situation.
Let's say Craig and Carolyn grow up and find themselves each stranded on identical islands. Let's say there are trees on each of the islands, which bear a fibrous nut that happens to taste just like marshmallows.
In fact, eating one of these nuts amazingly provides exactly the same experience as eating the marshmallows provided them by the Stanford researchers when they were kids. These "marshnuts" can be acquired by throwing rocks at the top of the tree. Some of the trees are taller than others, and thus their marshnuts are more difficult to reach with stones. But the taller the tree, the more abundant is its clusters; so a stone that reaches the top of a tall tree will knock down more marshnuts than one cast at a short tree.
Craig and Carolyn can achieve a certain low rate of productivity by throwing stones by hand at short trees, harvesting, say, one marshnut every 30 minutes.
But then they both have the idea of making a sling (a second-order good) out of the fibers of one of the marshnuts. The sling can be used to cast a stone higher, but they know the sling will break after one use.
They would each have to sacrifice the present satisfaction of eating one marshnut in order use it to build the sling. But the sling would enable them to get two marshnuts in 15 minutes (the time it takes to construct and use the sling).
Thus they can increase their productivity, but only by adding an order to their structure of production (the intermediate "sling-capital-good" order) and thus extending their period of production.
In economics, such extensions of the period of production are intimately tied to increases in productivity. Any change in the structure of production obviously must either involve an increase, decrease, or maintenance of its length. Improvements in productivity that involve less lengthy or equally lengthy production periods are easy to adopt. All that is required for their adoption is their discovery. For example, Craig might find that throwing rocks overhand is more productive of marshnuts than throwing underhand. Or he might come across bigger rocks that are better for knocking marshnuts down.
But for any given state of technological knowledge and available resources, the only conceivable way of improving productivity is to extend the period of production. And the only way to extend the period of production is to refrain from consuming now everything that could possibly be consumed: that is, to save.
The choice before Carolyn and Craig, between one present marshnut and two future marshnuts, ignoring the disutility of the labor involved, is precisely analogous to their choice in the Stanford experiment they underwent as children. Assuming the same time preferences (and the severely arrested development implied), Craig would not make the investment, but Carolyn would. Carolyn would refrain from consuming a present marshnut. In other words, she would save.
It is her sufficiently low time preference that brings her to save, and it is her saving which makes the extension of the period of production, and the concomitant creation of a productivity-enhancing capital good, possible.
As Mises wrote,
postponement of consumption makes it possible to direct action toward temporally remoter ends. It is now feasible to … choose methods of production in which the output of products is greater per unit of input than in other methods requiring a shorter period of production.[3]
So Carolyn spends 15 minutes constructing and using the sling, which yields her a return of two marshnuts. Again, the sling is single-use, so after using it up she faces a choice. She could choose one of the following options.
Eat both marshnuts, and go back to her old method of production. This would be "capital consumption" (quite literally in this case). Assuming her time preference has not suddenly spiked since her last decision, she would not choose this option.
Eat one marshnut and use the other to build another sling. This would be "capital maintenance."
Restrict current consumption even further, saving both marshnuts ("capital accumulation") for the purpose of building a single-use bow that would enable her to acquire four marshnuts!
Let's say she chooses option C, and thus acquires four marshnuts. Then, of those four marshnuts, she eats one, and uses the other three to build a single-use crossbow that produces seven marshnuts. Then she eats two of those marshnuts, and uses the other five to build a single-use catapult that produces ten marshnuts. The more she gathers, the more she can save. And the more she saves, the more she gathers; and thus, the more she is able to consume in the long run.
Thus we see how continuous increases in both production and consumption can be the result of an upward spiral caused by the mutual reinforcement between savings (capital accumulation) and increased productivity.
Acting man's savings rate is determined by his time preference. The higher it is, the more limited is his savings rate, which in turn limits his economic growth. And lower time preference means more savings, and thus greater capacity for economic growth.[4]
While consumption motivates production, it is savings that fuels it.
Too often historians neglect the role of savings in times of rising human welfare. Even my favorite historian, Will Durant, is guilty of this. In the first volume of his splendid 11-volume series, The Story of Civilization, Durant tells of various stages in the development of agriculture. He starts with the most primitive.
Even today, in certain tribes of Australia, the grains that grow spontaneously out of the earth are harvested without any attempt to separate and sow the seed; the Indians of the Sacramento River Valley never advanced beyond this stage.
At this stage the period of production is extremely short: virtually instantaneous. The Sacramento Indians simply gathered the grain as they found it. Durant then goes on to the more advanced method of another people.
The Juangs threw the seeds together into the ground, leaving them to find their own way up.
The Juangs' method is probably more productive than that of the Sacramento Indians. Now what does it take to move from the "Sacramento" level of productivity to the "Juang" level? Durant, like many historians and anthropologists, focuses on the discovery of the idea of the more productive technique.
We shall never discover when men first noted the function of the seed, and turned collecting into sowing; such beginnings are the mysteries of history, about which we may believe and guess, but cannot know. It is possible that when men began to collect unplanted grains, seeds fell along the way between field and camp, and suggested at last the great secret of growth.
But, as Austrian economists stress, a technological idea is useless if its realization is not supported by sufficient savings. The Juang method involves a more extended structure of production. Harvesting what they have sown involves goods of a certain order: harvest labor and the ripe food grain. And that stage of production depends on having sown prior to that, which means it depends on higher-order goods: sowing labor and seed grain. And the sowing stage in turn depends on harvesting the seed grain in the first place, which involves goods of a still-higher order.
So the Juang method requires at least two more stages of production than the Sacramento method. And each additional stage of production must be supported by savings, or abstention from consumption. For a Juang to have seed grain to sow, he must abstain from consuming it as food grain. And a Juang will only abstain from present consumption of his grain if his time preference is sufficiently low that he values the quantitatively greater, but temporally later, harvest more highly than his present enjoyment of the small amount of grain now in his possession.
Durant continues,
The natives of Borneo put the seed into holes which they dug with a pointed stick as they walked the fields. The simplest known culture of the earth is with this stick or "digger." In Madagascar fifty years ago the traveler could still see women armed with pointed sticks, standing in a row like soldiers, and then, at a signal, digging their sticks into the ground, turning over the soil, throwing in the seed, stamping the earth flat, and passing on to another furrow.
This "Madagascar" method requires even more intermediate goods and a further extension of the period of production: On top of all of the "Juang" stages, a stick must be found and then sharpened to create a "digger." Furthermore, the digger, as a capital good, must be maintained; it must be either periodically resharpened or replaced in order to maintain the capital structure. Otherwise, the Madagascan people would consume their capital, and then have to revert to the less productive Juang method. Moreover, all this activity that doesn't immediately result in more food must be supported by a "subsistence fund," which means it requires yet further saving.
Durant continues,
The second stage in complexity was culture with the hoe: the digging stick was tipped with bone, and fitted with a crosspiece to receive the pressure of the foot. When the Conquistadores arrived in Mexico they found that the Aztecs knew no other tool of tillage than the hoe.
A hoe requires even more time, labor, and material resources, and thus even more savings. Yet again, Durant's emphasis on "complexity" makes it sound like the economic step was simply a matter of the cognition of a higher technique.
With the domestication of animals and the forging of metals a heavier implement could be used; the hoe was enlarged into a plough, and the deeper turning of the soil revealed a fertility in the earth that changed the whole career of man. Wild plants were domesticated, new varieties were developed, old varieties were improved.
And the domestication of animals, the forging of metals, and the construction of ploughs, involve an even further extension of the structure of production, requiring a great deal of savings. As he embarks upon a discussion of early man's efforts to "save for a rainy day," Durant next says,
Finally nature taught man the art of provision, the virtue of prudence, the concept of time.
Unfortunately, many people think that the alleviation of uncertainty through this "prudence" is the primary purpose of saving. But as has been demonstrated above, everything Durant had discussed up to this point concerning improvements in productivity already depended on "the art of provision, the virtue of prudence, the concept of time."
These incidents of primitive saving have momentous consequences for future generations. As Mises wrote,
Every single performance in this ceaseless pursuit of wealth production is based upon the saving and the preparatory work of earlier generations. We are the lucky heirs of our fathers and forefathers whose saving has accumulated the capital goods with the aid of which we are working today. We favorite children of the age of electricity still derive advantage from the original saving of the primitive fishermen who, in producing the first nets and canoes, devoted a part of their working time to provision for a remoter future. If the sons of these legendary fishermen had worn out these intermediary products — nets and canoes — without replacing them by new ones, they would have consumed capital and the process of saving and capital accumulation would have had to start afresh. We are better off than earlier generations because we are equipped with the capital goods they have accumulated for us.[5]
And it is institutions that obstruct saving and capital accumulation which keep whole peoples economically primitive and "underdeveloped."
Shortage of capital means that one is further away from the attainment of a goal sought than if one had started to aim at it at an earlier date. Because one neglected to do this in the past, the intermediary products are wanting, although the nature-given factors from which they are to be produced are available. Capital shortage is dearth of time. It is the effect of the fact that one was late in beginning the march toward the aim concerned. It is impossible to describe the advantages derived from capital goods available and the disadvantages resulting from the paucity of capital goods without resorting to the time element of sooner and later. …
To have capital goods at one's disposal is tantamount to being nearer to a goal aimed at. An increment in capital goods available makes it possible to attain temporally remoter ends without being forced to restrict consumption. A loss in capital goods, on the other hand, makes it necessary either to abstain from striving after certain goals which one could aim at before or to restrict consumption. To have capital goods means, other things being equal, a temporal gain.[6]
Now let's go back to our marshnut gatherers. Let's say Craig "grows up" a little and starts to exhibit a time preference that is lower than before, but still higher than Carolyn's.
They both conceive of the idea of using 20 marshnuts to build a giant single-use trebuchet that could reach the top of the biggest tree on the island and thus rain down 200 marshnuts!
And so out of their 4-marshnut-per-day incomes, Carolyn and Craig both begin to save marshnuts in order to build their trebuchets. Carolyn (with her lower time preference) saves 2 marshnuts per day, and Craig (with his higher time preference) saves 1 marshnut per day.
After 15 days, Carolyn has saved 30 marshnuts. She now feels economically secure enough to begin breaking down the marshnuts to build her trebuchet. Starting with day 16, Carolyn produces 2 marshnuts per day, consumes 2 per day, and adds 2 per day to her trebuchet. Thus her stock of whole marshnuts dwindles by 2 per day. She has more than enough stock to see her capital-intensive, lengthy method of production through to completion in spite of her decreased rate of marshnut production.
After 15 days, Craig, with his lower savings rate, has only saved 15 marshnuts. He recognizes that he needs to keep saving. Due to their different time preferences, the two have different rates of economic growth, but they both have a plan for consumption and investment that is sustainable given their resources.
But little do they know that the spirit of John Maynard Keynes is looking down upon them.
Keynes thinks to himself, "I like that Craig boy's hedonist attitude, but the poor lad is an economic nincompoop! This one-man island nation needs some expert economic intervention. Obviously there is no money supply for me to expand, so instead I'll have to magically create 15 ectoplasmic marshnuts to fill out Craig's supply. They may be ephemeral and useless, but they'll stimulate spending and investment, which is what the young lad needs."
Time and MoneyCraig is pleasantly surprised to see that he was richer than he thought he was. "Dude, I've got 30 marshnuts? I must have miscounted yesterday — great!" Electrified by his newfound "wealth," Craig starts breaking down marshnuts to build his trebuchet at the same rate as Carolyn, and he increases his marshnut consumption to 3 per day.
"I've stimulated consumption and investment," crows Keynes. "Look how happy and productive he is. Stones to bread; it's an economic miracle!"
The economic boom, triggered by Keynes's "stimulus," hums along nicely for a few days. Craig makes good progress on his trebuchet and he's having the time of his life.
But his production and consumption structure is just not sustainable given his resources. Craig simply does not have enough income and real savings to both support his increased consumption and see his ambitious production plans through to completion. So the economic bubble will eventually pop in the long run. Keynes replied to such objections to his proposals by saying, "in the long run, we're all dead." Keynes may be dead, but unfortunately for Craig, his economic long run is five days.
"Not cool!" he says as his hand passes through the first of the illusory marshnuts. "These 15 marshnuts are nothing but pixie dust, and my trebuchet is only halfway finished. And what good is half of a trebuchet?!"
Now Craig realizes he did not really have enough savings to see his plans through fruition; and he now needs to reduce consumption and increase savings. He realizes that, to maintain even a tolerable lifestyle, he must scrap his malivenstment and reallocate its resources to shorter-term sustainable projects. But he has much less to work with now, because many of his invested marshnuts cannot be "liquidated" and so are simply wasted. Many of the marshnut fibers now in his half trebuchet are cut into shapes that are simply useless for the construction of other devices.
Craig has just gone through what might be called a one-man business cycle. Misled as he was by Keynes's "stimulus," Craig is now hardly better off than when he started saving for the trebuchet, while Carolyn, because she had an accurate perception of her wealth, and was able to plan accordingly, finishes her trebuchet with marshnuts to spare, and collects her bounty of 200 marshnuts.
In a modern economy it is, not ectoplasmic marshnuts, but artificial increases in the money supply that make individuals think they are wealthier than they really are. But according to the Austrian business-cycle theory, the societal response is much the same: ambitious capital investments that are simply unsustainable given the true amount of savings in the economy. Eventually, people realize the unsustainability of their investments, the bubble pops, boom gives way to bust, and the resources are (painfully) reallocated to sustainable investments.
The Law of ReturnsThe addition of factors to a structure of production is constrained by time preference. But it is also constrained by the "law of returns."
One of the most difficult sections to follow in Ludwig von Mises's Human Action is the section concerning the law of returns,[7] chiefly because Mises uses a lot of symbols representing quantities to explain the law and its implications. In Man, Economy, and State, Murray Rothbard uses numerical quantities, but he still uses symbols to represent goods, instead of using concrete examples.[8] In what follows, I will apply Rothbard's quantities (with a small modification to demonstrate an important concept) to a more concrete example in order to parse Mises's statement of the law.
Mises presents three goods:
b and c of the two complementary goods B and C, and p of the product D.
The capital letters represent goods, and the lowercase letters represent quantities of those goods. B and C are factors of production that in combination produce the consumers' good D. Let us say we are dealing with the fully automated kitchen of a high-tech restaurant. Let us have B represent the factor of production "stove," and so b represents the number of stoves. C represents the factor of production "robot cook," and so c represents the number of robot cooks. D represents the product "dish of pasta," and p represents the number of pasta dishes produced.
Now, in his examples, Mises sets b as unchanging. For us, this means that the number of stoves in the kitchen is fixed, let's say at 8. However, c is variable. For us, this means the number of robot cooks is variable.
Let us say
If the kitchen has 1 robot cook it can produce 4 dishes of pasta per night.
If it has 2 cooks, it can produce 10 dishes.
3 cooks produce 18 dishes.
4 cooks, 30 dishes.
5 cooks, 40 dishes.
6 cooks, 45 dishes.
7 cooks, 42 dishes.
Mises writes,
With b remaining unchanged, we call that value of c which results in the highest value of p/c the optimum.
In our case, "p/c" is the ratio of total dishes (total output) to total cooks (total variable input). Mainstream economists often refer to this value as the "Average Physical Product" (APP). Our different scenarios above have the following APP values:
4 (4 dishes divided by 1 cook)
5 (10 dishes divided by 2 cooks)
6 (18 dishes divided by 3 cooks)
7.5 (30 dishes divided by 4 cooks)
8 (40 dishes divided by 5 cooks)
7.5 (45 dishes divided by 6 cooks)
6 (42 dishes divided by 7 cooks)
Again, Mises defines the "optimum" as the highest value of p/c (the highest APP). So in our case the "optimum" would be scenario E with a APP of 8. This is also known as the "point of diminishing average returns." But this is not what is usually meant in mainstream economics by the familiar phrase "point of diminishing returns." That is still to come.
One could plot "number of cooks" vs. APP on a graph to create an "APP curve," and see at a glance Mises's "optimum," the point beyond which adding units of a factor of production makes total output smaller in proportion to total input. But such a graph adds nothing to what we already know about the assumptions used to construct the graph.
Mises writes of the "optimum":
If we deviate from this optimal combination by increasing the quantity of C without changing the quantity of B, the return will as a rule increase further, but not in proportion to the increase in the quantity of C.
First let us examine what he means by "the return will as a rule increase further." Here by "returns," he is talking about total output for each scenario. Economists often call this value the "total physical product" (TPP). In our example, that means the total number of dishes produced in each scenario. The TPPs for our alternative scenarios are as follows:
4
10
18
30
40
45
42
Remember, our "optimum" was E, with 5 cooks. Yet, if we keep adding robot cooks beyond our optimum, we are still increasing our TPP for a while, which, as Mises says will generally occur as a rule. It makes sense that, as a rule, the more input you put in, the more output you get out. But why does Mises say, "as a rule," which implies that it is not always the case?
As you can see above, we cannot forever keep adding robot cooks and at the same time keep increasing our TPP. Moving from scenario F (6 cooks) to scenario G (7 cooks) our TPP actually goes down.
"Wait a minute," you might object, "Why would 7 cooks produce fewer dishes than 6?" There are too many cooks in the kitchen, of course! It's a small kitchen, so adding a 7th cook will actually make the work slower, as the robots have to take longer routes from place to place to avoid running into each other. The 7th cook hurts production in absolute terms. The point at which adding another cook makes the output absolutely smaller is the point at which "negative returns" (or diminishing total returns) sets in. But this is still not what is usually meant by the familiar phrase "point of diminishing returns."
One could plot number of cooks vs. TPP on a graph to create a "TPP curve" and see at a glance at which point adding units of a factor of production hurts production in absolute terms. But again, such a graph adds nothing to what we already know about the assumptions used to construct the graph.
Again, Mises said that adding factors of production beyond the optimum may result in an increase of returns, but "not in proportion to the increase in the quantity of C" Here Mises is talking about yet another kind of ratio. It is crucial to note that we are no longer talking about simply output vs. input, but instead we are talking about change in output vs. change in variable input. Economists often call this value the "Marginal Physical Product" (MPP). The MPP for our alternative scenarios are as follows:
4 (4 more dishes divided by 1 more cook)
6 (10 total dishes minus the 4 dishes that would have produced without the second cook divided by 1 more cook)
8 [(18 − 10)/1]
12 [(30 − 18)/1]
10 [(40 − 30)/1]
5 [(45 − 40)/1]
2 [(42 − 40)/1]
We see that MPP, the ratio of additional (marginal) output to additional (marginal) input, is maximized in scenario D. Now, this is what is usually referred to in mainstream economics as "the point of diminishing returns." "Point of diminishing returns" is basically shorthand for "point of diminishing marginal returns."
Again Mises said that, beyond the optimum, increases in variable input only yield, at best, less than proportional increases in output. This might lead to a confusion, because "optimum" has been defined as the point of diminishing average returns (maximum APP) and the point at which output no longer increases in proportion to input has been identified as the point of diminishing marginal returns (maximum MPP). This may lead to the erroneous conclusion that Mises is saying the two points are necessarily the same. But that is not the case. For instance, in our example, the point of diminishing average returns is scenario E (5 cooks), while the point of diminishing marginal returns is scenario D (4 cooks).
"'Point of diminishing returns' is basically shorthand for 'point of diminishing marginal returns.'"However, it is logically necessary that the point of diminishing marginal returns can never occur after the point of diminishing average returns. To help understand why, think of APP as analogous to your overall grade in a course, and think of MPP as analogous to your percentage grade on the most recent quiz.[9] Let's say you have been continually improving with each successive quiz, always either getting the same score as previously or scoring higher. It is conceivable for you to break your "improvement streak," (by, for the first time, scoring lower on a quiz than you did on the previous one — this is analogous to MPP going down) and yet still see your overall grade go up (this is analogous to APP going up) if your grade on the most recent quiz (current MPP) was still higher than your overall grade before the quiz (previous APP).
For example, maybe you've been getting (ever-improving) Cs most of the term, and then you got an A−, which improved your grade, but was not quite enough to get your overall grade out of C territory. It is possible for you to then get a B+, which is a drop from your previous performance, and still see an improvement in your overall grade. However, it is inconceivable for your overall grade to go down (for APP to go down) until your improvement streak is broken (MPP goes down).
Mises' statement that, beyond the point of diminishing average returns ("the optimum"), marginal returns always diminish is still correct. It just must be remembered that marginal returns may start diminishing even sooner than that.
The law of returns is simply the proposition that, for every combination of factors of production there exists such an optimum as described above. But is there always such an optimum? Is the law of returns really a law?
As Rothbard said, "The law that such an optimum must exist can be proved by contemplating the implications of the contrary." For example, if there were no such optimum, that would mean that Mises' ratio of p/c (the APP) could be increased indefinitely by forever increasing c. But think about what that would mean for factor of production b (in our example, the stoves). That would mean that any decrease in b (the number of stoves) could be compensated by an increase in c (the number of robots) in order to keep p (the number of dishes) the same. But if that were the case, then C (cooks) would be a perfect substitute for b (stoves). And in that case, B (stoves) would not be a complementary good that was necessary for the production of D (dishes). In that case, D could be produced solely by C (cooks). But that is impossible, because, as Rothbard explained,
$50 $25
at each stage of production, the product must be produced by more than one scarce higher-order factor of production. If only one factor were necessary for the process, then the process itself would not be necessary, and consumers' goods would be available in unlimited abundance. Thus, at each stage of production, the produced goods must have been produced with the aid of more than one factor. These factors co-operate in the production process and are termed complementary factors.[10]
These principles of production praxeology underpin the production catallactics (the theory of production in a complex money economy) that is the subject of Robert Murphy's current Mises Academy course Production and the Market Process. Unlike mainstream production economics, the intricate propositions of Austrian production catallactics (including the Austrian business-cycle theory) never lose sight of the fundamental truths of production praxeology, such as the full role of savings, the true nature of capital goods, and the fundamental importance of the time structure of production.
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Notes[1] Krugman is aware of this Austrian answer, but does not buy it either.
Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom — which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment?
Robert Wenzel answered this well:
As for as Krugman's question as to why there isn't a rise in unemployment during the boom part of the cycle , this clearly demonstrates his lack of a deep understanding of ABCT. Before a boom starts, the economy can be said to be in equilibrium between the consumer goods production and capital goods production. When a central bank then pumps in new money, new demand is created for labor in the capital goods sector causing bidding for labor away from the consumer goods sector. Thus, there is no point where rising unemployment would be a factor in this part of the cycle. However, during the downturn part of the cycle, it is not a case that the central bank is pumping money into the consumer sector. What is occurring, instead, is that a transfer of money is taking place from the capital goods sector to the consumer goods sector. It is this money drain from the capital goods sector that causes the unemployment. During the central bank induced boom, money isn't being drained from anywhere."
[2] Obviously the researchers would not really count as interested "parties" in the exchange.
[3] Ludwig von Mises, Human Action, Ch. 18, Sec. 3.
[4] However, this is not to say that a lower time preference is objectively "better" than a higher time preference. Economic growth is not the only goal people have in life.
[5] Ludwig von Mises, Human Action, Ch. 18, Sec. 3.
[6] Ibid.
[7] Mises, Human Action, Ch. 7. Sec. 2.
[8] Murray N. Rothbard, Man, Economy, and State, Ch. 1, Sec. 6.
[9] Robert Murphy often uses this analogy to explain other aspects of the law of returns.
[10] Rothbard, Man, Economy, and State, Ch. 1, Sec. 6.
The Malthusian fallacy created the common view that economics is cold, hardhearted, excessively rational, and opposed to the welfare of people, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
Archived from the live Mises.tv broadcast, this lecture by Guido Hülsmann was presented at the 2011 Mises University in Auburn, Alabama. Includes an introduction by Mark Thornton.
[The Freeman (1963); republished in Economic Freedom and Interventionism (1980)]
As the popular philosophy of the common man sees it, human wealth and welfare are the products of the cooperation of two primordial factors: nature and human labor. All the things that enable man to live and to enjoy life are supplied either by nature or by work or by a combination of nature-given opportunities with human labor. As nature dispenses its gifts gratuitously, it follows that all the final fruits of production, the consumers' goods, ought to be allotted exclusively to the workers whose toil has created them.
But unfortunately in this sinful world conditions are different. There the "predatory" classes of the "exploiters" want to reap although they have not sown. The landowners, the capitalists, and the entrepreneurs appropriate to themselves what by rights belongs to the workers who have produced it. All the evils of the world are the necessary effect of this originary wrong.
Such are the ideas that dominate the thinking of most of our contemporaries. The socialists and the syndicalists conclude that in order to render human affairs more satisfactory it is necessary to eliminate those whom their jargon calls the "robber barons" — i.e., the entrepreneurs, the capitalists, and the landowners — entirely; the conduct of all production affairs ought to be entrusted either to the social apparatus of compulsion and coercion, the state (in the Marxian terminology called Society), or to the men employed in the individual plants or branches of production.
Other people are more considerate in their reformist zeal. They do not intend to expropriate those whom they call the "leisure class" entirely. They want only to take away from them as much as is needed to bring about "more equality" in the "distribution" of wealth and income.
But both groups, the party of the thoroughgoing socialists and that of the more cautious reformers, agree on the basic doctrine according to which profit and interest are "unearned" income and therefore morally objectionable. Both groups agree that profit and interest are the cause of the misery of the great majority of all honest workingmen and their families, and, in a decent and satisfactory organization of society, ought to be sharply curbed, if not entirely abolished.
Yet this whole interpretation of human conditions is fallacious. The policies engendered by it are pernicious from whatever point of view we may judge them. Western civilization is doomed if we do not succeed very soon in substituting reasonable methods of dealing with economic problems for the present disastrous methods.
Three Factors of ProductionMere work — that is, effort not guided by a rational plan and not aided by the employment of tools and intermediary products — brings about very little for the improvement of the worker's condition. Such work is not a specifically human device. It is what man has in common with all other animals. It is bestirring oneself instinctively and using one's bare hands to gather whatever is eatable and drinkable that can be found and appropriated.
Physical exertion turns into a factor of human production when it is directed by reason toward a definite end and employs tools and previously produced intermediary products. Mind — reason — is the most important equipment of man. In the human sphere, labor counts only as one item in a combination of natural resources, capital goods, and labor; all these three factors are employed, according to a definite plan devised by reason, for the attainment of an end chosen. Labor, in the sense in which this term is used in dealing with human affairs, is only one of several factors of production.
The establishment of this fact demolishes entirely all the theses and claims of the popular doctrine of exploitation. Those saving and thereby accumulating capital goods, and those abstaining from the consumption of previously accumulated capital goods, contribute their share to the outcome of the processes of production. Equally indispensable in the conduct of affairs is the role played by the human mind. Entrepreneurial judgment directs the toil of the workers and the employment of the capital goods toward the ultimate end of production, the best possible removal of what causes people to feel discontented and unhappy.
What distinguishes contemporary life in the countries of Western civilization from conditions as they prevailed in earlier ages — and still exist for the greater number of those living today — is not the changes in the supply of labor and the skill of the workers and not the familiarity with the exploits of pure science and their utilization by the applied sciences, by technology. It is the amount of capital accumulated. The issue has been intentionally obscured by the verbiage employed by the international and national government agencies dealing with what is called foreign aid for the underdeveloped countries. What these poor countries need in order to adopt the Western methods of mass production for the satisfaction of the wants of the masses is not information about a "know-how." There is no secrecy about technological methods. They are taught at the technological schools and they are accurately described in textbooks, manuals, and periodical magazines. There are many experienced specialists available for the execution of every project that one may find practicable for these backward countries.
What prevents a country like India from adopting the American methods of industry is the paucity of its supply of capital goods. As the Indian government's confiscatory policies are deterring foreign capitalists from investing in India, and as its prosocialist bigotry sabotages domestic accumulation of capital, their country depends on the alms that Western nations are giving to it.
Consumers Direct the Use of CapitalCapital goods come into existence by saving. A part of the goods produced is withheld from immediate consumption and employed for processes the fruits of which will only mature at a later date. All material civilization is based upon this "capitalistic" approach to the problems of production.
"Roundabout methods of production," as Böhm-Bawerk called them, are chosen because they generate a higher output per unit of input. Early man lived from hand to mouth. Civilized man produces tools and intermediary products in the pursuit of long-range designs that finally bring forth results that direct, less time-consuming methods could never have attained, or could have attained only with an incomparably higher expenditure of labor and material factors.
"The capitalists are virtually mandataries of the consumers, bound to comply with their wishes."Those saving — that is, consuming less than their share of the goods produced — inaugurate progress toward general prosperity. The seed they have sown enriches not only themselves but also all other strata of society. It benefits the consumers.
The capital goods are for the owner a dead fund, a liability rather than an asset, if not used in production for the best possible and cheapest provision of the people with the goods and services they are asking for most urgently. In the market economy the owners of capital goods are forced to employ their property as if it were entrusted to them by the consumers under the stipulation to invest it in those lines in which it best serves those consumers. The capitalists are virtually mandataries of the consumers, bound to comply with their wishes.
In order to attend to the orders received from the consumers, their real bosses, the capitalists themselves must either themselves proceed to investment and the conduct of business or, if they are not prepared for such entrepreneurial activity or distrust their own abilities, hand over their funds to men whom they consider as better fitted for such a function. Whatever alternative they may choose, the supremacy of the consumers remains intact. No matter what the financial structure of the firm or company may be, the entrepreneur who operates with other people's money depends no less on the market — that is, the consumers — than the entrepreneur who fully owns his outfit.
There is no other method to make wage rates rise than by investing more capital per worker. More investment of capital means: to give to the laborer more efficient tools. With the aid of better tools and machines, the quantity of the products increases and their quality improves. As the employer consequently will be in a position to obtain from the consumers more for what the employee has produced in one hour of work, he is able — and, by the competition of other employers, forced — to pay a higher price for the man's work.
Intervention and UnemploymentAs the labor-union doctrine sees it, the wage increases that they are obtaining by what is euphemistically called "collective bargaining" are not to burden the buyers of the products but should be absorbed by the employers. The latter should cut down what in the eyes of the communists is called "unearned income," that is, interest on the capital invested and the profits derived from success in filling wants of the consumers that until then had remained unsatisfied. Thus the unions hope to transfer step by step all this allegedly "unearned income" from the pockets of the capitalists and entrepreneurs into those of the employees.
What really happens on the market is, however, very different. At the market price m of the product p, all those who were prepared to spend m for a unit of p could buy as much as they wanted. The total quantity of p produced and offered for sale was s. It was not larger than s because with such a larger quantity the price, in order to clear the market, would have to drop below m to m-. But at this price of m- the producers with the highest costs would suffer losses and would thereby be forced to stop producing p. These marginal producers likewise incur losses and are forced to discontinue producing p if the wage increase enforced by the union (or by a governmental minimum-wage decree) causes an increase of production costs not compensated by a rise in the price of m to m+. The resulting restriction of production necessitates a reduction of the labor force. The outcome of the union's "victory" is the unemployment of a number of workers.
The result is the same if the employers are in a position to shift the increase in production costs fully to the consumers, without a drop in the quantity of p produced and sold. If the consumers are spending more for the purchase of p, they must cut down their buying of some other commodity q. Then the demand for q drops and brings about unemployment of a part of the men who were previously engaged in turning out q.
The union doctrine qualifies interest received by the owners of the capital invested in the enterprise as "unearned" and concludes that it could be abolished entirely or considerably shortened without any harm to the employees and the consumers. The rise in production costs caused by wage increases could therefore be borne by shortening the company's net earnings and a corresponding reduction of the dividends paid to the shareholders. The same idea is at the bottom of the unions' claim that every increase in what they call productivity of labor (that is, the sum of the prices received for the total output divided by the number of man hours spent in its production) should be added to wages.
Both methods mean confiscating for the benefit of the employees the whole or at least a considerable part of the returns on the capital provided by the saving of the capitalists. But what induces the capitalists to abstain from consuming their capital and to increase it by new saving is the fact that their forbearance is counterbalanced by the proceeds of their investments. If one deprives them of these proceeds, the only use they can make of the capital they own is to consume it and thus to inaugurate general progressive impoverishment.
The Only Sound PolicyWhat elevates the wage rates paid to the American workers above the rates paid in foreign countries is the fact that the investment of capital per worker is higher in this country than abroad. Saving, the accumulation of capital, has created and preserved up to now the high standard of living of the average American employee.
All the methods by which the federal government and the governments of the states, the political parties, and the unions are trying to improve the conditions of people anxious to earn wages and salaries are not only vain but directly pernicious. There is only one kind of policy that can effectively benefit the employees, namely, a policy that refrains from putting any obstacles in the way of further saving and accumulation of capital.
Originally published in the Freeman, August 1963, this article is included in Economic Freedom and Interventionism (1980).
The NYT is angry because the courts did not stick it to another American business, writes William L. Anderson.
This audio Mises Daily is narrated by Keith Hocker.
We should thank our lucky stars for air conditioning — and hope that that government won't destroy it, writes Mark Thornton.
This audio Mises Daily is narrated by the author.
Advertising must be defended by those who believe in freedom of speech — for that is all advertising is, writes Walter Block.
This audio Mises Daily is narrated by Jeff Riggenbach.
There are some continuously reappearing economic myths that can lead to serious social unrest and governmental policy errors unless they are recognized and refuted rather forcefully. The Ricardo effect is one of these. Coined over 200 years ago based on the observations of English economist David Ricardo (1772–1823), this term describes the phenomenon whereby labor is replaced by machinery, and occasionally vice versa. One example of the social unrest that can follow a misunderstanding of the normal — and beneficial! — action of the Ricardo effect is the early 19th century Luddite movement, in which workers smashed industrial machinery out of the fear that the machines were causing what is now mistakenly called "technological unemployment" in the textile mills.
Cotton-Picking Americans and Ditch-Digging IndiansKevin D. Williamson expressed this fear in his National Review article of May 2, titled "A Nation of Sharecroppers." He pointed out that 150 years ago picking cotton was a job for slaves; 50 years ago it was a job for the rural working class; and now it is a job for a handful of very wealthy entrepreneurs driving monster John Deere cotton picking machines.
What happened to the slaves and the rural working poor? Were all of them driven to destitution? Obviously not. Nevertheless, Mr. Williamson worries that America's working poor, who he feels may not be qualified for the growing number of jobs in the new information economy, will be driven to dependency alongside the current welfare-dependent underclass. He provides no answers and ends his essay with the lament that for,
a 21-year-old man of average intelligence with a high-school education and a bit of training […] his main attractions will be the sedative of dependency or the stimulant of underclass moral anarchy, and we cannot afford much more of either.
One of my economics students traveled to India during spring break this year. Upon her return to class, I asked if she had any observations about the Indian economy from an Austrian School perspective. She thought for a moment and then said that the Indians seemed to be very inefficient. For example, instead of using a backhoe to dig ditches or build foundations, Indian contractors used dozens of men with picks and shovels. I found this to be a wonderful observation, and the class discussed possible reasons for this phenomenon, which ranged from government regulations geared to increasing employment to the obvious surplus of cheap, manual labor. My students worried that Indian contractors may get wise, buy backhoes, and force many working-class Indians into unemployment.
At the other end of the debate are labor unions that justify striking for higher pay by claiming that such actions actually encourage businessmen to invest in productivity-enhancing capital, which raises the productivity of labor and labor wage scales. They claim to be more farsighted than the companies who employ their members. All misunderstand what Ricardo observed.
Benign and Malignant Causes of the Ricardo EffectLudwig von Mises explains the Ricardo effect starting on page 767 of his magnum opus, Human Action. Mises explains that machinery replaces men only when the market is driving the cost of labor higher. Labor costs are rising because capital investment is making labor more productive. To remain in business, the businessman must invest in capital goods to boost the productivity of labor in his industry, too. He will do that when capital is sufficiently available.
We now see that the apparent overemployment of unskilled Indian labor is a symptom of a lack of capital. Capital accumulation is the result of increased savings. Either Indians themselves must save more, or India must allow foreign capital investment, which represents the savings of non-Indians invested in the Indian economy.
As Mises explains, a developing country has full access to technological knowledge. It is the lack of capital that prevents its application. When capital becomes more plentiful, whether by increased domestic savings or foreign investment, labor productivity will be enhanced. Then labor will have a choice among many attractive, higher paying alternative employments. In an unhampered free-market system, the Ricardo effect is benign and progressive. It is just an interesting observation.
However, the Ricardo effect turns malignant when the cost of labor is rising, not due to improved labor productivity, but due to nonmarket forces. Government regulations such as minimum-wage laws, workers'-compensation insurance, matching social-security taxes, family-leave benefits, etc., are driving costs higher. Union-inspired labor unrest has the same malignant effect.
And these are just the "seen" costs, as Bastiat would say. There are the "unseen" costs as well, such as the cost of defending oneself against claims of "wrongful termination of employment" — a new government-invented right to a specific job. Gone forever, apparently, is the concept of employment at will, whereby — absent an employment contract — jobs are "owned" by the employers, (because employers create them) and they are "offered" and withdrawn at their pleasure.
To the businessman, the labor environment appears to be the same whether it's caused by a benign or a malignant Ricardo effect; i.e., the cost of labor is rising, and he must invest (if he can afford it) in productivity-improving capital goods. Because in recent years there has been no increase in capital accumulation, many businessmen will not be able to afford to invest, and they will have to close their doors. Even if they do remain in business, the workers who are replaced by more productive machinery will face a completely different labor environment from one in which higher labor costs are driven by economy-wide enhancements in labor productivity. Workers are not being enticed away by attractive, higher paying jobs elsewhere.
High Paying, Secure Jobs — In the Regulatory and Welfare IndustriesFurthermore, it is not at all clear that elevating low-end worker productivity — an outcome that Mr. Williamson hopes for but fears cannot be achieved — would reduce unemployment for those at the lower end of the wage scale. Government itself needs the unemployed in order to perpetuate its labor-regulating empire, which provides it with high paying and secure jobs. What would all those labor lawyers, judges, advocates, investigators, insurance providers, and record-keepers do if the country scrapped all labor laws? And what would happen to all the welfare administrators and caseworkers if all men were forced to be responsible and self-reliant, because government refused to enslave their fellow citizens to provide for their upkeep?
It's more likely that government will do what it has done since the Great Depression — keep raising the regulatory labor and welfare bars to provide itself with a steady supply of welfare dependents to nanny, and conmen and slackers to defend in its kangaroo courts. After all, human nature has not changed. There is a disincentive to work, which can be abetted with government payments, and government has an infinite ability to rationalize and propagandize its self-serving and predatory interventions.
So, what's the answer to this modern-day malignant Ricardo effect? As usual, it is getting government out of the free market — doing so would include not just eliminating costly labor laws but also eliminating the entire welfare industry. The idea that our nation has millions of people who cannot provide for themselves and must either ride through life on the backs of others or starve is a fallacy. All willing workers can find gainful employment, compete, and thrive without any government program or policy whatsoever. And they do not have to pick cotton by hand or dig ditches with picks and shovels.
The Mises Circle in Indianapolis. Sponsored by Weaver Popcorn Company. Recorded 14 May 2011.
The Mises Circle in Indianapolis. Sponsored by Weaver Popcorn Company. Recorded 14 May 2011.
"With the focus on food and cooking, we can see what it is that drives daily life among the Haitian multitudes."A Travel Channel episode of No Reservations, a cooking-focused show narrated by Anthony Bourdain, took viewers to Port-au-Prince, Haiti. I had heard that the show offered unique insight into the country and its troubles. I couldn't imagine how. But it turns out to be true. Through the lens of food, we can gain an insight into culture, and from culture to economy, and from economy to politics and finally to what's wrong in this country and what can be done about it.
Through this micro lens, we gain more insight than we would have if the program were entirely focused on economic issues. Such an episode on economics would have featured dull interviews with treasury officials and IMF experts and lots of talk about trade balances and other macroeconomic aggregates that miss the point entirely.
Instead, with the focus on food and cooking, we can see what it is that drives daily life among the Haitian multitudes. And what we find is surprising in so many ways.
In a scene early in the show set in this giant city after the earthquake, Bourdain and his crew stop to eat some local food from a vendor. He discusses its ingredients and samples some items. Crowds of hungry people begin to gather. They are doing more than gawking at the camera crews. They are waiting in the hope of getting something to eat.
Bourdain thinks of a way to do something nice for everyone. Realizing that in this one sitting, he is eating a quantity of food that would last most Haitians three days, he buys out the remaining food from the vendor and gives it away to locals.
Nice gesture! Except that something goes wrong. Once the word spreads about the free food — word-of-mouth in Haiti is faster than Facebook chat — people start pouring in. Lines form and get long. Disorder ensues. Some people step forward to keep order. They bring belts and start hitting. The entire scene becomes very unpleasant for everyone — and the viewer gets the sense that it is worse than we are shown.
Here is the scene.
Bourdain correctly draws the lesson that the solutions to the problem of poverty here are more complex than it would appear at first glance. Good intentions go awry. They were thinking with their hearts instead of their heads, and ended up causing more pain than was originally there in the first place. From this event forward, he begins to approach the problems of this country with a bit more sophistication.
The rest of the show takes us through shanty towns, markets, art shows, festivals, and parades — and interviews all kinds of people who know the lay of the land. This is not a show designed to tug at your heart strings in the conventional sort of way. Yes, there is obvious human suffering, but the overall impression I got was not that. Instead, I came away with a sense that Haiti is a very normal place not unlike all places we know from experience, but with one major difference: it is very poor.
"Many people rail against the term capitalism because it implies that freedom is all about privileging the owners of capital. But there is a sense in which capitalism is the perfect term for a developed economy…"By the time the show was made, the glamour of the postearthquake onslaught of American visitors seeking to help had vanished. One who remains is actor Sean Penn. Although he's known as a Hollywood lefty, he's actually living there, chugging up and down the hills of a shanty town, unshaven and disheveled, being what he calls a "functionary" and getting stuff for people who need it. He had no easy answers, and he had sharp words for American donors who think that dumping money into new projects is going to help anyone.
The people of Haiti in the documentary conform to what every visitor says about them. They are wonderfully friendly, talented, enterprising, happy, and full of hope. Like most people, they hate their government. Actually, they hate their government more than most Americans hate theirs. Truly, this is a precondition of liberty. There is a real sense of us-versus-them alive in Haiti, so much so that when the presidential palace collapsed in the recent earthquake, crowds gathered outside to cheer and cheer! It was the one saving grace of an otherwise terrible storm.
With all these enterprising, hard-working, and creative people, millions of them, what could possibly be wrong with the place? Well, for one thing, the earthquake destroyed most homes. If this had been the United States, this earthquake would not have caused the same level of damage. This led many outsiders to think that somehow the absence of building codes was the core of the problem, and hence the solution is more imposition of government control.
But the reality shows that this building-code notion is some sort of joke. The very idea that a government could somehow go around beating up people who provide shelter for themselves while failing to obey the central plan is simply laughable. Coercion of this sort would bring about no positive results and lead only to vast corruption, violence, and homelessness.
The core of the problem, says Robert Murphy, has nothing to do with a lack of regulations. The problem is the absence of wealth. It is obviously true that people prefer safer places to live, but the question is: what is the cost, and is this economically viable? The answer is that it is not viable, not in Haiti, not with this population that is barely getting by at all.
Where is the wealth? There is plenty of trade, plenty of doing, plenty of exchange and money changing hands. Why does the place remain desperately poor? If the market economists are correct that trade and commerce are the key to wealth, and there is plenty of both here, why is wealth not happening?
One can easily see how people can get confused, because the answer is not obvious until you have some economic understanding. A random visitor might easily conclude that Haiti is poor because somehow the wealth is being hogged by its northern neighbor, the United States. If we weren't devouring so much of the world's stock of wealth, it could be distributed more evenly and encompass Haiti too. Or another theory might be that the handful of international companies, or even aid workers, are somehow stealing all the money and denying it to the people.
These are not stupid theories. They are just theories — neither confirmed nor refuted by facts alone. They are only shown to be wrong once you realize a central insight of economics. It is this: trade and commerce are necessary conditions for the accumulation of wealth, but they are not sufficient conditions. Also necessary is that precious institution of capital.
What is capital? Capital is a thing (or service) that is produced not for consumption but for further production. The existence of capital industries implies several stages of production, or up to thousands upon thousands of steps in a long structure of production. Capital is the institution that gives rise to business-to-business trading, an extended workforce, firms, factories, ever more specialization, and generally the production of all kinds of things that by themselves cannot be useful in final consumption but rather are useful for the production of other things.
Capital is not so much defined as a particular good — most things have many varieties of uses — but rather a purpose of a good. Its purpose is extended over a long period of time with the goal of providing for final consumption. Capital is employed in a long structure of production that can last a month, a year, 10 years, or 50 years. The investment at the earliest (highest) stages has to take place long before the payoff circles around following final consumption.
As Hayek emphasized in The Pure Theory of Capital, another defining mark of capital is that it is a nonpermanent resource that must nonetheless be maintained over time in order to provide a continuing stream of income. That means that the owner must be able to count on being able to hire workers, replace parts, provide for security, and generally maintain operations throughout an extended period of production.
"The thriving of the capital-goods sector was the great contribution of the Industrial Revolution to the world."In a developed economy, the vast majority of productive activities consist in participation in these capital-goods sectors and not in final-consumption-goods sectors. In fact, as Rothbard writes in Man, Economy, and State,
at any given time, this whole structure is owned by the capitalists. When one capitalist owns the whole structure, these capital goods, it must be stressed, do him no good whatever.
And why is that? Because the test of the value of all capital goods is conducted at the level of final consumption. The final consumer is the master of the richest capitalist.
Many people (I've been among them) rail against the term capitalism because it implies that freedom is all about privileging the owners of capital.
But there is a sense in which capitalism is the perfect term for a developed economy: the development, accumulation, and sophistication of the capital-goods sector is the characteristic feature that makes it different from an undeveloped economy.
The thriving of the capital-goods sector was the great contribution of the Industrial Revolution to the world.
Capitalism did in fact arise at a specific time in history, as Mises said, and this was the beginning of the mass democratization of wealth.
Rising wealth is always characterized by such extended orders of production. These are nearly absent in Haiti. Most all people are engaged in day-to-day commercial activities. They live for the day. They trade for the day. They plan for the day. Their time horizons are necessarily short, and their economic structures reflect that. It is for this reason that all the toil and trading and busyness in Haiti feels like peddling a stationary bicycle. You are working very hard and getting better and better at what you are doing, but you are not actually moving forward.
Now, this is interesting to me because anyone can easily miss this point just by looking around Haiti where you see people working and producing like crazy, and yet the people never seem to get their footing. Without an understanding of economics, it is nearly impossible to see the unseen: the capital that is absent that would otherwise permit economic growth. And this is the very reason for the persistence of poverty, which, after all, is the natural condition of mankind. It takes something heroic, something special, something historically unique, to dig out of it.
Now to the question of why the absence of capital.
The answer has to do with the regime. It is a well-known fact that any accumulation of wealth in Haiti makes you a target, if not of the population in general (which has grown suspicious of wealth, and probably for good reason), then certainly of the government. The regime, no matter who is in charge, is like a voracious dog on the loose, seeking to devour any private wealth that happens to emerge.
This creates something even worse than the Higgsian problem of "regime uncertainty." The regime is certain: it is certain to steal anything it can, whenever it can, always and forever. So why don't people vote out the bad guys and vote in the good guys? Well, those of us in the United States who have a bit of experience with democracy know the answer: there are no good guys. The system itself is owned by the state and rooted in evil. Change is always illusory, a fiction designed for public consumption.
This is an interesting case of a peculiar way in which government is keeping prosperity at bay. It is not wrecking the country through an intense enforcement of taxation and regulation or nationalization. One gets the sense that most people never have any face time with a government official and never deal with paperwork or bureaucracy really. The state strikes only when there is something to loot. And loot it does: predictably and consistently. And that alone is enough to guarantee a permanent state of poverty.
Now, to be sure, there are plenty of Americans who are firmly convinced that we would all be better off if we grew our own food, bought only locally, kept firms small, eschewed modern conveniences like home appliances, went back to using only natural products, expropriated wealthy savers, harassed the capitalistic class until it felt itself unwelcome and vanished. This paradise has a name, and it is Haiti.
Often the dispersion of a fortune starts already in the lifetime of the businessman when his buoyancy, energy, and resourcefulness become weakened, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Keith Hocker.
I happened to sit down next to a man last week who has been my benefactor for my entire life and the large part of his, and yet we had never met. In fact, though he has been serving me faithfully for three decades, looking after my well-being and trying to improve my standard of living, he didn't even know my name, writes Jeffrey A. Tucker.
This audio Mises Daily is narrated by Nathaniel Foote.
What is called economic progress is the effect of an accumulation of capital goods exceeding the increase in population, writes Ludwig von Mises (1881–1973).
This audio Mises Daily, excerpted from the audiobook version, is narrated by John Pruden.
Hutcheson brought to Scottish philosophy a solid belief in natural rights and in the beneficence of nature, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
Higher food prices set off the revolutions in Tunisia and Egypt and the mass protests in countries like Algeria, Jordan, Yemen, Bahrain, and Iran. People in these countries buy more unprocessed foods and spend a much higher percentage of their income on food, so they have been severely impoverished by Bernanke's QE2, writes Mark Thornton.
This audio Mises Daily is narrated by the author.
The famous physiocratic tenet that only land is productive must be considered bizarre and absurd. It is certainly a tremendous loss of insight compared to Cantillon, who identified land and labor as original productive factors, and entrepreneurs as the motors of the market economy, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
Libertarian writers including Hoppe, Hummel, and Murphy have attempted to deal with the presence of free riders in theoretical private defense constructs. As with the provision of most public goods, free riders are also a problem in the production of security. This paper proposes a solution toward the free rider problem and analyzes further problems previously unconsidered in the literature.
Volume 22, Number 1 (2011)
Muetze Hellmer is a former student of mine at Loyola University New Orleans. The first draft of Hellmer (2005) started out as a term paper for a course she took with me. I am very proud of her for having an article she wrote while a mere undergraduate published in a prestigious scholarly journal such as The Journal of Libertarian Studies. While I gave her an “A” for her writing efforts,1 I attempted to convince her all throughout the writing process that lead up to this publication that she was in grave error in opposing imports from foreign sweatshops, as advocated by groups such as United Students Against Sweatshops (USAS). I succeeded to the extent that Hellmer (2005) exhibits a rare understanding of the free market economic position, especially uncommon amongst those who do not have years of appreciation of the finer points of this philosophy under their belts.
Volume 22, Number 1 (2011)
The 17th-century Dutch Protestant Hugo Grotius, deeply influenced by the late Spanish Scholastics, developed a theory of natural laws that he boldly declared was truly independent of the question of whether God had created them, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
It is certainly true that our age is full of conflicts which generate war. However, these conflicts do not spring from the operation of the unhampered market society. It is not capitalism that produces them but anticapitalistic policies, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
Private ownership of the means of production is the fundamental institution of the market economy. It is the institution the presence of which characterizes the market economy as such. Where it is absent, there is no question of a market economy.
Ownership means full control of the services that can be derived from a good. This catallactic notion of ownership and property rights is not to be confused with the legal definition of ownership and property rights as stated in the laws of various countries. It was the idea of legislators and courts to define the legal concept of property in such a way as to give to the proprietor full protection by the governmental apparatus of coercion and compulsion, and to prevent anybody from encroaching upon his rights. As far as this purpose was adequately realized, the legal concept of property rights corresponded to the catallactic concept.
However, nowadays there are tendencies to abolish the institution of private property by a change in the laws determining the scope of the actions that the proprietor is entitled to undertake with regard to the things that are his property. While retaining the term private property, these reforms aim at the substitution of public ownership for private ownership. This tendency is the characteristic mark of the plans of various schools of Christian socialism and of nationalist socialism. But few of the champions of these schools have been as keen as the Nazi philosopher Othmar Spann, who explicitly declared that the realization of his plans would bring about a state of affairs in which the institution of private property will be preserved only in a "formal sense, while in fact there will be only public ownership."
There is need to mention these things in order to avoid popular fallacies and confusion. In dealing with private property, catallactics deals with control, not with legal terms, concepts, and definitions. Private ownership means that the proprietors determine the employment of the factors of production, while public ownership means that the government controls their employment.
Private property is a human device. It is not sacred. It came into existence in early ages of history, when people with their own power and by their own authority appropriated to themselves what had previously not been anybody's property. Again and again, proprietors were robbed of their property by expropriation. The history of private property can be traced back to a point at which it originated out of acts that were certainly not legal. Virtually every owner is the direct or indirect legal successor of people who acquired ownership either by arbitrary appropriation of ownerless things or by violent spoliation of their predecessor.
However, the fact that legal formalism can trace back every title either to arbitrary appropriation or to violent expropriation has no significance whatever for the conditions of a market society. Ownership in the market economy is no longer linked up with the remote origin of private property. Those events in a far-distant past, hidden in the darkness of primitive mankind's history, are no longer of any concern for our day. For in an unhampered market society, the consumers daily decide anew who should own and how much he should own. The consumers allot control of the means of production to those who know how to use them best for the satisfaction of the most urgent wants of the consumers. Only in a legal and formalistic sense can the owners be considered the successors of appropriators and expropriators. In fact, they are mandataries of the consumers, bound by the operation of the market to serve the consumers best. Capitalism is the consummation of the self-determination of the consumers.
The meaning of private property in the market society is radically different from what it is under a system of each household's autarky. Where each household is economically self-sufficient, the privately owned means of production exclusively serve the proprietor. He alone reaps all the benefits derived from their employment.
In the market society, the proprietors of capital and land can enjoy their property only by employing it for the satisfaction of other people's wants. They must serve the consumers in order to have any advantage from what is their own. The very fact that they own means of production forces them to submit to the wishes of the public.
Ownership is an asset only for those who know how to employ it in the best possible way for the benefit of the consumers.
[This article is excerpted from chapter 24 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.]
Private ownership of the means of production is the fundamental institution of the market economy. It is the institution the presence of which characterizes the market economy as such. Where it is absent, there is no question of a market economy, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
Charles, the third Viscount Townshend (1700–1764), has been shamefully neglected by virtually all historians of economic thought. He is virtually unknown and is often confused with his son of the same name, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
[Excerpted from The Causes of the Economic Crisis]
The Marxian critique censures the capitalistic social order for the anarchy and planlessness of its production methods. Allegedly, every entrepreneur produces blindly, guided only by his desire for profit, without any concern as to whether his action satisfies a need. Thus, for Marxists, it is not surprising if severe disturbances appear again and again in the form of periodical economic crises. They maintain it would be futile to fight against all this with capitalism. It is their contention that only socialism will provide the remedy by replacing the anarchistic profit economy with a planned economic system aimed at the satisfaction of needs.
Strictly speaking, the reproach that the market economy is "anarchistic" says no more than that it is just not socialistic. That is, the actual management of production is not surrendered to a central office which directs the employment of all factors of production, but this is left to entrepreneurs and owners of the means of production. Calling the capitalistic economy "anarchistic," therefore, means only that capitalistic production is not a function of governmental institutions.
Yet, the expression "anarchy" carries with it other connotations. We usually use the word "anarchy" to refer to social conditions in which, for lack of a governmental apparatus of force to protect peace and respect for the law, the chaos of continual conflict prevails. The word "anarchy," therefore, is associated with the concept of intolerable conditions. Marxian theorists delight in using such expressions. Marxian theory needs the implications such expressions give to arouse the emotional sympathies and antipathies that are likely to hinder critical analysis. The "anarchy of production" slogan has performed this service to perfection. Whole generations have permitted it to confuse them. It has influenced the economic and political ideas of all currently active political parties and, to a remarkable extent, even those parties which loudly proclaim themselves anti-Marxist.
The Role and Rule of ConsumersEven if the capitalistic method of production were "anarchistic," i.e., lacking systematic regulation from a central office, and even if individual entrepreneurs and capitalists did, in the hope of profit, direct their actions independently of one another, it is still completely wrong to suppose they have no guide for arranging production to satisfy need. It is inherent in the nature of the capitalistic economy that, in the final analysis, the employment of the factors of production is aimed only toward serving the wishes of consumers.
In allocating labor and capital goods, the entrepreneurs and the capitalists are bound, by forces they are unable to escape, to satisfy the needs of consumers as fully as possible given the state of economic wealth and technology. Thus, the contrast drawn between the capitalistic method of production, as production for profit, and the socialistic method, as production for use, is completely misleading. In the capitalistic economy, it is consumer demand that determines the pattern and direction of production, precisely because entrepreneurs and capitalists must consider the profitability of their enterprises.
An economy based on private ownership of the factors of production becomes meaningful through the market. The market operates by shifting the height of prices so that again and again demand and supply will tend to coincide. If demand for a good goes up, then its price rises, and this price rise leads to an increase in supply. Entrepreneurs try to produce those goods the sale of which offers them the highest possible gain. They expand production of any particular item up to the point at which it ceases to be profitable. If the entrepreneur produces only those goods whose sale gives promise of yielding a profit, this means that they are producing no commodities for the manufacture of which labor and capital goods must be used which are needed for the manufacture of other commodities more urgently desired by consumers.
In the final analysis, it is the consumers who decide what shall be produced and how. The law of the market compels entrepreneurs and capitalists to obey the orders of consumers and to fulfill their wishes with the least expenditure of time, labor, and capital goods. Competition on the market sees to it that entrepreneurs and capitalists who are not up to this task will lose their position of control over the production process. If they cannot survive in competition, that is, in satisfying the wishes of consumers cheaper and better, then they suffer losses which diminish their importance in the economic process. If they do not soon correct the shortcomings in the management of their enterprise and capital investment, they are eliminated completely through the loss of their capital and entrepreneurial position. Henceforth, they must be content as employees with a more modest role and reduced income.
Production for ConsumptionThe law of the market applies to labor also. Like other factors of production, labor is also valued according to its usefulness in satisfying human wants. Its price, the wage rate, is a market phenomenon like any other market phenomenon, determined by supply and demand, by the value the product of labor has in the eye of consumers. By shifting the height of wages, the market directs workers into those branches of production in which they are most urgently needed. Thus the market supplies to each type of employment that quality and quantity of labor needed to satisfy consumer wants in the best possible way.
In the feudal society, men became rich by war and conquest and through the largesse of the sovereign ruler. Men became poor if they were defeated in battle or if they fell from the monarch's good graces. In the capitalistic society, men become rich — directly as the producer of consumers' goods, or indirectly as the producer of raw materials and semiproduced factors of production — by serving consumers in large numbers. This means that men who become rich in the capitalistic society are serving the people. The capitalistic market economy is a democracy in which every penny constitutes a vote. The wealth of the successful businessman is the result of a consumer plebiscite. Wealth, once acquired, can be preserved only by those who keep on earning it anew by satisfying the wishes of consumers.
The capitalistic social order, therefore, is an economic democracy in the strictest sense of the word. In the last analysis, all decisions are dependent on the will of the people as consumers. Thus, whenever there is a conflict between consumers' views and those of the business managers, market pressures assure that the views of the consumers win out eventually. This is certainly something very different from the pseudo–economic democracy toward which the labor unions are aiming. In such a system as they propose, the people are supposed to direct production as producers, not as consumers. They would exercise influence, not as buyers of products, but as sellers of labor, that is, as sellers of one of the factors of production. If this system were carried out, it would disorganize the entire production apparatus and thus destroy our civilization. The absurdity of this position becomes apparent simply upon considering that production is not an end in itself. Its purpose is to serve consumption.
The Perniciousness of a "Producer's Policy"Under pressure of the market, entrepreneurs and capitalists must order production so as to carry out the wishes of consumers. The arrangements they make and what they ask of workers is always determined by the need to satisfy the most urgent wants of consumers. It is precisely this which guarantees that the will of the consumer shall be the only guideline for business. Yet capitalism is usually reproached for placing the logic of expediency above sentiment and arranging things in the economy dispassionately and impersonally for monetary profit only.
It is because the market compels the entrepreneur to conduct his business so that he derives from it the greatest possible return that the wants of consumers are covered in the best and cheapest way. If potential profit were no longer taken into consideration by enterprises, but instead the workers' wishes became the criterion, so that work was arranged for their greatest convenience, then the interests of consumers would be injured. If the entrepreneur aims at the highest possible profit, he performs a service to society in managing an enterprise. Whoever hinders him from doing this, in order to give preference to considerations other than those of business profits, acts against the interests of society and imperils the satisfaction of consumer needs.
Workers and consumers are, of course, identical. If we distinguish between them, we are only differentiating mentally between their respective functions within the economic framework. We should not let this lead us into the error of thinking they are different groups of people. The fact that entrepreneurs and capitalists also are consuming plays a less important role quantitatively; for the market economy, the significant consumption is mass consumption.
Directly or indirectly, capitalistic production serves primarily the consumption of the masses. The only way to improve the situation of the consumer, therefore, is to make enterprises still more productive, or as people may say today, to "rationalize" still further. Only if one wants to reduce consumption should one urge what is known as "producers' policy" — specifically the adoption of those measures which place the interests of producers over those of consumers.
Opposition to the economic laws which the market decrees for production must always be at the expense of consumption. This should be kept in mind whenever interventions are advocated to free producers from the necessity of complying with the market.
The market processes give meaning to the capitalistic economy. They place entrepreneurs and capitalists in the service of satisfying the wants of consumers. If the workings of these complex processes are interfered with, then disturbances are brought about which hamper the adjustment of supply to demand and lead production astray, along paths which keep them from attaining the goal of economic action — i.e., the satisfaction of wants.
These disturbances constitute the economic crisis.
The economic and business community constantly attempts to forecast the effects of various economic changes and government policies on corporate profits. But both the cause and effect of increasing profits are other than what most people imagine. It will therefore be helpful to gain a concrete understanding of what profits do and do not represent.Most of the insights in this paper consist of summaries of principles originally laid out by professor George Reisman in his book Capitalism: A Treatise on Economics.
What Are Profits?First, it is necessary to understand exactly what profits are. Profits, narrowly defined, are the excess earnings that companies make from forecasting economic changes accurately at the expense of other companies that forecast incorrectly. As Mises said, "If all people were to anticipate correctly the future state of the market, the entrepreneurs would neither earn any profits nor suffer any losses."
But to understand profits in the wider sense is to understand how it is that total economy-wide business revenues can exceed total economy-wide business costs, year in and year out (Revenues − Costs = Profits). Total economy-wide revenues consist of (1) spending by companies to purchase capital goods from capital-goods-producing companies, and (2) spending by individuals to purchase consumer goods from consumer-goods-producing companies. The two together comprise all the sales revenues received by all companies in the economy.
The spending by the purchasing companies reflects their spending for capital goods (supplies, materials, tools, machines, etc.) on their income statements and budgets. An example would be Boeing purchasing aluminum alloys from Alcoa.
The spending by consumers is derived from — and reflects — the spending for wage payments by businesses: workers receive wage payments and spend their money on consumer goods. An example would be a Boeing factory worker purchasing movie tickets from Regal Cinemas.
Thus, businesses engage in two basic forms of spending: purchases of capital goods and purchases of labor.
Since the money businesses receive originates in one form or another from the spending by businesses themselves, one would think that the total economy-wide spending that businesses engage in (economy-wide business costs) would be equal to the total amount businesses receive (economy-wide revenues). In this circular flow of spending, one would think that costs would equal revenues, therefore leaving no aggregate profit.
Costs in fact do equal revenues. But in addition to business and consumer spending on capital goods and consumers' goods (the two types of spending for companies' products that constitute sales revenues), there is yet another form of spending that does not have any corresponding prior costs. This is the spending by individual investors and businessmen from dividends, draw, or any other form of disinvestment in a company.
When funds invested in companies are withdrawn and are instead consumed to purchase consumer goods or services, there results economy-wide spending over and above the spending that comes from the spending on capital and wage payments; this spending generates sales revenues without corresponding costs, since dividends, draw, and the like are not regular company expenses in the form of income-statement items. While draw and other distributions are somewhat random, various companies are always paying out regular dividends that are consumed and not reinvested. The spending of these monies causes sales revenues to be greater than costs.This excess spending, which causes sales revenues to be greater than costs, is what Reisman has termed net consumption. Similarly, money taken from under the mattress and spent on consumer goods would also help sales revenues to be higher than costs.
In this broader view of profits, time preference and the corresponding savings rate affect the rate of profit by affecting the rate at which people disinvest and consume their capital.To reconcile this view with the traditional Austrian explanation of profit and interest, please see George Reisman's 2005 Mises University lecture on profit and interest. The higher people's time preference, the faster they will consume their invested funds and the higher will be the rate of profit.
This line of reasoning is aligned with the traditional view of time preference and savings: the fewer savings available, the higher the rate of interest. (It must be remembered that interest exists only because profit exists.)
The explanation above describes what constitutes real profits — profits in the economy prior to the effects of money and credit.
But money and credit do in fact have a tremendous affect on nominal profits: as the money supply is increased, profits increase because revenues rise faster than costs. Various accounting techniques such as costs of goods sold and depreciation cause many costs on companies' income statements to be recognized in a delayed fashion. At any given time, then, income-statement costs largely reflect productive expenditures made years prior, while the corresponding revenues reflect current sales values.
Given that much of the cost of production was incurred in the past, and given the ever increasing quantity of money through time, the monetary value of revenues is usually greater than the monetary value of corresponding costs, since most costs were incurred when there was less money existing (i.e., when things cost less and therefore had a lower monetary value). Thus, because of inflation, the total monetary value of business costs incurred in a given time frame is smaller than the total monetary value of the corresponding business-sales revenues. Thus, credit expansion increases the spread between revenues and costs, thereby increasing profit margins.
The higher the rate of inflation, the wider are profit margins. This is why companies in countries with very high inflation have high profit margins (and high interest rates).Since it is profits that pay interest, high interest rates can exist only if high profits exist. If profits were lower than interest rates, businesses could not afford to pay the interest, and rates would fall to the level of profit rates.
With these two drivers of profits in mind — disinvestment spending and credit creation/inflation — let's take a look at the various economic and policy drivers that might or might not affect economy-wide aggregate profits.
Technology and ProductivityTechnology and productivity are widely cited as drivers of increasing profits. The general argument is that because these things help bring about increased economic growth, companies are able to produce more goods and make more money, thus increasing their profits. But as I have explained previously, economic growth does not consist of companies making more money, since companies do not actually create money (the central bank does); it consists of their making more goods and services.
Technology and productivity can help some firms make higher profits at the expense of other firms: think about the first jet-airplane manufacturer taking business away from manufacturers of prop engines, or owners of the first electric sewing machines taking business away from those who sewed by hand.
But one firm's gain is another's loss. And if all firms adopted a new technology or a productivity-enhancing tool, there would be no source of excess profits. Taking all firms together, technology and productivity serve to increase the rate of production but they do not increase economy-wide profits.
Central-Bank PoliciesSince the central bank is the entity responsible for enabling the banks to extend more credit and expand the money supply and therefore the volume of spending (velocity), it is an important driver of corporate profits. Because company revenues rise faster than their largely fixed (partial-historical) costs, when the central bank prints money and raises prices, profits are expanded. By contrast, when the money supply and volume of spending contract, revenues fall more quickly than costs, resulting in rapidly shrinking profit margins.
We have seen both of these effects in action during the last few years. Starting in 2007, due to mortgage-related losses, the volume of spending in the economy declined significantly. Thus, business revenues fell accordingly, resulting in compressed corporate earnings.
Then, the Fed came along in 2008 and more than doubled the monetary base; the portion of those new reserves that were loaned out by banks were taken by businesses and spent to buy goods from other businesses, causing a surge in business spending. This spending once again raised revenues and earnings much higher than costs; it raised profit margins.
It is this spending of new credit — not true consumer- and time-preference-driven economic growth — that is currently causing companies to be more profitable. True economic growth would result not in increased (monetary) revenues and profits but instead in steady ones and falling prices, as explained in this article.
The Degree of CapitalismCounter to expectations, the more capitalism, the lower, not higher, are the profits. Capitalism, in this context, refers to the degree of business investment in the economy. It can also be regarded as the proportion of spending in the economy devoted to production versus consumption.
To fully grasp this inverse relationship between profits and the degree of capitalism, we must understand that the original and most basic form of income is profit, not wages.
A quick example will illustrate this concept. Suppose you rent a retail space in which to sell hot dogs. You also purchase machinery and supplies and hire workers to help sell hot dogs on a daily basis. Assume that in the first year you make $100,000 in sales and have to deduct $70,000 worth of costs: $20,000 in supplies and $50,000 in labor (for simplicity, we'll assume that rent is a "supply"). This leaves a net profit of 30 percent ($100K − $70K = $30K; $30K / $100K = 30 percent).
The profit exists after paying wages. Had there been no wages, the profit would have been much higher at 80 percent ($100K − $20K of supplies / $100K). Contrary to the Smithian/Marxian view, wages are deducted from profit, not vice versa.
Had there been a greater investment in supplies and labor, say $90,000 instead of $70,000, profits would have been only 10 percent instead of 30 percent. The greater the amount of business investment (i.e., productive spending and degree of capitalism) in the economy, the lower is the rate of profit.It should be remembered that the economy-wide rate of profit is necessarily unrelated to the overall profitability of individual firms and to the real standards of living of individuals. The explanation, however, is beyond the scope of this article. Conversely, the lower the business investment is, the greater the rate of profit.
It is not true, however, that any individual business can prosper by spending less on production in order to raise its profits — it would be rapidly wiped out due to a lack of both capital and monetary income.
Taxes and Government SpendingThe greater the proportion of government spending in the economy, the higher the rate of economy-wide profit is. To the extent that the government imposes taxes (the main source of government spending) that are paid with funds that would otherwise have been spent on investments of labor and capital (business investment), the effect is to raise the pretax rate of profit.
This is because money that businesses spend to pay taxes is taken away from business spending. Suppose our hot-dog business above has to pay $10,000 in taxes when its business spending is $90,000 and its corresponding profit is 10 percent. In order to maintain its after-tax profit of 10 percent it will have to pay taxes out of what it would have otherwise spent on capital and labor. Its previous pretax profits of 10 percent are now increased to 20 percent: $100K − ($90K [investment spending] − $10K [to pay taxes]) = $20K; $20K / $100K = 20 percent. Conversely, if the company were then given a tax break, it would invest the savings on capital and labor.Due to competitive market forces and the company's own need for a higher amount of profit — i.e., because it could make more on higher volume carrying a lower percentage profit — the company would not keep the difference as profit. For a better understanding, please see discussions in my book The Case for Legalizing Capitalism on the uniformity-of-profit principle (pp. 40–41) and competition for labor services (pp. 51–52).
At the aggregate level, businesses as a whole, when paying higher taxes, divert spending from productive processes to taxes. Businesses spend less in the economy, but government takes up that slack by spending more. Thus, spending on production is replaced with spending on consumption. Total economy-wide revenues, therefore, stay the same, but corresponding business costs decrease since business spending is lower than before. With the same total revenues but lower costs, the economy-wide rate of profit is higher.
The consequence of this higher rate of profit is a reduction in standards of living. With businesses investing less in productive processes, fewer goods and services are produced, and consumer prices rise relative to wages.
Paradoxical as it might sound, lower profits and lower prices — not higher profits and higher prices — are what result from economic progress. All taxes applied to profits, interest, inheritance, etc. — taxes paid with funds that would otherwise support productive processes — reduce economic growth.
ConclusionThese explanations of the forces affecting profit are not in any way intended to denounce profits — quite the opposite.
For it is the seeking of profits that is the key to increased living standards for everyone. But it must be understood that high profits do not necessarily correspond to real economic growth and can come about due to adverse circumstances. More importantly we must grasp that neither the existence of high profits nor the goal of raising the rate of profit of all companies are necessarily economically beneficial.
Paul Krugman is despairing of late, because a growing number of mainstream economists are adopting (versions of) Austrian business-cycle theory. The most recent convert is Minneapolis Fed president Narayana Kocherlakota.
Krugman uses the occasion to criticize what he derides as "the hangover theory" of economic slumps, in which high unemployment is necessary after an artificial boom. As happened with his earlier criticism of "the hangover theory," here too Krugman buttresses his Keynesian logic with a misguided appeal to the data.
As I'll demonstrate, once we look at more relevant statistics the evidence comes down squarely in favor of the Austrian view, not the Keynesian.
Kocherlakota vs. KrugmanTo set the context, let's extensively quote from Krugman's recent blog post:
At least some members of the FOMC have bought into the hangover theory — the modern version of liquidationism in which mass unemployment is somehow necessary in the aftermath of a burst bubble:
[From a WSJ story:] Narayana Kocherlakota, president of the Minneapolis Fed, argued that a large part of today's unemployment problem is caused by issues the Fed can't solve, such as the mismatch between the skills of jobless workers and the skills that employers wanted.Here's what Kocherlakota said in a speech after the meeting:
Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.I tried, in that old piece on hangover theorists, to explain what's wrong with this view in general. Among other things, "this story bears little resemblance to what actually happens in a recession, when every industry — not just the investment sector — normally contracts."
And this is strikingly true this time around. Kocherlakota would have us believe that there's a big problem of mismatch because manufacturing is trying to hire, while construction has slumped. But here's the employment reality:
Manufacturing employment has slumped, not risen — in fact, it has fallen more than construction employment. The problem is lack of overall demand, not worker mismatch.
Krugman vs. the AustriansIt's true that Kocherlakota's particular story is self-serving ("Hey, don't blame the Fed; we've done all we can!") and it also doesn't explain the big drop in manufacturing through 2009. However, Krugman's riposte by no means disposes of the complete Austrian explanation of what has happened to the US economy.
First of all, Austrians can easily explain why there is a general drop in employment after a bubble pops, rather than just drops in (say) capital-goods industries. The problem in the aftermath of a bubble isn't merely that a "given" level of demand switches from one sector to another. On the contrary, people in general are poorer than they thought they were at the height of the boom.
In particular, during the boom, people unwittingly consumed capital. In a simplistic Keynesian model with "no time and no capital," it's not surprising that Krugman finds the Austrian story nonsensical. But as I spelled out in my "sushi article," a distortion in the interlocking capital structure of a modern economy can quite obviously lead to a general rise in unemployment across many sectors, as the mistaken investments are flushed out of the system.
In the second place, the US (and world) economy right now isn't suffering merely from the need to rearrange resources in light of the unsustainable housing boom years. No, the Keynesian and monetarist wizards in the government and Federal Reserve have unleashed a string of deadly blows to the already weakened economy.
Think of it this way — even if the economy had been perfectly healthy in the summer of 2008, Austrian economists would have been horrified at the damage of the ensuing policies: the government seized Fannie and Freddie, thereby effectively nationalizing a large portion of the entire US housing market; the Fed nationalized AIG; the treasury secretary told everybody that he needed $700 billion pronto to patch up the financial sector or the world would end; the treasury secretary then proceeded to partially nationalize the US financial sector; the federal government took over two of the Big Three car companies and threw traditional creditor rights out the window; the Fed more than doubled the monetary base in six months' time; the new Obama administration borrowed almost $800 billion to spend on "stimulus"; the federal government has taken a giant leap forward to socialized medicine; and just for kicks, the federal government also banned offshore drilling (though the rules are yet again undergoing revision).
Now say what he will about the Austrian economists, surely Dr. Krugman will concede that they opposed the above actions, and that they would have predicted at any time that these policies would lead to economic stagnation. (For example, here, here, and here.)
My point here is that it's no surprise the US economy is suffering a slump throughout all major industries, even though it's been years since the housing bubble peaked. Those of us Austrians who have been warning of price inflation have not (yet) been vindicated, but we have definitely been on the record from the get-go that these massive government and Fed interventions would cripple the economy.
Looking at the Employment DataThus far some readers may be suspicious that I'm trying to wriggle out of Krugman's headlock by changing the terms of the debate. So by all means, let's put aside the fact that the economy has had bombs dropped on it after the housing bubble popped. For the sake of argument, let's go to the employment data and test an Austrianized "hangover theory."
Now before we look, what would an Austrian expect to find? Well, he would expect a general drop across the board as people experienced the shock of the housing (and stock market) crash, and consequently postponed as many purchases as they could. This "hoarding" corresponds to a legitimate change in the way real resources are deployed: when everyone realizes there aren't enough capital goods to support the structure of production, things need to come to a screeching halt while entrepreneurs reevaluate their operations in light of the new information.
Besides general observations about the economy as a whole, Austrian business-cycle theory makes predictions (other things being equal, of course) about the relative impacts on particular sectors. For example, the "higher-order" (or more capital-intensive) sectors of the economy would crash much harder than the "lower-order" sectors, such as retail. (For an introduction to Austrian business-cycle theory, see Roger Garrison's amazing PowerPoint shows.)
Guided by Austrian business-cycle theory, we would also expect to see the retail sectors begin to recover earlier than the more capital-intensive sectors. In other words, in the immediate aftermath of the crash, total employment would go down. The heavy industries would be hemorrhaging jobs, but the sectors closer to final consumption would also lay people off.
However, at some point the retail sectors would turn around, and begin hiring. These sectors would start to draw down the accumulating pool of unemployed workers, even as the capital-intensive sectors still piled on newly laid-off workers. As more time passed, the trends would flip, so that the recovering sectors would be hiring more new workers on net than the capital-intensive ones were laying off. At this point, the total number of unemployed workers in the economy would begin falling. Finally, even the higher-order industries — the ones furthest up the chain of production in a chronological sense — would find their bottom, and they would begin hiring workers on net.
In contrast to the Austrian story, what does the Keynesian view predict? Well, if a recession is really just about a general drop in aggregate demand, then we shouldn't see any particular relationship among individual sectors, and how they respond both in magnitude and across time. If you reread Krugman's commentary on his chart, that's exactly what he himself says the Keynesian story means.
The problem with Krugman's chart is that he shows absolute job losses. So yes, "[m]anufacturing employment … has fallen more than construction employment," but that's because there were more people in manufacturing in the first place.
Let's construct a more accurate test. Let's look at the percentage decline in (a) construction employment, (b) durable-goods manufacturing, and (c) nondurable-goods manufacturing. In the Austrian framework, construction would typically be the "highest order" of these, because things like office buildings and houses are very capital-intensive and provide a flow of services for decades. Next in line would be durable-goods manufacturing, while nondurable-goods manufacturing would be the "lowest order" of these three categories. Here's the chart, showing an index of employment in these three sectors, and covering the same time period as Krugman's chart:
I submit that the above chart is entirely consistent with the Austrian explanation of business slumps following an unsustainable boom period. Contrary to Krugman's misleading chart, in percentage terms the construction sector has taken a larger hit than "manufacturing" in general, and construction has been brutalized compared to the mild downturn in nondurable-goods manufacturing.
Moreover — and this is presumably what motivated Kocherlakota's comments — a naive extrapolation of year-to-date trends suggests that the manufacturing sector has bottomed out and is on the road to recovery. Construction employment, on the other hand, is still falling.
The Austrians can easily interpret the above chart. How does Krugman? If the recession is really just about falling aggregate demand, then why did construction fall so much more than nondurable manufacturing, and why has durable manufacturing risen in 2010 while construction still languishes?
ConclusionAustrian economists are correctly wary of aping the methods of the natural sciences. In economics, it's far more important to have a logically coherent theory than a multivariate regression with a "high R-squared."
Even so, a true theory will be consistent with the empirical evidence.It's true that I "already knew the answer" before writing this article. In other words, I went to the FRED website and plotted the three data series, to make sure my smoking gun graph would actually be a smoking gun. However, after writing the complete article, I decided to truly put Austrian business-cycle theory to the test. I added the series "All Employees: Retail Trade" to my chart. And lo and behold, the Mises-Hayek theory came out with flying colors: The line for retail trade falls entirely above the line for nondurable manufactured goods, and bottomed out slightly before the other lines. (However it slightly dipped again in the last monthly data point.) As the data on construction and manufacturing employment show, the Austrian story of recessions fits the facts better than the Keynesian explanation.
Robbins concentrates on the history of the main propositions of the theory of development·as they apply to a closed economy.
This book is based on the 1966 Chichele lectures.
I am a lead pencil — the ordinary wooden pencil familiar to all boys and girls and adults who can read and write.
Writing is both my vocation and my avocation; that's all I do.
You may wonder why I should write a genealogy. Well, to begin with, my story is interesting. And, next, I am a mystery — more so than a tree or a sunset or even a flash of lightning. But, sadly, I am taken for granted by those who use me, as if I were a mere incident and without background. This supercilious attitude relegates me to the level of the commonplace. This is a species of the grievous error in which mankind cannot too long persist without peril. For, the wise G.K. Chesterton observed, "We are perishing for want of wonder, not for want of wonders."
I, Pencil, simple though I appear to be, merit your wonder and awe, a claim I shall attempt to prove. In fact, if you can understand me — no, that's too much to ask of anyone — if you can become aware of the miraculousness that I symbolize, you can help save the freedom mankind is so unhappily losing. I have a profound lesson to teach. And I can teach this lesson better than can an automobile or an airplane or a mechanical dishwasher because — well, because I am seemingly so simple.
Simple? Yet, not a single person on the face of this earth knows how to make me. This sounds fantastic, doesn't it? Especially when it is realized that there are about one and one-half billion of my kind produced in the United States each year.
Pick me up and look me over. What do you see? Not much meets the eye — there's some wood, lacquer, the printed labeling, graphite lead, a bit of metal, and an eraser.
Innumerable Antecedents Just as you cannot trace your family tree back very far, so is it impossible for me to name and explain all my antecedents. But I would like to suggest enough of them to impress upon you the richness and complexity of my background.
My family tree begins with what in fact is a tree, a cedar of straight grain that grows in Northern California and Oregon. Now contemplate all the saws and trucks and rope and the countless other gear used in harvesting and carting the cedar logs to the railroad siding. Think of all the persons and the numberless skills that went into their fabrication: the mining of ore, the making of steel and its refinement into saws, axes, motors; the growing of hemp and bringing it through all the stages to heavy and strong rope; the logging camps with their beds and mess halls, the cookery and the raising of all the foods. Why, untold thousands of persons had a hand in every cup of coffee the loggers drink!
The logs are shipped to a mill in San Leandro, California. Can you imagine the individuals who make flat cars and rails and railroad engines and who construct and install the communication systems incidental thereto? These legions are among my antecedents.
Consider the millwork in San Leandro. The cedar logs are cut into small, pencil-length slats less than one-fourth of an inch in thickness. These are kiln dried and then tinted for the same reason women put rouge on their faces. People prefer that I look pretty, not a pallid white. The slats are waxed and kiln dried again. How many skills went into the making of the tint and the kilns, into supplying the heat, the light and power, the belts, motors, and all the other things a mill requires? Sweepers in the mill among my ancestors? Yes, and included are the men who poured the concrete for the dam of a Pacific Gas & Electric Company hydroplant, which supplies the mill's power!
Don't overlook the ancestors present and distant who have a hand in transporting 60 carloads of slats across the nation.
Once in the pencil factory — $4,000,000 in machinery and building, all capital accumulated by thrifty and saving parents of mine — each slat is given eight grooves by a complex machine, after which another machine lays leads in every other slat, applies glue, and places another slat atop — a lead sandwich, so to speak. Seven brothers and I are mechanically carved from this "wood-clinched" sandwich.
My "lead" itself — it contains no lead at all — is complex. The graphite is mined in Ceylon. Consider these miners and those who make their many tools and the makers of the paper sacks in which the graphite is shipped and those who make the string that ties the sacks and those who put them aboard ships and those who make the ships. Even the lighthouse keepers along the way assisted in my birth — and the harbor pilots.
The graphite is mixed with clay from Mississippi in which ammonium hydroxide is used in the refining process. Then wetting agents are added such as sulfonated tallow — animal fats chemically reacted with sulfuric acid. After passing through numerous machines, the mixture finally appears as endless extrusions — as from a sausage grinder — cut to size, dried, and baked for several hours at 1,850 degrees Fahrenheit. To increase their strength and smoothness the leads are then treated with a hot mixture that includes candelilla wax from Mexico, paraffin wax, and hydrogenated natural fats.
My cedar receives six coats of lacquer. Do you know all the ingredients of lacquer? Who would think that the growers of castor beans and the refiners of castor oil are a part of it? They are. Why, even the processes by which the lacquer is made a beautiful yellow involve the skills of more persons than one can enumerate!
Observe the labeling. That's a film formed by applying heat to carbon black mixed with resins. How do you make resins and what, pray, is carbon black?
My bit of metal — the ferrule — is brass. Think of all the persons who mine zinc and copper and those who have the skills to make shiny sheet brass from these products of nature. Those black rings on my ferrule are black nickel. What is black nickel and how is it applied? The complete story of why the center of my ferrule has no black nickel on it would take pages to explain.
Then there's my crowning glory, inelegantly referred to in the trade as "the plug," the part man uses to erase the errors he makes with me. An ingredient called "factice" is what does the erasing. It is a rubberlike product made by reacting rapeseed oil from the Dutch East Indies with sulfur chloride. Rubber, contrary to the common notion, is only for binding purposes. Then, too, there are numerous vulcanizing and accelerating agents. The pumice comes from Italy; and the pigment that gives "the plug" its color is cadmium sulfide.
No One Knows Does anyone wish to challenge my earlier assertion that no single person on the face of this earth knows how to make me?
Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. Now, you may say that I go too far in relating the picker of a coffee berry in far-off Brazil and food growers elsewhere to my creation; that this is an extreme position. I shall stand by my claim. There isn't a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-how. From the standpoint of know-how the only difference between the miner of graphite in Ceylon and the logger in Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed with, any more than can the chemist at the factory or the worker in the oil field — paraffin being a byproduct of petroleum.
Here is an astounding fact: neither the worker in the oil field nor the chemist nor the digger of graphite or clay nor any who mans or makes the ships or trains or trucks nor the one who runs the machine that does the knurling on my bit of metal nor the president of the company performs his singular task because he wants me. Each one wants me less, perhaps, than does a child in the first grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Their motivation is other than me. Perhaps it is something like this: each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.
No Mastermind There is a fact still more astounding: the absence of a mastermind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead, we find the Invisible Hand at work. This is the mystery to which I earlier referred.
It has been said that "only God can make a tree." Why do we agree with this? Isn't it because we realize that we ourselves could not make one? Indeed, can we even describe a tree? We cannot, except in superficial terms. We can say, for instance, that a certain molecular configuration manifests itself as a tree. But what mind is there among men that could even record, let alone direct, the constant changes in molecules that transpire in the life span of a tree? Such a feat is utterly unthinkable!
I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles that manifest themselves in nature an even-more-extraordinary miracle has been added: the configuration of creative human energies — millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire and in the absence of any human masterminding! Since only God can make a tree, I insist that only God could make me. Man can no more direct these millions of know-hows to bring me into being than he can put molecules together to create a tree.
The above is what I meant when writing, "If you can become aware of the miraculousness that I symbolize, you can help save the freedom mankind is so unhappily losing." For, if one is aware that these know-hows will naturally, yes, automatically, arrange themselves into creative and productive patterns in response to human necessity and demand — that is, in the absence of governmental or any other coercive masterminding — then one will possess an absolutely essential ingredient for freedom: a faith in free people. Freedom is impossible without this faith.
Once government has had a monopoly of a creative activity such, for instance, as the delivery of the mails, most individuals will believe that the mails could not be efficiently delivered by men acting freely. And here is the reason: each one acknowledges that he himself doesn't know how to do all the things incident to mail delivery. He also recognizes that no other individual could do it. These assumptions are correct. No individual possesses enough know-how to perform a nation's mail delivery any more than any individual possesses enough know-how to make a pencil. Now, in the absence of faith in free people — in the unawareness that millions of tiny know-hows would naturally and miraculously form and cooperate to satisfy this necessity — the individual cannot help but reach the erroneous conclusion that mail can be delivered only by governmental "masterminding."
Testimony Galore If I, Pencil, were the only item that could offer testimony on what men and women can accomplish when free to try, then those with little faith would have a fair case. However, there is testimony galore; it's all about us and on every hand. Mail delivery is exceedingly simple when compared, for instance, to the making of an automobile or a calculating machine or a grain combine or a milling machine or to tens of thousands of other things.
Delivery? Why, in this area where men have been left free to try, they deliver the human voice around the world in less than one second; they deliver an event visually and in motion to any person's home when it is happening; they deliver 150 passengers from Seattle to Baltimore in less than four hours; they deliver gas from Texas to one's range or furnace in New York at unbelievably low rates and without subsidy; they deliver each four pounds of oil from the Persian Gulf to our Eastern Seaboard — halfway around the world — for less money than the government charges for delivering a one-ounce letter across the street!
The lesson I have to teach is this: Leave all creative energies uninhibited. Merely organize society to act in harmony with this lesson. Let society's legal apparatus remove all obstacles the best it can. Permit these creative know-hows freely to flow. Have faith that free men and women will respond to the Invisible Hand. This faith will be confirmed. I, Pencil, seemingly simple though I am, offer the miracle of my creation as testimony that this is a practical faith, as practical as the sun, the rain, a cedar tree, the good earth.
This article appears in Anything That's Peaceful: The Case for the Free Market, 1964.
Carried through consistently, the right of property would entitle the proprietor to all the advantages that the good's employment may generate — and all the disadvantages resulting from its employment, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
There is no such thing as interests independent of ideas, preceding them temporally and logically. What a man considers his interest is the result of his ideas, writes Ludwig von Mises (1881–1973).
This audio Mises Daily, excerpted from the audiobook version, is narrated by John Pruden.
It is good luck for the laborer if market conditions are such that a kind of work he is able to perform is lavishly remunerated; it is chance, not personal merit, if his innate talents are highly appreciated by his fellow men, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
Labor is a factor of production. The price the seller of labor can obtain on the market depends on the data of the market.
The quantity and the quality of labor an individual is fitted to deliver is determined by his innate and acquired characteristics. The innate abilities cannot be altered by any purposeful conduct. They are the individual's heritage with which his ancestors have endowed him on the day of his birth. He can bestow care upon these gifts and cultivate his talents; he can keep them from prematurely withering away; but he can never cross the boundaries that nature has drawn to his forces and abilities. He can display more or less skill in his endeavors to sell his capacity to work at the highest price that is obtainable on the market under prevailing conditions; but he cannot change his nature in order to adjust it better to the state of the market data. It is good luck for him if market conditions are such that a kind of labor he is able to perform is lavishly remunerated; it is chance, not personal merit, if his innate talents are highly appreciated by his fellow men.
Miss Greta Garbo, if she had lived a hundred years earlier, would probably have earned much less than she did in this age of moving pictures. As far as her innate talents are concerned, she is in a position similar to that of a farmer whose farm can be sold at a high price because the expansion of a neighboring city converted it into urban soil.
Within the rigid limits drawn by his innate abilities, a man's capacity to work can be perfected by training for the accomplishment of definite tasks. The individual — or his parents — incurs expenses for training, the fruit of which consists in the acquisition of the ability to perform certain kinds of work. Such schooling and training intensify a man's one-sidedness; they make him a specialist.
Every special training enhances the specific character of a man's capacity to work. The toil and trouble, the disutility of the efforts to which an individual must submit in order to acquire these special abilities, the loss of potential earnings during the training period, and the money expenditure required are laid out in the expectation that the later increment in earnings will compensate for them. These expenses are an investment and as such speculative. It depends on the future state of the market whether or not they will pay. In training himself the worker becomes a speculator and entrepreneur. The future state of the market will determine whether profit or loss results from his investment.
Thus the wage earner has vested interests in a twofold sense — as a man with definite innate qualities and as a man who has acquired definite special skills.
The wage earner sells his labor on the market at the price the market allows for it today. In the imaginary construction of the evenly rotating economy the sum of the prices the entrepreneur must expend for all the complementary factors of production together must equal — due consideration being made for time preference — the price of the product. In the changing economy, changes in the market structure may bring about differences between these two magnitudes. The ensuing profits and losses do not affect the wage earner. Their incidence falls upon the employer alone. The uncertainty of the future affects the employee only as far as the following items are concerned:
Audiobook read by Jeff RiggenbachThe expenses incurred in time, disutility, and money for training.
The expenses incurred in moving to a definite place of work.
In case of a labor contract stipulated for a definite period of time, changes in the price of the specific type of labor occurring in the meantime and changes in the employer's solvency.
This article is excerpted from chapter 21 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.
Indeed, deplorable conditions existed, but one must not blame the factory owners, who did all they could to eradicate them. These evils were caused by the economic order of the precapitalistic era — the "good old days", writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
How a free market in law enforcement and military defense could work. Recorded at Mises University 2010.
Is consumer product regulation necessary or does the free market have superior alternatives? Considers the government’s failure to provide the best level of protection for consumers. Recorded at Mises University 2010.
The truth is that capitalism has poured a horn of plenty upon the masses of wage earners, who frequently did all they could to sabotage the adoption of those innovations that render their life more agreeable, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
Implications of economizing time and time preference in human action; the nature of uncertainty and the role of uncertainty and risk in human action. Recorded at Mises University 2010.
The horror of starvation no longer terrifies men living in a capitalist society. He who is able to work earns much more than is needed for bare sustenance, writes Ludwig von Mises (1881–1973).
This audio Mises Daily is narrated by Jeff Riggenbach.
[This article is excerpted from chapter 21 of Human Action, the Scholar's Edition and is read by Jeff Riggenbach.]
The life of primitive man was an unceasing struggle against the scantiness of the nature-given means for his sustenance. In this desperate effort to secure bare survival, many individuals and whole families, tribes, and races succumbed. Primitive man was always haunted by the specter of death from starvation. Civilization has freed us from these perils. Human life is menaced day and night by innumerable dangers; it can be destroyed at any instant by natural forces which are beyond control or at least cannot be controlled at the present stage of our knowledge and our potentialities. But the horror of starvation no longer terrifies people living in a capitalist society. He who is able to work earns much more than is needed for bare sustenance.
There are also, of course, disabled people who are incapable of work. Then there are invalids who can perform a small quantity of work; but their disability prevents them from earning as much as normal workers do; sometimes the wage rates they could earn are so low that they could not maintain themselves. These people can keep body and soul together only if other people help them. The next of kin, friends, the charity of benefactors and endowments, and communal poor relief take care of the destitute. Alms folk do not cooperate in the social process of production; as far as the provision of the means for the satisfaction of wants is concerned, they do not act; they live because other people look after them. The problems of poor relief are problems of the arrangement of consumption, not of the arrangement of production activities. They are as such beyond the frame of a theory of human action that refers only to the provision of the means required for consumption, not to the way in which these means are consumed. Catallactic theory deals with the methods adopted for the charitable support of the destitute only as far as they can possibly affect the supply of labor. It has sometimes happened that the policies applied in poor relief have encouraged unwillingness to work and the idleness of able-bodied adults.
In the capitalist society there prevails a tendency toward a steady increase in the per capita quota of capital invested. The accumulation of capital soars above the increase in population figures. Consequently the marginal productivity of labor, wage rates, and the wage earners' standard of living tend to rise continually. But this improvement in well-being is not the manifestation of the operation of an inevitable law of human evolution; it is a tendency resulting from the interplay of forces that can freely produce their effects only under capitalism. It is possible and, if we take into account the direction of present-day policies, even not unlikely that capital consumption on the one hand and an increase or an insufficient drop in population figures on the other hand will reverse things. Then it could happen that men will again learn literally what starvation means and that the relation of the quantity of capital goods available and population figures will become so unfavorable as to make part of the workers earn less than a bare subsistence. The mere approach to such conditions would certainly cause irreconcilable dissensions within society, conflicts the violence of which must result in a complete disintegration of all societal bonds. The social division of labor cannot be preserved if part of the cooperating members of society are doomed to earn less than a bare subsistence.
The notion of a physiological minimum of subsistence to which the "iron law of wages" refers and which demagogues put forward again and again is of no use for a catallactic theory of the determination of wage rates. One of the foundations upon which social cooperation rests is the fact that labor performed according to the principle of the division of labor is so much more productive than the efforts of isolated individuals that able-bodied people are not troubled by the fear of starvation that daily threatened their forebears. Within a capitalist commonwealth the minimum of subsistence plays no catallactic role.
Furthermore, the notion of a physiological minimum of subsistence lacks that precision and scientific rigor that people have ascribed to it. Primitive man, adjusted to a more animal-like than human existence, could keep himself alive under conditions that are literally unbearable to his dainty scions pampered by capitalism. There is no such thing as a physiologically and biologically determined minimum of subsistence, valid for every specimen of the zoological species homo sapiens. No more tenable is the idea that a definite quantity of calories is needed to keep a man healthy and progenitive, and a further definite quantity to replace the energy expended in working. The appeal to such notions of cattle breeding and the vivisection of guinea pigs does not aid the economist in his endeavors to comprehend the problems of purposive human action. The "iron law of wages" and the essentially identical Marxian doctrine of the determination of "the value of labor power" by "the working time necessary for its production, consequently also for its reproduction,"Cf. Marx, Das Kapital (7th ed. Hamburg, 1914), I, 133. In the Communist Manifesto (Section II) Marx and Engels formulate their doctrine in this way: "The average price of wage labor is the minimum wage, i.e., that quantum of means of subsistence which is absolutely required to keep the laborer in bare existence as laborer." It "merely suffices to prolong and reproduce a bare existence." are the least tenable of all that has ever been taught in the field of catallactics.
Yet it was possible to attach some meaning to the ideas implied in the iron law of wages. If one sees in the wage earner merely a chattel and believes that he plays no other role in society, if one assumes that he aims at no other satisfaction then feeding and proliferation and does not know of any employment for his earnings other than the procurement of those animal satisfactions, one may consider the iron law as a theory of the determination of wage rates. In fact the classical economists, frustrated by their abortive value theory, could not think of any other solution of the problem involved. For Torrens and Ricardo, the theorem that the natural price of labor is the price that enables the wage earners to subsist and to perpetuate their race without any increase or diminution was the logically inescapable inference from their untenable value theory. But when their epigones saw that they could no longer satisfy themselves with this manifestly preposterous law, they resorted to a modification of it that was tantamount to a complete abandonment of any attempt to provide an economic explanation of the determination of wage rates. They tried to preserve the cherished notion of the minimum of subsistence by substituting the concept of a "social" minimum for the concept of a physiological minimum. They no longer spoke of the minimum required for the necessary subsistence of the laborer and for the preservation of an undiminished supply of labor; they spoke instead of the minimum required for the preservation of a standard of living sanctified by historical tradition and inherited customs and habits. While daily experience taught impressively that, under capitalism, real wage rates and the wage earners' standard of living were steadily rising, while it became from day to day more obvious that the traditional walls separating the various strata of the population could no longer be preserved, because the social improvement in the conditions of the industrial workers demolished the vested ideas of social rank and dignity, these doctrinaires announced that old customs and social convention determine the height of wage rates. Only people blinded by preconceived prejudices and party bias could resort to such an explanation in an age in which industry supplies the consumption of the masses again and again with new commodities hitherto unknown and makes accessible to the average worker satisfactions of which no king could dream in the past.
It is not especially remarkable that the Prussian Historical School of the wirtschaftliche Staatswissenschaften viewed wage rates no less than commodity prices and interest rates as "historical categories" and that in dealing with wage rates it had recourse to the concept of "income adequate to the individual's hierarchical station in the social scale of ranks." It was the essence of the teachings of this school to deny the existence of economics and to substitute history for it. But it is amazing that Marx and the Marxians did not recognize that their endorsement of this spurious doctrine entirely disintegrated the body of the so-called Marxian system of economics. When the articles and dissertations published in England in the early 1860s convinced Marx that it was no longer permissible to cling unswervingly to the wage theory of the classical economists, he modified his theory of the value of labor power. He declared that "the extent of the so-called natural wants and the manner in which they are satisfied, are in themselves a product of historical evolution" and "depend to a large extent on the degree of civilization attained by any given country and, among other factors, especially on the conditions and customs and pretensions concerning the standard of life under which the class of free laborers has been formed." Thus "a historical and moral element enter into the determination of the value of labor power." But when Marx adds that nonetheless "for a given country at any given time, the average quantity of indispensable necessaries of life is a given fact,"Cf. Marx, Das Kapital, p. 134. Italics are mine. The term used by Marx which in the text is translated as "necessaries of life" is "Lebensmittel." The Muret-Sanders Dictionary (16th ed.) translates this term "articles of food, provisions, victuals, grub." he contradicts himself and misleads the reader. What he has in mind is no longer the "indispensable necessaries," but the things considered indispensable from a traditional point of view, the means necessary for the preservation of a standard of living adequate to the workers' station in the traditional social hierarchy. The recourse to such an explanation means virtually the renunciation of any economic or catallactic elucidation of the determination of wage rates. Wage rates are explained as a datum of history. They are no longer seen as a market phenomenon, but as a factor originating outside of the interplay of the forces operating on the market.
However, even those who believe that the height of wage rates as they are actually paid and received in reality are forced upon the market from without as a datum cannot avoid developing a theory that explains the determination of wage rates as the outcome of the valuations and decisions of the consumers. Without such a catallactic theory of wages, no economic analysis of the market can be complete and logically satisfactory. It is simply nonsensical to restrict the catallactic disquisitions to the problems of the determination of commodity prices and interest rates and to accept wage rates as a historical datum. An economic theory worthy of the name must be in a position to assert with regard to wage rates more than that they are determined by a "historical and moral element." The characteristic mark of economics is that it explains the exchange ratios manifested in market transactions as market phenomena the determination of which is subject to a regularity in the concatenation and sequence of events. It is precisely this that distinguishes economic conception from the historical understanding, theory from history.
We can well imagine a historical situation in which the height of wage rates is forced upon the market by the interference of external compulsion and coercion. Such institutional fixing of wage rates is one of the most important features of our age of interventionist policies. But with regard to such a state of affairs it is the task of economics to investigate what effects are brought about by the disparity between the two wage rates, the potential rate that the unhampered market would have produced by the interplay of the supply of and the demand for labor on the one hand, and on the other the rate that external compulsion and coercion impose upon the parties to the market transactions.
It is true, wage earners are imbued with the idea that wages must be at least high enough to enable them to maintain a standard of living adequate to their station in the hierarchical gradation of society. Every single worker has his particular opinion about the claims he is entitled to raise on account of "status," "rank," "tradition," and "custom" in the same way as he has his particular opinion about his own efficiency and his own achievements. But such pretensions and self-complacent assumptions are without any relevance for the determination of wage rates. They limit neither the upward nor the downward movement of wage rates. The wage earner must sometimes satisfy himself with much less than what, according to his opinion, is adequate to his rank and efficiency. If he is offered more than he expected, he pockets the surplus without a qualm. The age of laissez-faire for which the iron law and Marx's doctrine of the historically determined formation of wage rates claim validity witnessed a progressive, although sometimes temporarily interrupted, tendency for real wage rates to rise. The wage earners' standard of living rose to a height unprecedented in history and never thought of in earlier periods.
The labor unions pretend that nominal wage rates at least must always be raised in accordance with the changes occurring in the monetary unit's purchasing power in such a way as to secure to the wage earner the unabated enjoyment of the previous standard of living. They raise these claims also with regard to wartime conditions and the measures adopted for the financing of war expenditure. In their opinion even in wartime neither inflation nor the withholding of income taxes must affect the worker's take-home real wage rates. This doctrine tacitly implies the thesis of the Communist Manifesto that "the working men have no country" and have "nothing to lose but their chains"; consequently they are neutral in the wars waged by the bourgeois exploiters and do not care whether their nation conquers or is conquered. It is not the task of economics to scrutinize these statements. It only has to establish the fact that it does not matter what kind of justification is advanced in favor of the enforcement of wage rates higher than those the unhampered labor market would have determined. If as a result of such claims real wage rates are really raised above the height consonant with the marginal productivity of the various types of labor concerned, the unavoidable consequences must appear without any regard to the underlying philosophy.
The same is valid with regard to the confused doctrine that wage earners are entitled to claim for themselves all the benefits derived from improvements in what union officers call the productivity of labor. On the unhampered labor market wage rates always tend toward the point at which they coincide with the marginal productivity of labor. The concept of the productivity of labor in general is no less empty than all other universal concepts of this kind, e.g., the concept of the value of iron or gold in general. To speak of the productivity of labor in a sense other than that of the marginal productivity is meaningless. What these union officers have in mind is an ethical justification of their policies. However, the economic consequences of these policies are not affected by the pretexts advanced in their favor.
Wage rates are ultimately determined by the value the wage earner's fellow citizens attach to his services and achievements. Labor is appraised like a commodity not because the entrepreneurs and capitalists are hardhearted and callous but because they are unconditionally subject to the supremacy of the pitiless consumers. The consumers are not prepared to satisfy anybody's pretensions, presumptions, and self-conceit. They want to be served in the cheapest way.
This article is excerpted from chapter 21 of Human Action, the Scholar's Edition and is read by Jeff Riggenbach.
In many ways, the unemployment numbers are much worse than they appear. One factor has been the timing of the US census. The bureau hired some 700,000 workers to collect data — people who otherwise were having a very difficult time navigating the choppy labor markets. They went for the jobs because they were a sure thing, paid decently, and didn't require unusual skills (anyone can knock on a door and pester people about their private lives).
That inflated the jobs number for a while. But now these jobs are at an end — a highly unusual event because government jobs usually last a lifetime. Now all of these people are facing the bracing reality of looking for employment in an economy wrecked by the government.
The press has been posting tributes to these people and their jobs and wailing about their fate now that their jobs are vanishing. And that raises questions. If these jobs are so great, why should they be eliminated at all? Surely, there is a way that these people could be transitioned to some other kind of government-funded service? That way, one might reason, people would have jobs, work would get done, and everyone would be better off.
Right? Wrong. Census jobs perform no market function, and the wages of these workers are paid by the taxpayer, meaning that these jobs are actually destructive of wealth. They siphon wealth and work out of the private sector into the wasteful sector. In fact, we can go further to say that eliminating these jobs is actually a step toward economic recovery.
Given the way economic fallacy has gone viral these days, it seems necessary to explain the issue further. The point of employment is not just jobs: it is productive and economically viable jobs.
It would be possible, for example, to reduce unemployment to its bare minimum simply by a mandatory regression in technology. We could abolish the trucking industry and force all freight to be carried by car, thereby creating millions of new jobs. Or we could abolish the car and create even more jobs for people to haul freight around by hand.
"The point of employment is not just jobs: it is productive and economically viable jobs." In each case, the number of jobs created would vastly outnumber the number of jobs lost. But would we be richer as a result? Not in any way. It would amount to a mandatory drop in living standards for everyone. These kinds of policies violate the Hazlitt dictum that part of good economic thinking consists in looking at what is good not just for one group (the unemployed) but for all groups in society, and not just for the short term but for the long term.
The point of jobs is for people to work towards providing goods and services that are valued by the marketplace. If there is no consumer-driven demand for the things people are doing, their jobs are nothing more than waste. It does nothing for society if everyone is employed building pyramids, contrary to what Keynes once claimed. It would be senseless to have a business that employs thousands to do nothing but break new cellphones and repair them again, or to dig holes and fill them. And why is that? Because there is no economically rational basis for these tasks to exist.
To be sure, a wealthy entrepreneur can create a business doing anything, even something that loses money and is even socially ridiculous. But in order to sustain that, he will have to continue to throw good money after bad for an indefinite period of time, even unto the end of time. The day that he decides to stop doing it, the jobs will go away.
Of course, no businessman in his right mind wants to do such a thing. If you are going to create and retain uneconomic jobs, there is really only one way to do it: government. The government takes money from the private sector to throw around in inefficient ways, regardless of whether the job is worth doing in the first place.
The taxing and debt creation that is necessary to fund the government jobs is extracted from the real engine of wealth creation. This is not only true of census jobs but of all public sector jobs, whether in the federal bureaucracy, the military, or the educational sector. For this reason, the public sector's payrolls really ought to be excluded from the employment rolls.
One objection might be that some of what public jobs produce is actually necessary for long-term economic health. We need an educated society, people might say, and even the results of the census are necessary for private-sector planning. But if that is true, there is no reason why the private sector would not have the incentive to provide these services themselves.
And they do in fact. The private sector has ever more sophisticated means for educating its employees and making up for the inferior products of public schooling. It is the same with the census results, which are used by the state to keep track of us and control us; the private sector has its own methods of assessing demographic concerns over business location and product development. Even if there were government jobs that are in fact productive in their results, they could be performed at a profit instead of by extortion.
While everyone obsesses about the plight of census workers, there is a genuine calamity taking place in the private sector, which is being attacked by government every day. This is why the latest jobs numbers show nothing like robust job growth where it matters most. We see only slight overall increases from a decade ago, with boom-time jobs almost entirely wiped out in the bust.
This is what needs attention, but not from government programs. We need an absence of government programs, plus dramatic cuts in taxes and regulations of all sorts, and across the board. We need wage reductions in some sectors so that employment can grow in other sectors. Government cannot plan real job growth. It can only get out of the way and let it happen.
In deciding to hire a worker, the employer does not ask himself what the worker gets as take-home wages. The only relevant question for him is, What is the total price I have to expend to secure the services of this worker?
This audio Mises Daily is narrated by Jeff Riggenbach.
[This article is excerpted from chapter 21 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.]
What the employer buys on the labor market and what he gets in exchange for the wages paid is always a definite performance which he appraises according to its market price. The customs and usages prevailing on the various sectors of the labor market do not influence the prices paid for definite quantities of specific performances. Gross wage rates always tend toward the point at which they are equal to the price for which the increment resulting from the employment of the marginal worker can be sold on the market, due allowance being made for the price of the required materials and to originary interest on the capital needed.
In weighing the pros and cons of the hiring of workers, the employer does not ask himself what the worker gets as take-home wages. The only relevant question for him is, What is the total price I have to expend for securing the services of this worker? In speaking of the determination of wage rates, catallactics always refers to the total price which the employer must spend for a definite quantity of work of a definite type, i.e., to gross wage rates. If laws or business customs force the employer to make other expenditures besides the wages he pays to the employee, the take-home wages are reduced accordingly. Such accessory expenditures do not affect the gross rate of wages. Their incidence falls entirely upon the wage-earner. Their total amount reduces the height of take-home wages, i.e., of net wage rates.
It is necessary to realize the following consequences of this state of affairs:
Audiobook read by Jeff RiggenbachIt does not matter whether wages are time wages or piecework wages. Also where there are time wages, the employer takes only one thing into account; namely, the average performance he expects to obtain from each worker employed. His calculation discounts all the opportunities time work offers to shirkers and cheaters. He discharges workers who do not perform the minimum expected. On the other hand a worker eager to earn more must either shift to piecework or seek a job in which pay is higher because the minimum of achievement expected is greater.
Neither does it matter on an unhampered labor market whether time wages are paid daily, weekly, monthly, or as annual wages. It does not matter whether the time allowed for notice of discharge is longer or shorter, whether agreements are made for definite periods or for the worker's life time, whether the employee is entitled to retirement and a pension for himself, his widow, and his orphans, to paid or unpaid vacations, to certain assistance in case of illness or invalidism or to any other benefits and privileges. The question the employer faces is always the same: Does it or does it not pay for me to enter into such a contract? Don't I pay too much for what I am getting in return?
Consequently the incidence of all so-called social burdens and gains ultimately falls upon the worker's net wage rates. It is irrelevant whether or not the employer is entitled to deduct the contributions to all kinds of social security from the wages he pays in cash to the employee. At any rate these contributions burden the employee, not the employer.
The same holds true with regard to taxes on wages. Here too it does not matter whether the employer has or has not the right to deduct them from take-home wages.
Neither is a shortening of the hours of work a free gift to the worker. If he does not compensate for the shorter hours of work by increasing his output accordingly, time wages will drop correspondingly. If the law decreeing a shortening of the hours of work prohibits such a reduction in wage rates, all the consequences of a government-decreed rise in wage rates appear. The same is valid with regard to all other so-called social gains, such as paid vacations and so on.
If the government grants to the employer a subsidy for the employment of certain classes of workers, their take-home wages are increased by the total amount of such a subsidy.
If the authorities grant to every employed worker whose own earnings lag behind a certain minimum standard an allowance raising his income to this minimum, the height of wage rates is not directly affected. Indirectly a drop in wage rates could possibly result as far as this system could induce people who did not work before to seek jobs and thus bring about an increase in the supply of labor.In the last years of the eighteenth century, amidst the distress produced by the protracted war with France and the inflationary methods of financing it, England resorted to this makeshift (the Speenhamland system). The real aim was to prevent agricultural workers from leaving their jobs and going into the factories where they could earn more. The Speenhamland system was thus a disguised subsidy for the landed gentry saving them the expense of higher wages.
[This article is excerpted from chapter 20 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.]
"Unemployment in the unhampered market is always voluntary."If a job seeker cannot obtain the position he prefers, he must look for another kind of job. If he cannot find an employer ready to pay him as much as he would like to earn, he must abate his pretensions. If he refuses, he will not get any job. He remains unemployed.
What causes unemployment is the fact that — contrary to the above-mentioned doctrine of the worker's inability to wait — those eager to earn wages can and do wait. A job seeker who does not want to wait will always get a job in the unhampered market economy in which there is always unused capacity of natural resources and very often also unused capacity of produced factors of production. It is only necessary for him either to reduce the amount of pay he is asking for or to alter his occupation or his place of work.
There were and still are people who work only for some time and then live for another period from the savings they have accumulated by working. In countries in which the cultural state of the masses is low, it is often difficult to recruit workers who are ready to stay on the job. The average man there is so callous and inert that he knows of no other use for his earnings than to buy some leisure time. He works only in order to remain unemployed for some time.
It is different in the civilized countries. Here the worker looks upon unemployment as an evil. He would like to avoid it provided the sacrifice required is not too grievous. He chooses between employment and unemployment in the same way in which he proceeds in all other actions and choices: he weighs the pros and cons. If he chooses unemployment, this unemployment is a market phenomenon whose nature is not different from other market phenomena as they appear in a changing market economy. We may call this kind of unemployment market-generated or catallactic unemployment.
The various considerations which may induce a man to decide for unemployment can be classified in this way:
The individual believes that he will find at a later date a remunerative job in his dwelling place and in an occupation which he likes better and for which he has been trained. He seeks to avoid the expenditure and other disadvantages involved in shifting from one occupation to another and from one geographical point to another. There may be special conditions increasing these costs. A worker who owns a homestead is more firmly linked with the place of his residence than people living in rented apartments. A married woman is less mobile than an unmarried girl. Then there are occupations which impair the worker's ability to resume his previous job at a later date. A watchmaker who works for some time as a lumberman may lose the dexterity required for his previous job. In all these cases the individual chooses temporary unemployment because he believes that this choice pays better in the long run.
There are occupations the demand for which is subject to considerable seasonal variations. In some months of the year the demand is very intense, in other months it dwindles or disappears altogether. The structure of wage rates discounts these seasonal fluctuations. The branches of industry subject to them can compete on the labor market only if the wages they pay in the good season are high enough to indemnify the wage earners for the disadvantages resulting from the seasonal irregularity in demand. Then many of the workers, having saved a part of their ample earnings in the good season, remain unemployed in the bad season.
The individual chooses temporary unemployment for considerations which in popular speech are called noneconomic or even irrational. He does not take jobs which are incompatible with his religious, moral, and political convictions. He shuns occupations the exercise of which would impair his social prestige. He lets himself be guided by traditional standards of what is proper for a gentleman and what is unworthy. He does not want to lose face or caste.
Unemployment in the unhampered market is always voluntary. In the eyes of the unemployed man, unemployment is the minor of two evils between which he has to choose. The structure of the market may sometimes cause wage rates to drop. But, on the unhampered market, there is always for each type of labor a rate at which all those eager to work can get a job. The final wage rate is that rate at which all job seekers get jobs and all employers as many workers as they want to hire. Its height is determined by the marginal productivity of each type of work.
Wage rate fluctuations are the device by means of which the sovereignty of the consumers manifests itself on the labor market. They are the measure adopted for the allocation of labor to the various branches of production. They penalize disobedience by cutting wage rates in the comparatively overmanned branches and recompense obedience by raising wage rates in the comparatively undermanned branches. They thus submit the individual to a harsh social pressure. It is obvious that they indirectly limit the individual's freedom to choose his occupation. But this coercion is not rigid. It leaves to the individual a margin in the limits of which he can choose between what suits him better and what less. Within this orbit he is free to act of his own accord. This amount of freedom is the maximum of freedom that an individual can enjoy in the framework of the social division of labor, and this amount of coercion is the minimum of coercion that is indispensable for the preservation of the system of social cooperation. There is only one alternative left to the catallactic pressure exercised by the wages system: the assignment of occupations and jobs to each individual by the peremptory decrees of an authority, a central board planning all production activities. This is tantamount to the suppression of all freedom.
It is true that under the wages system the individual is not free to choose permanent unemployment. But no other imaginable social system could grant him a right to unlimited leisure. That man cannot avoid submitting to the disutility of labor is not an outgrowth of any social institution. It is an inescapable natural condition of human life and conduct.
It is not expedient to call catallactic unemployment in a metaphor borrowed from mechanics "frictional" unemployment. In the imaginary construction of the evenly rotating economy there is no unemployment because we have based this construction on such an assumption. Unemployment is a phenomenon of a changing economy. The fact that a worker discharged on account of changes occurring in the arrangement of production processes does not instantly take advantage of every opportunity to get another job but waits for a more propitious opportunity is not a consequence of the tardiness of the adjustment to the change in conditions but is one of the factors slowing down the pace of this adjustment. It is not an automatic reaction to the changes which have occurred, independent of the will and the choices of the job seekers concerned, but the effect of their intentional actions. It is speculative, not frictional.
Catallactic unemployment must not be confused with institutional unemployment. Institutional unemployment is not the outcome of the decisions of the individual job seekers. It is the effect of interference with the market phenomena intent upon enforcing by coercion and compulsion wage rates higher than those the unhampered market would have determined. The treatment of institutional unemployment belongs to the analysis of the problems of interventionism.
This article is excerpted from chapter 20 of Human Action: The Scholar's Edition and is read by Jeff Riggenbach.