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An Introduction to Austrian Economics
Thomas C. Taylor

6.
Production in an Evenly Rotating Economy

We must now explain how scarce resources are allocated in the production of various consumer goods in the market economy. The generation of consumer goods, as will be shown, is a complex process in which the production of numerous goods used to make other goods, often called capital goods, plays an essential role. Production requires the creation of capital goods to be used in further production as well as the final goods designed to please the consumer. One can readily observe that in our economy the decisively preponderant form of economic activity is the production of intermediate or capital goods as opposed to final consumption goods. Nature does not bestow an abundance of goods on man in immediately consumable forms. With the exception of the air (and this exception is not everywhere applicable), there is hardly any good that nature supplies that cannot be made far more useful through the application of some productive effort. The question is not whether there should be production, but to what ends should production be directed so that the most desirable goods and services are produced.

Resource Pricing in an Evenly Rotating Economy (ERE)

In order for the owners of productive factors to be willing to contribute resources to the productive process of the market, there must be some means by which they can share in the output arising from production. Their participation is achieved through the price system. Particular units of productive factors are exchanged for specific quantities of money through supply-and-demand forces in the same way that consumer goods are bought and sold. However, there is one crucial difference between the pricing of consumer goods and productive factors: Consumer goods are evaluated directly by consumers as ends or ultimate sources of satisfaction, but consumers do not evaluate the resources used to generate the final goods. It should be clear that effective allocation of scarce resources requires a system in which specific employments are considered in terms of the relative importance of alternative results. If certain ends or consumer goods are more important than others, then resources versatile enough to serve a variety of ends should be directed to the creation of the most important ones. An explanation of the pricing of units of resources will show how this goal is accomplished.

The concept of an imaginary economy devoid of change in technology, resources, and tastes, an economy in which the same steps of production and consumption are repeated over and over, is useful in understanding the nature of the pricing of resource units in the real world of continuous change. Rothbard has called such an economy an evenly rotating economy, or ERE. In the ERE, each producer, given his predicament of owning some resources and bidding for units of particular resources, would be able to impute to a given resource unit the money value of its contribution to the final product because he would know in advance the monetary result of particular production decisions. He would not encounter the uncertainty arising from changing economic conditions. Past results would exactly predict future results.

The unit price of each type of resource would equal the discounted value of its marginal contribution to product value. (The discount relates to a margin reflecting time preference or interest, a matter to be discussed below.) This price would apply to the resource in all of its various lines of employment to the extent that the resource owners were indifferent to the nonmonetary factors relating to the different lines. The resource could not earn more in one line than in another because resource owners would have shifted their factor to the more remunerative lines. This shift would have driven the factor price down in the attractive employments and caused the price to rise in those abandoned lines. Prices of homogeneous factors would become equal in all employments.

This uniform price would be equated to the resource's marginal value product, which would thus be the same in all lines of employment. Producers would not tolerate any discrepancy between a factor's price and its contribution to product value. If a resource had been receiving a price lower than its marginal value product, producers would have increased the use of the resource in these outputs so that its unit price would be bid upward but not in excess of its contribution to productive value. Conversely, if a resource unit had been paid a price higher than its marginal value product, employment of the resource would have fallen off in those lines at least until the price ceased to exceed the factor's contribution to product revenues. The price of a durable factor would be derived from and equal to the summation of the marginal value products of its specific service units to be used over time. Durable resources, then, could be purchased or rented in the ERE according to the value imputed to the service units to be derived.

Thus in the evenly rotating economy the price of each product would (except for the interest factor) equal the summation of the marginal value products of its complementary factors of production. For each producer, total money revenues (excluding interest) would equal total money costs. Adjustments leading up to the ERE would have eliminated all instances of profit and loss. The continuous stability and certainty of an evenly rotating economy would preclude the need for further adjustments or changes in resource allocation. Each factor would be allocated to various uses so that its marginal product contribution would be the same in each use. With perfect knowledge about the future, producers would make no mistakes about imputing product values to resource values. What is of extreme importance here is that the influence is from product price back to factor price, and not the other way around. Means derive their importance from the ends or results they effect. Here lies the key to effective resource utilization. Yet, the erroneous notion that factor costs determine product prices has widespread acceptance.

Only those factor units whose marginal effect on product value could be isolatable and hence determinable would be subject to the competitive forces that would set resource prices equal to discounted marginal value product. This means that determinate pricing would require the existence of versatile, relatively nonspecific factors whose multiple uses set the competitive process in motion as producers bid for the factors' employment in various lines of production. A price emerges on the market for a particular resource because producers compete for its employment in alternative uses. If products were produced by strictly specific resources, then the market could establish only cumulative prices for each combinational group of resource factors, and each price would represent the monetary value of the common product. Prices are determinate for absolutely specific resources in those situations in which the production process uses no more than one specific resource. As a result of the bidding of competitive producers, such prices of specific resources equal the residual difference between the final product price and the sum of the prices of the nonspecific factors.

Cumulative residual prices will prevail on the market in connection with those processes in which more than one specific resource is required. In such cases, the amount singly paid to each specific factor is established only through the process of bargaining among the separate owners of the specific factors. Prices of particular factors emerge only when producers compete for their use in alternative lines of production or when there is only one specific resource in each productive process, thereby imputing marginal value to the particular factor's units.

It is important to realize that the imputation of value to factors of production on the part of producers is done only on an incremental or marginal basis. In hiring or purchasing productive services, the producer always makes his decision in terms of the added advantage of the additional factor. This does not mean that he deals with infinitesimal increments. For example, his marginal unit may be fifty additional employees or four new machines, but he thinks in terms of his particular situation and bids for services in light of their expected marginal contribution. Rothbard has effectively dealt with this point:

It is, then, clearly impossible to impute absolute "productivity" to any productive factor or class of factors. In the absolute sense, it is meaningless to try to impute productivity to any factor, since all the factors are necessary to the product. We can discuss productivity only in marginal terms, in terms of the productive contribution of a single unit of a factor, given the existence of the other factors. This is precisely what entrepreneurs do on the market, adding and subtracting units of factors in an attempt to achieve the most profitable course of action. [1]

Just as the farmer's five sacks of grain were allocated to the most urgent uses first, so are the units of a productive factor. As additional units of any factor are employed in a given process or throughout the economy, the marginal value product declines. The decline in the marginal value product is enhanced as a result of the law of diminishing returns, which holds that in the employment of any variable factor to a fixed factor, marginal physical productivity begins to fall at a certain point. This means that, given the supply of a particular factor, the price per unit of that factor will be set equal to the marginal value product related to the last unit of supply. As each of the farmer's sacks of grain carried the same value equal to the value of the marginal use--feeding pet parrots--each unit of a particular factor is priced in the ERE equal to the marginal value product, which is the money value that would be sacrificed if one unit of the factor were lost.

This process of resource pricing would apply to factor service units, whether purchased on a limited scale through renting or on a greater scale through the purchase of whole factors. In the ERE, all factor service units would receive their marginal value product, and there would exist no reason for their being shifted to other lines of employment once this condition was reached. Each particular factor would have one unit price throughout the market. In each specific use the resource would be employed to the extent that its marginal value product was equal to its price, competitively established throughout its market. The demand curve for each factor in each particular use depicts its declining marginal value product; like the demand curve for consumers' goods, it would be downward-sloping to the right.

The supply curve for each productive resource in each line of use would be upward-sloping to the right, reflecting the fact that resource units, possessing a versatility of productiveness in alternative uses, would be shifted away from the given use to other uses at lower prices and would be attracted to the given use from alternative lines of employment at higher prices. The curve would probably be flatter for factors of labor than for land and capital goods factors because of the relatively greater degree of nonspecificity and flexibility in the nature of the labor resources.

Resource Supply, Entrepreneurial Activity,
and Subjective Valuation

The theory of subjective value must not be overlooked in the discussion of factor supply curves. The owners of the units of factor service will subjectively determine the various quantities of service units that they are willing to offer to producers for each possible price per service unit in each particular use of the factor. They will weigh subjectively the monetary and nonmonetary results of committing the various possible quantities of service units to production. For example, the laborer will consider the value of leisure as well as other nonmonetary factors like working conditions in reaching his decision about employment. Those lines of work associated with significantly favorable nonmonetary characteristics would attract a greater number of workers than those characterized by noticeably unfavorable working conditions. Higher wage rates or prices than otherwise necessary would be paid those working in the generally disliked jobs; conversely, lower wages than otherwise required would be paid to those employed in the generally favored jobs.

These results are consistent with the principle of declining marginal value product for each particular use. Greater quantities of factors employed would tap decreasing marginal value products; lesser quantities would relate to higher marginal value products. Market supply curves for each factor in each particular use would show the summation of individual supply curves. The intersection of the market demand-and-supply curves would show the establishment of the equilibrium price for each factor in each particular line of employment, and this price would represent the marginal value product of a factor unit in that particular use. Such would be the endlessly prevailing price structure for units of productive resources in the evenly rotating economy.

In hiring or purchasing factors of production, the producer, like all other market participants, is acting on his own subjective value judgments. [2] His willingness to invest specific amounts of money or commit himself to the investment of amounts of money obtained from others, who likewise act on personal valuations, reflects his decision that taking other actions instead would contribute less satisfaction to him than pursuing his business plan. His subjective evaluation of expected "money costs" and other forms of sacrifice, i.e., forgone alternative satisfaction, or in Buchanan's terms, his "choice-influencing" costs, is lower than the subjective value expected to be realized from the action chosen.

The Efficiency of Resource Allocation in an ERE

In an advanced economy the time between the inception of virtually every consumer good and its fruition is exceedingly long. In order to obtain goods that they desire and can consume, people are able to resort ultimately to only two types of productive resources, themselves and nature. Because either the goods that come from nature are not completely accessible to humans, or the resources of nature are not always usable in their natural state, humans inject their own efforts into the natural process. This productive effort transforms and combines the gifts of nature into more satisfactory goods. All such production must take place through time; thus, the fundamental and ultimate requirements for production are nature, man, and time.

Humans can combine their own efforts with the gifts of nature to produce consumable goods either directly or indirectly. Using the direct approach, a person applies his energies to a natural resource for immediate satisfaction, as in obtaining a drink of water from a stream. It was owing to the great contribution of Bohm-Bawerk that economic analysis recognized that production cannot occur without the passing of time, a recognition that was especially pertinent in connection with the indirect approach to production. [3] Under this second method, production first yields intermediate goods that are not consumable but rather are used to assist in further production efforts. These intermediate goods, known as producers' goods or capital goods, include tools, equipment, buildings, and all other produced means of production. An example of this indirect method, which Bohm-Bawerk called "roundabout production," is obtaining water to drink from the stream with a log hollowed out to make a bucket. The bucket could be used to make the acquisition of water easier by reducing the number of trips to the stream.

The advantage of roundabout or indirect production is not confined to making it easier to acquire goods that already exist in consumable form, such as water. A far greater advantage is its capacity to produce consumer goods that otherwise could never be made available. All modern conveniences such as cars, communications devices, refrigerators, eyeglasses, and countless others would be nonexistent were their production not preceded by the creation of tools and equipment. In an advanced economy, units of these capital goods are a significant part of the factors being purchased for production purposes. In the ERE, each particular type would be priced per service unit at an amount equal to its discounted marginal value product. The price of the whole capital good would equal the capitalization of its future marginal value products.

Time Preference and Interest

Because of the time-consuming element of production, the price paid each factor unit in the ERE is its discounted marginal value product and not its full marginal value product. The principle of time-preference, which holds that people prefer present goods to future goods, underlies the requirement that future marginal value products be discounted to their present values. People who save some of their purchasing power and invest in productive undertakings thereby forgo the enjoyment of consumption goods that purchasing power could have obtained. They exchange present goods for future goods. When they purchase units of productive factors in the expectation of generating future purchasing power, i.e., future goods, they provide the former owners of these resources with a means to acquire present goods. However, since they prefer present goods over future goods, future goods are valued less in the present than are present goods, and it is this lesser value that is presently imputed to the marginal value product of each productive factor. This is why in an ERE producers would earn an interest income, the difference between the money value of consumer goods and the money value of productive resources purchased at earlier points in time.

In an advanced economy in which extensive use of roundabout production processes is prominent, the interest factor is of utmost importance. Here rests the kernel of Bohm-Bawerk's devastating reply to Marx's exploitation theory, which maintained that capitalist-producers exploited the working class by paying them less than the value of their products. Marx was right in citing the emergence of a surplus value, but he was wrong in overlooking that rather than being a matter of exploitation, this discrepancy was partly the result of a natural and unavoidable phenomenon: interest.

In an ERE, the interest rate would be the same throughout the economy and in every productive stage because if interest rates were higher in certain industries or stages than in others, producers would shift to the more remunerative lines so that the differences would disappear as the result of competitive forces. In those industries or stages that producers abandon, the demand for productive resources falls, thereby reducing the prices of units of factors. This raises the discrepancy between marginal value product and money costs; hence the interest rate in those lines is increased. On the other hand, in those industries that attract additional investment, interest rates fall as a result of higher resource prices and the lower selling prices of finished goods.

This process of shifting investment would go on until the interest rate in every line of production became the same, at which point an evenly rotating economy would be reached. The higher the rate of interest, the more production efforts will be directed toward the production of consumer goods and the less saving available for more time-consuming production of future goods. A lower rate of interest indicates a lower discounting of future goods to present goods and is concomitant with greater savings and the opportunity to adopt more time-consuming processes of production.

Even Bohm-Bawerk, who played such a vital role in developing interest theory, committed the common error of attributing the interest factor to the productivity of capital goods. But interest can be explained completely by the principle of time-preference and does not arise only in connection with the employment of capital goods. The productivity of capital goods is already taken into consideration in determining which marginal value products should be discounted for the time period expected to elapse before the future goods become present goods. And this applies to all factors of production, not just capital goods. Mises says:

The contribution of the complementary factors of production to the result of the process is the reason for their being considered as valuable; it explains the prices paid for them and is fully taken into account in the determination of these prices. No residuum is left that is not accounted for and could explain interest. [4]

Interest is not a return peculiarly characteristic of the use of capital goods, as has often been contended. The classical association of interest only with capital goods is not tenable because interest permeates all economic activity in which present goods are furnished in exchange for future goods. Thus interest arises in consumer loans as well as producer loans. The phenomenon of interest operates as well in the price paid for land and labor whose benefits or proceeds are to be received in the future. In fact, if it were not for the element of time-preference, the prices of parcels of land would be infinite.

Suggested Readings

Mises, Ludwig von. Human Action: A Treatise on Economics, pp. 244-56 and pp. 479-537.

Rothbard, Murray N. Man, Economy, and State: A Treatise on Economic Principles, pp. 273-433.

[1] Rothbard, Man, Economy, and State. II, p. 520.

[2] Under the assumption of perfect knowledge posited with the ERE, there would be no place for the entrepreneur. This explains the absence here of the term used repeatedly in earlier sections, the "entrepreneur-producer." Nevertheless, the same point being made above concerning the relevance of subjective value is no less applicable to the entrepreneur-producer in the real world of uncertainty.

[3] Bohm-Bawerk, Capital and Interest.

[4] Mises, Human Action, p. 530.

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