HAVING DEVELOPED IN THE PREVIOUS chapters our basic analysis of the market economy, we now proceed to discuss more dynamic and specific applications, as well as the consequences of intervention in the market.

In the evenly rotating economy, there are only two ultimate categories of producers’ prices and incomes: interest (uniform throughout the economy), and “wages”—the prices of the services of various labor factors. In a changing economy, however, wage rates and the interest rate are not the only elements that can change. Another category of both positive and negative income appears: entrepreneurial profit and loss. We shall concentrate on the capitalist-entrepreneurs, economically the more important type of entrepreneur. These are the men who invest in “capital” (land and/or capital goods) used in the productive process. Their function is as we have described: the advance of money to owners of factors and the consequent use of the goods until the more nearly present product is later sold. We have worked out the laws of the ERE in detail: factor prices will equal DMVP, every factor will be allocated to its most value-productive uses, capital values will equal the sums of the DMVPs, the interest rate will be uniform and governed solely by time preferences, etc.

The difference in the dynamic, real world is this. None of these future values or events is known; all must be estimated, guessed at, by the capitalists. They 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. As a result of the arbitrage of the entrepreneurs, the tendency is always toward the ERE; in consequence of ever-changing reality, changes in value scales and resources, the ERE never arrives.

The capitalist-entrepreneur buys factors or factor services in the present; his product must be sold in the future. He is always on the alert, then, for discrepancies, for areas where he can earn more than the going rate of interest. Suppose the interest rate is 5 percent; Jones can buy a certain combination of factors for 100 ounces; he believes that he can use this agglomeration to sell a product after two years for 120 ounces. His expected future return is 10 percent per annum. If his expectations are fulfilled, then he will obtain a 10-percent annual return instead of 5 percent. The difference between the general interest rate and his actual return is his money profit (from now on to be called simply “profit,” unless there is a specific distinction between money profit and psychic profit). In this case, his money profit is 10 ounces for two years, or an extra 5 percent per annum.

What gave rise to this realized profit, this ex post profit fulfilling the producer’s ex ante expectations? The fact that the factors of production in this process were underpriced and undercapitalized— underpriced in so far as their unit services were bought, undercapitalized in so far as the factors were bought as wholes. In either case, the general expectations of the market erred by underestimating the future rents (MVPs) of the factors. This particular entrepreneur saw better than his fellows, however, and acted on this insight. He reaped the reward of his superior foresight in the form of a profit. His action, his recognition of the general undervaluation of productive factors, results in the eventual elimination of profits, or rather in the tendency toward their elimination. By extending production in this particular process, he increases the demand for these factors and raises their prices. This result will be accentuated by the entry of competitors into the same area, attracted by the 10-percent rate of return. Not only will the rise in demand raise the prices of the factors, but the increase in output will lower the price of the product. The result will be a tendency for a fall in the rate of return back to the pure interest rate.

What function has the entrepreneur performed? In his quest for profits he saw that certain factors were underpriced vis-à-vis their potential value products. By recognizing the discrepancy and doing something about it, he shifted factors of production (obviously nonspecific factors) from other productive processes to this one. He detected that the factors’ prices did not adequately reflect their potential DMVPs; by bidding for, and hiring, these factors, he was able to allocate them from production of lower DMVP to production of higher DMVP. He has served the consumers better by anticipating where the factors are more valuable. For the greater value of the factors is due solely to their being more highly demanded by the consumers, i.e., being better able to satisfy the desires of the consumers. That is the meaning of a greater discounted marginal value product.

It is clear that there is no sense whatever in talking of a going rate of profit. There is no such rate beyond the ephemeral and momentary. For any realized profit tends to disappear because of the entrepreneurial actions it generates. The basic rate, then, is the rate of interest, which does not disappear. If we start with a dynamic economy, and if we postulate given value scales and given original factors and technical knowledge throughout, the result will be a wiping out of profits to reach an ERE with a pure interest rate. Continual changes in tastes and resources, however, constantly shift the final equilibrium goal and establish a new goal toward which entrepreneurial action is directed—and again the final tendency in the ERE will be the disappearance of profits. For the ERE means the disappearance of uncertainty, and profit is the outgrowth of uncertainty.

A grave error is made by a host of writers and economists in considering only profits in the economy. Almost no account is taken of losses. The economy should not be characterized as a “profit economy,” but as a “profit and loss economy.”1

A loss occurs when an entrepreneur has made a poor estimate of his future selling prices and revenues. He bought factors, say, for 1,000 ounces, developed them into a product, and then sold it for 900 ounces. He erred in not realizing that the factors were overpriced and overcapitalized on the market in relation to their discounted marginal value products, i.e., to the prices of his output.

Every entrepreneur, therefore, invests in a process because he expects to make a profit, i.e., because he believes that the market has underpriced and undercapitalized the factors in relation to their future rents. If his belief is justified, he makes a profit. If his belief is unjustified, and the market, for example, has really overpriced the factors, he will suffer losses.

The nature of loss has to be carefully defined. Suppose an entrepreneur, the market rate of interest being 5 percent, buys factors at 1,000 and sells their product for 1,020 one year later. Has he suffered a “loss” or made a “profit”? At first, it might seem that he has not taken a loss. After all, he gained back the principal plus an extra 20 ounces, for a 2-percent net return or gain. However, closer inspection reveals that he could have made a 5-percent net return anywhere on his capital, since this is the going interest return. He could have made it, say, investing in any other enterprise or in lending money to consumer-borrowers. In this venture he did not even earn the interest gain. The “cost” of his investment, therefore, was not simply his expenses on factors—1,000—but also his forgone opportunity of earning interest at 5 percent, i.e., an additional 50. He therefore suffered a loss of 30 ounces.

The absurdity of the concept of “rate of profit” is even more evident if we attempt to postulate a rate of loss. Obviously, no meaningful use can be made of “rate of loss”; entrepreneurs will be very quick to leave the losing investment and take their capital elsewhere. With entrepreneurs leaving the line of production, the prices of the factors there will drop and the price of the product will rise (with reduced supply), until the net return in that branch of production will be the same as in every branch, and this return will be the uniform interest rate of the ERE. It is clear, therefore, that the process of equalization of rate of return throughout the economy, one that results in a uniform rate of interest, is the very same process that brings about the abolition of profits and losses in the ERE. A real economy, in other words, where line A yields a net return of 10 percent to some entrepreneur, and line B yields 2 percent, while other lines yield 5 percent, is one in which the rate of interest is 5 percent, A makes a pure profit of 5 percent, and B suffers a pure loss of 3 percent. A correctly estimated that the market had underpriced his factors in relation to their true DMVPs; B had incorrectly guessed that the market had underpriced (or, at the very least, correctly priced) his factors, but found to his sorrow that they had been overpriced in relation to the uses that he made of the factors. In the ERE, where all future values are known and there is therefore no underpricing or overpricing, there are no entrepreneurial profits or losses; there is only a pure interest rate.

In the real world, profits and losses are almost always intertwined with interest returns. Our separation of them is conceptually valid and very important, but cannot be made easily and quantitatively in practice.

Let us sum up the essence of an evenly rotating economy. It is this: all factors of production are allocated to the areas where their discounted marginal value products are the greatest. These are determined by consumer demand schedules. In the modern world of specialization and division of labor, it is almost always the consumers alone who decide, and this in effect excludes the capitalists, who rarely consume more than a negligible amount of their own products. It is the consumers, then, given the “natural” facts of stocks of resources (particularly labor and land factors), who make the decisions for the economic system. The consumers, through their buying and abstention from buying, decide how much of what will be produced, at the same time determining the incomes of all the participating factors. And every man is a consumer.

One obvious exception to this “rule” occurs when either capitalists or laborers have strong preferences or dislikes for a particular line of production. The equilibrium rate of return in the ERE for a strongly disliked line will be considerably higher than the uniform rate, and the equilibrium rate of return for a strongly liked line will be lower. These preferences, however, have to be strong enough to affect the investment or productive actions of a considerable number of potential investors or laborers in order to register as a change in the rate of return.

Do profits have a social function? Many critics point to the ERE, where there are no profits (or losses) and then attack entrepreneurs earning profits in the real world as if they were doing something mischievous or at best unnecessary. Are not profits an index of something wrong, of some maladjustment in the economy? The answer is: Yes, profits are an index of maladjustment, but in a sense precisely opposed to that usually meant. As we have seen above, profits are an index that maladjustments are being met and combatted by the profit-making entrepreneurs. These maladjustments are the inevitable concomitants of the real world of change. A man earns profits only if he has, by superior foresight and judgment, uncovered a maladjustment—specifically an undervaluation of certain factors by the market. By stepping into this situation and gaining the profit, he calls everyone’s attention to that maladjustment and sets forces into motion that eventually eliminate it. If we must condemn anyone, it should not be the profit-making entrepreneur, but the one that has suffered losses. For losses are a sign that he has added further to a maladjustment, through allocating factors where they were overvalued as compared to the consumers’ desire for their product. On the other hand, the profit-maker is allocating factors where they had been undervalued as compared to the consumers’ desires. The greater a man’s profit has been, the more praiseworthy his role, for then the greater is the maladjustment that he alone has uncovered and is combatting. The greater a man’s losses, the more blameworthy he is, for the greater has been his contribution to maladjustment.2

Of course, we should not be too hard on the bumbling loser. He receives his penalty in the form of losses. These losses drive him from his poor role in production. If he is a consistent loser wherever he enters the production process, he is driven out of the entrepreneurial role altogether. He returns to the job of wage earner. In fact, the market tends to reward its efficient entrepreneurs and penalize its inefficient ones proportionately. In this way, consistently provident entrepreneurs see their capital and resources growing, while consistently imprudent ones find their resources dwindling. The former play a larger and larger role in the production process; the latter are forced to abandon entrepreneurship altogether. There is no inevitably self-reinforcing tendency about this process, however. If a formerly good entrepreneur should suddenly made a bad mistake, he will suffer losses proportionately; if a formerly poor entrepreneur makes a good forecast, he will make proportionate gains. The market is no respecter of past laurels, however large. Moreover, the size of a man’s investment is no guarantee whatever of a large profit or against grievous losses. Capital does not “beget” profit. Only wise entrepreneurial decisions do that. A man investing in an unsound venture can lose 10,000 ounces of gold as surely as a man engaging in a sound venture can profit on an investment of 50 ounces.3

Beyond the market process of penalization, we cannot condemn the unfortunate capitalist who suffers losses. He was a man who voluntarily assumed the risks of entrepreneurship and suffered from his poor judgment by incurring losses proportionate to his error. Outside critics have no right to condemn him further. As Mises says:

Nobody has the right to take offense at the errors made by the entrepreneurs in the conduct of affairs and to stress the point that people would have been better supplied if the entrepreneurs had been more skillful and prescient. If the grumbler knew better, why did he not himself fill the gap and seize the opportunity to earn profits? It is easy indeed to display foresight after the event.4

• 1“One thing I miss ... in discussion generally in the field, is any use of words recognizing that profit means profit or loss and is in fact as likely to be a loss as a gain.” Frank H. Knight, “An Appraisal of Economic Change: Discussion,” American Economic Review, Papers and Proceedings, May, 1954, p. 63. Professor Knight’s great contributions to profit theory are in sharp contrast to his errors in capital and interest theory. See his famous work, Risk, Uncertainty, and Profit (3rd ed.; London: London School of Economics, 1940). Perhaps the best presentation of profit theory is in Ludwig von Mises, “Profit and Loss” in Planning for Freedom (South Holland, Ill.: Libertarian Press, 1952), pp. 108–51.
• 2We may make such value judgments, of course, only to the extent that we believe it is “good” to correct maladjustments and to serve the consumers, and “bad” to create such maladjustments. These value judgments, therefore, are not at all praxeological truths, though most people would probably subscribe to them. Those who prefer maladjustments in serving consumers will adopt the opposite value judgments.
• 3On all this, see Mises, “Profit and Loss.” On the role of the fallacy of capital’s automatically yielding profit in public utility regulation, see Arthur S. Dewing, The Financial Policy of Corporations (5th ed.; New York: Ronald Press, 1953), I, 308–53.
• 4Mises, Planning for Freedom, p. 114.

Having considered the ERE and its relation to specific entrepreneurial profit and loss, let us now turn to the problem: When will there be aggregate profits or losses in the economy? This is connected with the question: What is the effect of a change in the level of aggregate saving or investment in the economy?

Let us begin with an economy in the equilibrium depicted in chapters 5 and 6. Production occurs in processes up to six years in total length; total gross income is 418 gold ounces, gross savings-investment is 318 ounces, total consumption 100 ounces, net savings-investment is zero. Of the 100 ounces of income, 83 ounces of net income are earned by land and labor owners, 17 ounces by capital owners. The production structure remains constant because the natural rates of interest coincide, and the resulting price spreads conform to the aggregate of individual time-preference schedules in the economy. As Hayek states:

Whether the structure of production remains the same depends entirely upon whether entrepreneurs find it profitable to reinvest the usual proportion of the return from the sale of the product in turning out intermediate goods of the same sort. Whether this is profitable, again, depends upon the prices obtained for the product of this particular stage of production on the one hand and on the prices paid for the original means of production and for the intermediate products taken from the preceding stage of production on the other. The continuance of the existing degree of capitalistic organization depends, accordingly, on the prices paid and obtained for the product of each stage of production, and these prices are, therefore, a very real and important factor in determining the direction of production.5

What happens if, in a certain period, there are now net savings as a result of a lowering of time-preference schedules? Suppose, for example, that consumption decreases from 100 to 80 and that the saved 20 ounces enter the time market. Gross savings have increased by 20 ounces. During the transition period, net saving has changed from zero to 20; after the new level of saving has been reached, however, there will be a new equilibrium with gross savings equalling 338 and net savings equalling zero. To the superficial, it might seem that all is lost. Has not consumption decreased from 100 to 80 ounces? What, then, will happen to the whole complex of productive activities that rest on final consumption sales? Will this not lead to a disastrous depression for all firms? And how can a reduced consumption profitably support an increased volume of expenditures on producers’ goods? The latter has aptly been termed by Hayek the “paradox of saving,” i.e., that saving is the necessary and sufficient condition for increased production, and yet that such investment seems to contain within itself the seeds of financial disaster for the investors.6

If we observe the diagram in Figure 40 above, it is clear that the volume of money incomes to Capitalists1 will be drastically reduced. Capitalists1 will receive a total of 80 instead of 100 ounces. The amount that they have to apportion to original factors and to Capitalists2 is therefore also considerably decreased. Thus, from the side of final consumers’ spending, an impetus toward declining money incomes and prices is sent along the production structure. In the meanwhile, however, another force has concurrently come into play. The 20 ounces have not been lost to the system. They are in the process of being invested in the economy, their owners ranging throughout the economy looking for maximum interest returns on their investment. The new savings have changed the ratio of gross investment to consumption from 318:100 to 338:80. A “narrower” consumption base must support a larger amount of producers’ spending. How can this happen, especially since the lower-rank capitalists must also receive a lower aggregate income? The answer is: in only one way—by shifting investment further up the ladder to the higher-order production stages. Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages, while preserving uniform (lowered) interest differentials (cumulative price spreads) at each stage, is to increase the number of productive stages in the economy, i.e., to lengthen the structure of production. The impact of net saving on the economy, i.e., of increased total savings, is to lengthen and narrow the structure of production, and this procedure is viable and self-supporting, since it preserves essential price spreads from stage to stage. The diagram in Figure 60 illustrates the impact of net saving.

In this diagram we see the narrowing and the lengthening of the structure of production. The heavy line AA outlines the original structure. The bottom rectangle—consumption—is narrowed with the addition of new savings. As we go up in step-wise fashion—the steps in these diagrams accounting for the interest spreads7 —the new production structure BB (the shaded area) becomes relatively less and less narrow compared to the original structure, until it becomes wider in the upper registers, and finally adds new and higher stages.

The reader will notice that the steps (differentials between stages) in the new production structure BB are considerably narrower than the ones in AA. This is not an accident. If the steps in BB were of the same width as in AA, there would be no lengthening of the structure, and total investment would diminish instead of increase. But what is the significance of the narrowing steps in the structure? On the assumptions on which we have drawn the diagram, it is equivalent to a lowering of the interest spreads, i.e., a lowering of the natural rate of interest. But we have seen above that the consequence of lower time-preference rates in the society is precisely a lowering of the rate of interest. Thus, lowered time preferences mean an increased proportion of savings-investment to consumption and lead to smaller price spreads and an equivalent lowering of the rate of interest.

The lowering of interest spreads may be portrayed by another diagram, as in Figure 61.

In this diagram, cumulative prices are plotted against stages of production, and the further right we go, the lower the stage of production, until consumption is reached. AA is the original curve with the topmost dot representing the highest cumulative price—the one for the final product consumed. The dots next to the left are the lower cumulative prices of the higher stages, and the differences between the dots represent the interest spread and therefore the rate of interest return from stage to stage. BB is the curve applicable to the new situation, after saving has increased. Consumption has declined; hence the rightmost dot in B is lower than the one in A, and the arrow depicts the change.

The point next to the left on the BB curve is, of course, lower than the rightmost dot, but lower by a smaller amount than the corresponding dot in AA, because the lower interest rate signifies a smaller spread between the cumulative prices of the two stages. The next dot to the left, having the same rate of interest return, will be on approximately the same slope. Therefore, since the BB curve is flatter than the AA curve—because of the lower interest spread—it crosses the AA curve and from that point leftward, i.e., in the higher productive stages, its prices are higher than A‘s. Arrows depict this change as well.

In Figure 60 we saw the effect of additional saving, i.e., positive net savings, on the structure of production and on the rate of interest. Here we see that the change in the rate of interest lessens the spreads of cumulative prices, so that aggregate consumption is lower, the immediate next higher stages are less and less lower, until the lines cross, and the prices in the higher stages are higher than before. 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 of the factors in these stages. It is as if the impact of 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.

The process of readjustment to lower price spreads caused by increased gross saving has been lucidly described by Hayek. As he states:

The final effect will be that, through the fall of prices in the later stages of production and the rise of prices in the earlier stages of production, price margins between the different stages of production will have decreased all round.8

The changes in cumulative prices in the various sectors will lead to changes in the prices of the particular goods that enter into the cumulation of factors. These factors are, of course, the capital goods, land, and labor factors, and are ultimately reducible to the latter two, since capital goods are produced (and reproduced) factors. It is clear that lower aggregate demand in the lower stages will cause the prices of the various factors there to decline. The specific factors will have to bear the brunt of the decline, since they have nowhere else to go. The nonspecific factors, on the other hand, can and do go else-where—to the earlier stages, where the monetary demand for factors has increased.

The pricing of capital goods is ultimately unimportant in this connection, because it is reducible to the prices of land, labor, and time, and because the slopes of the curves, the interest spread, indicate the mode of pricing of the capital goods. The ultimately important factors, then, are land, labor, and time. The time element has been extensively considered and accounts for the interest spread. It is the land and labor elements that constitute the fundamental resources being shifted or remaining in production. Some land is specific and some nonspecific; some can be used in several alternative types of productive processes; some can be used in only one type. Labor, on the other hand, is almost always nonspecific; very rare indeed is the person who could conceivably perform only one type of task.9 Of course, there are different degrees of nonspecificity for any factor, and the less specific ones will be more readily shifted from one stage or product to another.

Those factors which are specific to only one particular stage and process will therefore fall in price in the later stages and rise in the earlier stages. What of the nonspecific factors, which include all labor factors? These will tend to shift from the later to the earlier stages. At first, there will be a difference in the price of each nonspecific factor; it will be lower in the lower stages and higher in the higher stages. In equilibrium, however, as we have seen time and again, there must be a uniform price for any factor throughout the economy. The lower demand in the lower stages, and the consequent lower price, coupled with the higher demand and higher price in the higher stages, causes the shift of the factor from later to earlier stages. The shift ceases when the price of the factor is again uniform throughout.

We have seen the impact of new saving, i.e., a shift from consumption to investment, on the prices of goods at various levels. What, however, is the aggregate impact of a change to a higher level of gross savings on the prices of factors? Here we reach a paradoxical situation. Net income is the total amount of money that ultimately goes to factors: land, labor, and time. In any equilibrium situation, net saving is zero by definition (since net saving means a change in the level of gross saving over the previous period of time), and net income equals consumption and consumption alone. If we look again at Figure 41 above, we see that the total income for original factors and interest can come only from net, rather than gross, income. Let us consider the new ERE after the change has taken place to a higher level of saving (ignoring for a moment the relevant conditions during the period of change). Gross savings = gross investment has increased from 318 to 338. But consumption has declined from 100 to 80, and it is consumption that provides the net income in the equilibrium situation. Net income is, as it were, the “fund” out of which money prices and incomes are paid to original factors. And this fund has declined.

The recipients of the net income fund are the original factors (labor and land) and interest on time. We know that the interest rate declines; this is a corollary of the increased saving and investment in the productive system, caused by lowered time preference. However, the absolute amount of interest income is gross investment multiplied by the rate of interest. Gross investment has increased, so that it is impossible for economic analysis to determine whether interest income has fallen, increased, or remained the same. Any of these alternatives is a possibility.

What happens to total original-factor income is also indeterminate. Two forces are pulling different ways in a progressing economy (an economy with increasing gross investment). On the one hand, the total net income money fund is falling; on the other hand, if the interest decline is large enough, it is possible that the fall in interest income will outstrip the fall in total net income, so that total factor income actually increases. For this to occur is possible but empirically highly unlikely.

The one certain prospect is that total net income for factors and interest will fall. If the total original-factor income falls, then, since we have implicitly been assuming a given supply of original factors, the prices of these factors, as well as the interest rate, will “in general” also decline.

That the general trend of original-factor incomes and prices may well be downward is a startling conclusion, for it is difficult to conceive of a progressing economy as one in which factor prices, such as wage rates and ground rents, steadily decline. What interests us, however, is not the course of money incomes and prices of factors, but of real incomes and prices, i.e., the “goods-income” accruing to factors. If money wage rates or wage incomes fall, and the supply of consumers’ goods increases such that the prices of these goods fall even more, the result is a rise in “real” wage rates and “real incomes” to factors. That this is precisely what does happen solves the paradox that a progressing economy experiences falling wages and rents. There may be a fall in money terms (although not in all conceivable cases); but there will always be a rise in real terms.

The rise in real rates and incomes is due to the increase in the marginal physical productivity of factors that always results from an increase in saving and investment.10 The increased productivity of the longer production processes leads to a greater physical supply of capital goods, and, most important, of consumers’ goods, with a consequent fall in the prices of consumers’ goods. As a result, even if the money prices of labor and land fall, those of consumers’ goods will always fall farther, so that real factor incomes will rise. That this is always true in a progressing economy can be seen from the following considerations.

At any time, the wage or rent of the service of an original factor of production will equal its DMVP, the discounted marginal value product. This DMVP is equal to the MVP (marginal value product) divided by a discount factor, say d, which is directly dependent on the rate of interest. The MVP, in turn, is approximately equal to the MPP (marginal physical product) of the factor times the selling price, i.e., the final price of the consumers’ good product. Hence,

In this discussion, we are considering the prices of consumers’ goods “in general” or in the aggregate. The “real” prices of the original factors equal the money prices divided by the prices of consumers’ goods. Strictly, there is no precise praxeological way of measuring these aggregates, or “real” income, based on changes in the purchasing power of money, but we can make qualitative statements about these elements even though we cannot make precise quantitative measurements.

The P‘s cancel, and the result:

Now the progressing economy consists of two leading features: an increase in the MPP of original factors resulting from more productive and longer production processes, and a fall in the discount or interest rate concomitant with falling time preference and increasing gross investment. Both elements—the increase in MPP and the fall in d—impel an increase in the real prices of factor services in a progressing economy.

The conclusion is that in a progressing economy, i.e., in an economy with increases in gross savings and investment, money wages and ground rents may well fall, but real wages and rents will rise.11

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 investment goes into increasing the number of stages, pushing back the stages of production and employing longer production processes. It is this increasing “roundabout-ness” that causes every increase in capital—even if unaccompanied by an advance in technological knowledge—to lead to higher physical productivity per original factor. The increase in gross investment, in particular, raises the prices of capital goods at the highest stages, encouraging new stages and inducing entrepreneurs to shift factors into this new and flowering field. 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.12

• 5Hayek, Prices and Production, pp. 48–49.
• 6See Hayek, “The ‘Paradox’ of Saving” in Profits, Interest, and Investment, pp. 199–263.
• 7This production structure diagram differs from our usual ones; it presents both the capital structure and the payment to owners of original factors as amalgamated in the same bar, to represent total investment at each stage. The steps in the diagram, then, represent the interest spreads to the capitalists (in rough, not exact, fashion).
• 8Hayek, Prices and Production, pp. 75–76.
• 9Of course, the productivity of a labor factor will differ from one task to another. No one disputes this; indeed, if this were not so, the factor would be purely nonspecific, and we have seen that this is an impossibility. “Specific” is here used to mean pure specificity for one production process.
• 10See below for discussion of this point.
• 11Historically, the advancing capitalist economy has coincided with an expanding money supply, so that we have rarely had an empirical illustration of the above “pure” process described in the text. We must remember that we have throughout been making the implicit assumption that the “money relation”—the demand for, and particularly the supply of, money—remains unchanged. Effects of changes in this relation will be considered in chapter 11. The only relaxation of this assumption here is that the number of stages increases, and this tends to increase the demand for money to that extent.
• 12The demand for money increases to the extent that each gold unit must “turn over” more times in the increased number of stages, thus tending to lower the “general level” of prices.

Net saving, as we have seen, increases gross investment in the economy. This increase in gross investment at first accrues as profits to the firms doing the increased business. These profits will accrue particularly in the higher stages, toward which old capital is shifting and in which new capital is invested. An accrual of profits to a firm increases, by that amount, the capital value of its assets, just as the losses decrease the capital value. The first impact of the new investment, then, is to cause aggregate profits to appear in the economy, concentrated in the new production processes in the higher stages. As the transition to the new ERE begins to take place, however, these profits more and more become imputed to the factors for which these entrepreneurs must pay in production. Eventually, if no other interfering changes occur, the result will be a disappearance of profits in the economy, a settling into the new ERE, an increase in real wages and other real rents, and an increase in the real capital value of ground land. This latter result, of course, is in perfect conformity with the previous conclusion that a progressing economy will lead to an increase in the real rents of ground land and a fall in the rate of interest. These two factors, in conjunction, both impel a rise in the real capital value of ground land.

Future rises in the real values of rents can be either anticipated or not anticipated. To the extent that they are anticipated, the rise in future rents is already accounted for, and discounted, in the capital value of the whole land. A rise in the far future may be anticipated, but will have no appreciable effect on the present price of land, simply because time preference places a very distant date beyond the effective “time horizon” of the present. To the extent that rises in the real rate are not foreseen, then, of course, entrepreneurial errors have been made, and the market has undercapitalized in the present price.13 Throughout the whole history of landholding, therefore, income from basic land can be earned in only three ways (we are omitting improving the land): (1) through entrepreneurial profit in correcting the forecasting errors of others; (2) as interest return; or (3) by a rise in the capital value to the first finder and user of the land.

The first type of income is obvious and not unique. It is pervasive in any field of enterprise. The second type of income is the general income earned by ground land. Because of the market phenomenon of capitalization, income from ground land is largely interest return on investment, just as in any other business. The only unique component of income that ground land confers, therefore, is (3), accruing to the first user, whose land value began at zero and became positive. After that, the buyer of the land must pay its capitalized value. To earn rent on ground land, in other words, a man must either buy it or find it, and in the former case he earns only interest, and not pure rent. The capitalized value can increase from time to time and not be discounted in advance only if some new and unexpected development occurs (or if better knowledge of the future comes to light), in which case the previous owner has suffered an entrepreneurial loss in profit forgone for not having anticipated the new situation, and the current owner earns an entrepreneurial profit.

The only unique aspect to ground land, then, is that it is found and first put on the market at some particular time, so that the first user earns pure rent as a result of his initial discovery and use of the land. All later increases in the capital value of the land are accounted for in the value, either as entrepreneurial profits resulting from better forecasting or as interest return.

The first user earns his gain only at first and not at whatever later date he actually sells the land. After the capital value has increased, his refusal to sell the land involves an opportunity cost—the forgone utility of selling the land for its capital value. Therefore, his true gain was reaped earlier, when the capital value of his land increased, and not at the later date when he “took” his gain in the form of money.

If we set aside uncertainty and entrepreneurial profits for a moment, and assume the highly unlikely condition that all future changes can be anticipated correctly by the market,14 then all future increases in the value of ground rents will be capitalized back into the land when it is first found and put into use. The first finder will reap the net gain immediately, and from then on all that will be earned by him and by successive heirs or purchasers is the usual interest return. When future rises are too remote to enter into the capitalized price, this is simply a phenomenon of time preference, not a sign of some mysterious breakdown in the market’s process of adjustment. The fact that complete discounting never takes place is due to the presence of uncertainty, and the result is a continual accretion of entrepreneurial gains through rising capital values of land.

Thus, we see, this time from the landowner’s point of view, that aggregate gains in capital value are synonymous with aggregate profits. Aggregate profits begin with the higher-order firms, then filter down until they increase real wages and the aggregate profits of landowners, particularly owners of land specific to the higher-order stages of production. (Land specific to the lower stages will, of course, bear the brunt of decreases in capital value, i.e., losses, in the progressing economy.)

As the only income to ground land that is not profit or interest, we are left with the original gains to the first finder of land. But, here again, there is capitalization and not a pure gain. Pioneering—finding new land, i.e., new natural resources—is a business like any other. Investing in it takes capital, labor, and entrepreneurial ability. The expected rents of finding and using are taken into account when the investments and expenses of exploration and shaping into use are made. Therefore, these gains are also capitalized backward in the original investment, and the tendency will be for them too to be the usual interest return on the investment. Deviations from this return will constitute entrepreneurial profits and losses. Therefore, we conclude that there is practically nothing unique about incomes from ground land and that all net income in the productive system goes to wages, to interest, and to profit.

A progressive economy is marked by aggregate net profits. When there is a shift from one savings-investment level to a higher one (therefore, a progressing economy), aggregate profits are earned in the economy, particularly in the higher stages of production. The increased gross investment first increases the aggregate capital value of firms that earn net profits. As production and investment increase in the higher stages, and the effects of the new saving continue, the profits disappear and become imputed to increases in real wage rates and in real ground rents. The latter effect, added to a fall in the rate of interest, leads to a rise in the real capital values of ground land.

What happens when there is a shift in the reverse direction—a changed proportion such that gross saving and investment decline and consumption increases? For the most part, we may simply trace the above analysis in reverse—that is, consider the shift from a 338:80 situation to a 318:100 situation. During the transition to a new equilibrium, there would be a net dissaving of 20 ounces, since gross saving decreases from 338 to 318. There would also be a net disinvestment of the same amount. The cause of such a shift would be an increase in the time-preference schedules of the individuals on the market. This would increase the rate of interest and widen the interest spread between cumulative prices in the production stages. It would broaden the consumption base, but leave less money available for saving and investment. We may simply reverse the diagrams above and consider the reverse shift, e.g., to a shorter and wider structure of production, to a steeper price curve with a smaller number of productive stages. The interest spread goes up, but the investment base declines. There would be higher prices for consumers’ goods and therefore a greater demand for factors in this and other lower stages; on the other hand, there would be general abandonment of the higher stages in the face of the monetary attractions of the later stages, the decline in investment funds, and the shift of these funds from the higher to the lower stages. Specific factors will bear the brunt of lowered incomes and sheer abandonment in the higher stages, and they will gain in the lower stages.

There will be a rise in net income and consumption, in monetary terms, and therefore a rise in aggregate factor income. The interest rate increases, while the gross investment base declines. In real terms the important result is a lowering in the physical productivity of labor (and of land) because of the abandonment of the most productive processes of production—the lengthiest ones. The lower output at every stage, the lower supply of capital goods, and the consequent lower output of consumers’ goods leads to a lowering in the “standard of living.” Money wage rates and money rents may rise (although this possibly might not occur because of the higher interest rate), but the prices of consumers’ goods will rise further because of the reduced physical supply of goods.15

The case of decreasing gross capital investment is defined as a retrogressing economy.16 The decreased investment is first revealed as aggregate losses in the economy, particularly losses to firms in the highest stages of production, the firms which are now losing customers. As time proceeds, these losses will tend to disappear, as firms leave the industry and abandon the now unprofitable production processes. The losses will thereby be imputed to factors in the form of lower real wage rates and lower real rents, which, combined with a higher interest rate, cause lower real capital values of ground land. Particularly hard hit will be the factors specific to these lines of production.

The reason why there are aggregate profits in the progressing economy and aggregate losses in the retrogressing economy, may be demonstrated in the following way. For profits to appear, there must be undercapitalization, or overdiscounting, of productive factors on the market. For losses to appear, there must be overcapitalization, or underdiscounting, of factors on the market. But if the economy is stationary, i.e., if from one period to another the total gross investment remains constant, the total value of capital remains constant. There might be an increase of investment in one line of production, but this is made possible only by a decrease elsewhere. Aggregate capital values remain constant, and therefore any profits (the result of mistaken undercapitalization) must be offset by equal losses (the result of mistaken overcapitalization). In the progressing economy, on the other hand, there are additional investment funds made available through new savings, and this provides a source for new revenue not yet capitalized anywhere in the system. These constitute the aggregate net profits during this period of change. In the retrogressing economy, investment funds are lowered, and this leaves net areas of overcapitalization of factors in the economy. Their owners suffer aggregate net losses during this period of change.17

Thus, another conclusion of our analysis is that aggregate profits will equal aggregate losses in a stationary economy, i.e., profits and losses will equal zero. This stationary economy is not the same construct as the evenly rotating economy that has played such a large role in our analysis. In the stationary economy, uncertainty does not disappear and no unending constant round pervades all elements in the system. There is, in fact, only one constancy: total capital invested. Clearly, the stationary economy (like all other economies) tends to evolve into the ERE, given constant data. After a time, market forces will tend to eliminate all individual profits and losses as well as aggregate profits and losses.

We might pause here to consider briefly the old problem: Are “capital gains”—increases in capital value—income? If we fully realize that profits and capital gains, and losses and capital losses, are identical, the solution becomes clear. No one would exclude business profits from money income. The same should be true of capital gains. In the ERE, of course, there are neither capital gains nor capital losses.

Let us now return to the case of the retrogressing economy and a decrease in capital investment. The greater the shift from saving to consumption, the more drastic will the effects tend to be, and the greater the lowering of productivity and living standards. The fact that such shifts can and do happen serves to refute easily the fashionable assumption that our capital structure is, by some magical provision or hidden hand, permanently and eternally self-reproducing once it is built. No positive acts of saving by capitalists are deemed necessary to maintain it.18 ,19 The ruins of Rome are mute illustrations of the error of this assumption.20

Refusal to maintain the value of capital, i.e., the process of net dissaving, is known as consuming capital. Granting the impossibility of measuring the value of capital in society with any precision, this is still a highly important concept. “Consuming capital” means, of course, not “eating machines,” as some critics have scoffingly referred to it, but failing to maintain existing gross investment and the existing capital goods structure, using some of these funds instead for consumption expenditure.21

Professor Frank H. Knight has been the leader of the school of thought that assumes capital to be automatically permanent. Knight has contributed a great deal to economics in his analysis of profit theory and entrepreneurship, but his theories of capital and interest have misled a generation of American economists. Knight succinctly summed up his doctrine in an attack on the “Austrian” investment theory of Böhm-Bawerk and Hayek. Knight said that the latter involved two fallacies. One is that Böhm-Bawerk viewed production as the production of concrete goods, whereas “in reality, what is produced, and consumed, is services.” There is no real problem here, however. It is not to be denied—in fact it has been stressed herein—that goods are valued for their services. Yet it is also undeniable that the concrete capital goods structure must be produced before its services can be obtained. The second alleged correction, and here we come directly to the problem of capital consumption, is that “the production of any service includes the maintenance of things used in the process, and this includes reproduction of any which are used up ... really a detail of maintenance.”22 This is obviously incorrect. Services are yielded by things, at least in the cases relevant to our discussion, and they are produced through the using up of things, of capital goods. And this production does not necessarily “include” maintenance and reproduction. This alleged “detail” is a completely separate area of choice and involves the building up of more capital at a later date to replace the used-up capital.

The case of the retrogressing economy is our first example of what we may call a crisis situation. A crisis situation is one in which firms, in the aggregate, are suffering losses. The crisis aspect of the case is aggravated by a decline in production through the abandonment of the highest production stages. The troubles arose from “undersaving” and “underinvestment,” i.e., a shift in people’s values so that they do not now choose to save and invest enough to enable continuation of production processes begun in the past. We cannot simply be critical of this shift, however, since the people, given existing conditions, have decided voluntarily that their time preferences are higher, and that they wish to consume more proportionately at present, even at the cost of lowering future productivity.

Once an increase to a greater level of gross investment occurs, therefore, it is not maintained automatically. Producers have to maintain the gross investment, and this will be done only if their time preferences remain at the lower rates and they continue to be willing to save a greater proportion of gross monetary income. We have demonstrated, further, that this maintenance and further progress can take place without any increase in the money supply or other change in the money relation. Progress can occur, in fact, with falling prices of all products and factors.23

• 13For a view of capitalized gains similar to the one presented here, see Roy F. Harrod, Economic Essays (New York: Harcourt, Brace & Co., 1952), pp. 198–205.
• 14This is not the same as assuming an ERE, for in the ERE there are no changes to be foreseen.
• 15The rise in general money prices, in monetary terms, is accounted for by the decreased demand for money as a result of the lower number of stages for the monetary unit to “turn over” in.
• 16The definitions of the progressing and the retrogressing economy differ from those of Mises in Human Action. They are defined here as an increase or a decrease in capital in society, while Mises defines them as an increase or a decrease in total capital per person in the society. The present definitions focus on the analysis of saving and investment, population growth or decline being a very different phase of the subject. When we are making an historical “welfare” assessment of the conditions of the economy, however, the question of production per capita becomes important.
• 17It is possible that the changes in investment were anticipated in the market. To the extent that an increase or a decrease was anticipated, the aggregate profits or losses will accrue in the form of a gain in capital value before the actual change in investment takes place. Losses arise during retrogression because previously employed processes have to be abandoned. The fact that the highest stages, already begun, have to be abandoned is an indication that the shift was not fully anticipated by the producers.
• 18It is this assumption, coupled with a completely unjustifiable dichotomizing of “consumers’ goods industries” and “capital goods industries” (whereas, in fact, there are stages of capital goods leading to consumers’ goods, and not an arbitrary dichotomy) that is at the bottom of Nurkse’s criticism of the structure of production analysis. See Ragnar Nurkse, “The Schematic Representation of the Structure of Production,” Review of Economic Studies II (1935).
• 19The popular assumption now, in fact, is that a hidden hand somehow guarantees that capital will automatically increase continually, so that factor productivity will increase by “2–3 percent per year.”
• 20An illustration from modern times:
  Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures, she increased wages, she increased social benefits, she increased bank credits, she increased consumption. After all those achievements she was on the verge of ruin. (Fritz Machlup, “The Consumption of Capital in Austria,” Review of Economic Statistics II [1935], p. 19)
• 21It is often assumed that only depreciation funds for durable capital goods are available for capital consumption. But this overlooks a very large part of capital—so-called “circulation capital,” the less durable capital goods which pass quickly from one stage to another. As each stage receives funds from its sale of these or other goods, it is not necessary for the producer to continue to repurchase circulation capital. These funds too may be immediately spent on consumption. See Hayek, Pure Theory of Capital, pp. 47 ff., for a contrast between the correct and the fashionable approaches toward capital.
• 22Frank H. Knight, “Professor Hayek and the Theory of Investment,” Economic Journal, March, 1935, p. 85 n. Also see Knight, Risk, Uncertainty, and Profit, pp. xxxvii–xxxix.
• 23Very few writers have realized this. See Hayek, “The ‘Paradox’ of Saving,” pp. 214 ff., 253ff.

We have been demonstrating that investment lengthens the structure of production. Now we may consider some criticisms of this approach.

Böhm-Bawerk is the great founder of production-structure analysis, but unfortunately he left room for misinterpretation by identifying capital accumulation with adopting “more roundabout” methods of production. Thus, consider his famous example of the Crusoe who must first construct (and then maintain) a net if he wishes to catch more than the number of fish he can catch without any capital. Böhm-Bawerk stated: “The roundabout ways of capital are fruitful but long; they procure us more or better consumption goods, but only at a later period of time.”24 Calling these methods “roundabout” is definitely paradoxical; for do we not know that men strive always to achieve their ends in the most direct and shortest manner possible? As Mises demonstrates, rather than speak of the higher productivity of roundabout methods of production, “it is more appropriate to speak of the higher physical productivity of production processes requiring more time” (longer processes).25

Now let us suppose that we are confronted with an array of possible production processes, based on their physical productivities. We may also rank the processes in accordance with their length, i.e., in terms of the waiting time between the input of the resources and the yielding of the final product. The longer the waiting period between first input and final output, the greater the disutility, ceteris paribus, since more time must elapse before the satisfaction is attained.

The first processes to be used will be those most productive (in value and physically) and the shortest. No one has maintained that all long processes are more productive than all short processes.26 The point is, however, that all short and ultraproductive processes will be the first ones to be invested in and established. Given any present structure of production, a new investment will not be in a shorter process because the shorter, more productive process would have been chosen first.

As we have seen, there is only one way by which man can rise from the ultraprimitive level: through investment in capital. But this cannot be accomplished through short processes, since the short processes for producing the most valuable goods will be the ones first adopted. Any increase in capital goods can serve only to lengthen the structure, i.e., to enable the adoption of longer and longer productive processes. Men will invest in longer processes more productive than the ones previously adopted. They will be more productive in two ways: (1) by producing more of a previously produced good, and/or (2) by producing a new good that could not have been produced at all by the shorter processes. Within this framework these longer processes are the most direct that must be used to attain the goal—not more roundabout. Thus, if Crusoe can catch 10 fish per day directly without capital and can catch 100 fish per day with a net, building a net should not be considered as a “more roundabout method of catching fish,” but as the “most direct method for catching 100 fish a day.” Furthermore, no amount of labor and land without capital could enable a man to produce an automobile; for this a certain amount of capital is required. The production of the requisite amount of capital is the shortest and most direct method of obtaining an automobile.

Any new investment will therefore be in a longer and more productive method of production. Yet, if there were no time preference, the most productive methods would be invested in first, regardless of time, and an increase in capital would not cause more productive methods to be used. The existence of time preference acts as a brake on the use of the more productive but longer processes. Any state of equilibrium will be based on the time-preference, or pure interest, rate, and this rate will determine the amount of savings and capital invested. It determines capital by imposing a limit on the length of the production processes and therefore on the maximum amount produced. A lowering of time preference, therefore, and a consequent lowering of the pure rate of interest signify that people are now more willing to wait for any given amount of future output, i.e., to invest more proportionately and in longer processes than heretofore. A rise in time preference and in the pure interest rate means that people are less willing to wait and will spend proportionately more on consumers’ goods and less on the longer production processes, so that investments in the longest processes will have to be abandoned.27

One qualification to the law that increased investment lengthens production processes appears when investment turns to a type of good which is less useful than the goods previously acquired, yet which has a shorter process of production than some of the others. Here the investment in this process was checked, not by the length of the process, but by its inferior (value) productivity. Yet even here the structure of production was lengthened, since people have to wait longer for the new and the old goods than they previously did for the old good. New capital investment always lengthens the overall structure of production.

What of the case where a technological invention permits a more productive process with a lesser amount of capital investment? Is this not a case in which increased investment shortens the production structure? Up to this point we have been assuming technological knowledge as given. Yet it is not given in the dynamic world. Technological advance is one of the most dramatic features of the world of change. What then of these “capital-saving” inventions? One interesting example was cited by Horace White in a criticism of Böhm-Bawerk.28 Oil was produced first by ships hunting in the Arctic for whales, the whale oil being processed from the whales, etc., an obviously lengthy production process. Later an invention permitted people to bore for oil in the ground, thereby immeasurably shortening the production period.

Aside from the fact that, empirically, most inventions do not shorten physical production processes, we must reply that the limits at any time on investment and productivity are a scarcity of saved capital, not the state of technological knowledge. In other words, there is always an unused shelf of technological projects available and idle. This is demonstrable by the fact that a new invention is not immediately and instantaneously adopted by all firms in the society. Therefore, any further investment will lengthen production processes, many of them more productive because of superior technique. A new invention does not automatically impel itself into production, but first joins the unused array. Further, in order for the new invention to be used, more capital must be invested. The ships for whaling have already been built; the oil wells and machinery, etc., must be created anew. Even the newly invented method will yield a greater product only through further investment in longer processes. In other words, the only way to obtain more oil now is to invest more capital in more machinery and lengthier production periods in the oil-drilling business. As Böhm-Bawerk pointed out, White’s criticism would apply only if the invention were progressively capital-saving, so that the product would always increase with the shortening of the process. But in that case, boring for oil with one’s bare hands, unaided by capital, would have to be more productive than drilling for oil with machinery.29

Böhm-Bawerk drew the analogy of an agricultural invention applied to two grades of land, one grade previously yielding a marginal product of 100 bushels of wheat, the lower grade yielding 80 bushels. Now suppose use of the invention raises the marginal product of the lower-grade land to 110 bushels. Does this mean that the poorer land now yields more than the fertile land and that the effect of agricultural inventions is to make poorer lands more productive than fertile ones? Yet this is precisely analogous to White’s position, which maintains that inventions may cause shorter production processes to be more productive! As Böhm-Bawerk pointed out, it is obvious that the source of the error is this: inventions increase the physical productivity of both grades of land. The better land becomes still better. Similarly, perhaps it is true that an invention will cause a shorter process to be more productive now than a longer process was previously. But this does not mean that it is superior to all longer processes; longer processes using the invention will still be more productive than the shorter ones. (Boring for oil with machinery is more productive than boring for oil without machinery.)

Technological inventions have received a far more important place than they deserve in economic theory. It has often been assumed that production is limited by the “state of the arts”—by technological knowledge—and therefore that any improvement in technology will immediately show itself in production. Technology does, of course, set a limit on production; no production process could be used at all without the technological knowledge of how to put it into operation. But while knowledge is a limit, capital is a narrower limit. It is logically obvious that while capital cannot engage in production beyond the limits of existing available knowledge, knowledge can and does exist without the capital necessary to put it to use. Technology and its improvement, therefore, play no direct role in the investment and production process; technology, while important, must always work through an investment of capital. As was stated above, even the most dramatic capital-saving invention, such as oil-drilling, can be put to use only by saving and investing capital.

The relative unimportance of technology in production as compared to the supply of saved capital becomes evident, as Mises points out, simply by looking at the “backward” or “underdeveloped” countries.30 What is lacking in these countries is not knowledge of Western technological methods (“know-how”); that is learned easily enough. The service of imparting knowledge, in person or in book form, can be paid for readily. What is lacking is the supply of saved capital needed to put the advanced methods into effect. The African peasant will gain little from looking at pictures of American tractors; what he lacks is the saved capital needed to purchase them. That is the important limit on his investment and on his production.31

A businessman’s new investment in a longer and more physically productive process will therefore be made from a sheaf of processes previously known but unusable because of the time-preference limitation. A lowering of time preferences and of the pure interest rate will signify an expansion of saved capital at the disposal of investors and therefore an expansion of the longer processes, the time limitation on investment having been weakened.

Some critics charge that not all net investment goes to lengthening the structure—that new investments might duplicate pre-existing processes. This criticism misfires, however, because our theory does not assume that net saving must be invested in an actually longer process in some specific line of production. A longer production structure can just as well be achieved by a shift from consumption to investment that will lengthen the aggregate production structure by greater investment in already existing longer processes, accompanied by less investment in existing shorter processes. Thus, in the case of Crusoe mentioned above, suppose that Crusoe now invests in a second net, which will permit him to catch a total of 150 fish a day. The structure of production is now lengthened even though the second net may be no more productive than the first. For the total period of production, from the time he must build and rebuild his total capital until his product arrives, is now considerably longer. He must now cut down again on present consumption (including leisure) and work on his second net.32

• 24Böhm-Bawerk, Positive Theory of Capital, p. 82.
• 25Mises, Human Action, pp. 478–79.
• 26See Hayek, Pure Theory of Capital, pp. 60 ff. Similarly, there are numerous long processes which are not productive at all or which are less productive than shorter processes. These longer processes will obviously not be chosen at all. In sum, while all new investment will be in longer processes, it certainly does not follow that all longer processes are more productive and therefore worthy of investment. For Böhm-Bawerk’s strictures on this point, see Eugen von Böhm-Bawerk, Capital and Interest, Vol. 3: Further Essays on Capital and Interest (South Holland, Ill.: Libertarian Press, 1959), p. 2.
• 27It should be clear that, as Mises lucidly put it,
  Originary [pure] interest is not a price determined on the market by the interplay of the demand for and the supply of capital or capital goods. Its height does not depend on the extent of this demand and supply. It is rather the rate of originary interest that determines both the demand for and the supply of capital and capital goods. It determines how much of the available supply of goods is to be devoted to consumption in the immediate future and how much to provision for remoter periods of the future. (Mises, Human Action, pp. 523–24)
• 28Eugen von Böhm-Bawerk, “The Positive Theory of Capital and Its Critics, Part III,” Quarterly Journal of Economics, January, 1896, pp. 121–35. See also idem, Further Essays on Capital and Interest, pp. 31ff.
• 29Böhm-Bawerk, “The Positive Theory of Capital and Its Critics, Part III,” pp. 128 ff.
• 30Mises, Human Action, pp. 492ff.
• 31The futility of “Point 4” and “technical assistance” in furthering production in the backward countries should be evident from this discussion. As Böhm-Bawerk commented, in discussing advanced techniques: “There are always thousands of persons who know of the existence of the machines, who would be glad to secure the advantage of their use, but who do not dispose of the capital necessary for their purchase.” Böhm-Bawerk, “The Positive Theory of Capital and Its Critics, Part III,” p. 127. See also idem, Further Essays on Capital and Interest, pp. 4–10.
• 32As Hayek states:
  It is frequently supposed that all increases in the quantity of capital per head ... 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. ... 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, Pure Theory of Capital, pp. 77–78)Also see Hayek, Prices and Production, p. 77, and Böhm-Bawerk, Further Essays on Capital and Interest, pp. 57–71.

At any given time, then, there will be a shelf of available and more productive techniques that remain unused by many firms continuing with older methods. What determines the extent to which these firms adopt new and more productive techniques?

The reason that firms do not scrap their old methods immediately and begin afresh is that they and their ancestors have invested in a certain structure of capital goods. As times and tastes, resources, and techniques change, much of this capital investment becomes an ex post entrepreneurial error. If, in other words, investors had been able to foresee the changed pattern of values and methods, they would have invested in a far different manner. Now, however, the investment has been made, and the resulting capital structure is a given residue from the past that supplies the resources they have to work with. Since costs in the present are only present and future opportunities forgone, and bygones are bygones, existing equipment must be used in the most profitable way. Thus, there undoubtedly would have been far less investment in railroads in late nineteenth-century America if investors had foreseen the rise of truck and plane competition.33 Now that the existing railroad equipment remains, however, decisions concerning how much of it is to be used must be based on current and expected future costs, not on past expenses or losses.

An old machine will be scrapped for a new and better substitute if the superiority of the new machine or method is great enough to compensate for the additional expenditure necessary to purchase the machine. The same applies to the shifting of a plant from an old location to a superior new location (superior because of greater access to factors or consumers). At any rate, the adoption of new techniques or locations is limited by the usefulness of the already given (and specific) capital-goods structure. This means that those processes and methods will be adopted at any time which will best satisfy the desires of the consumers. The fact that investment in a new technique or location is unprofitable means that the use of capital in the new process at the cost of scrapping the old equipment is a waste from the point of view of satisfying consumer wants. How fast equipment or location is scrapped as obsolescent, then, is not decided arbitrarily by businessmen; it is determined by the values and desires of consumers, who decide on the price and profitability of the various goods and on the values of the necessary nonspecific factors used to produce these goods.34

As is often true, critics of the free market have attacked it from two contradictory points of view: one, that it unduly slows down the rate of technological improvement from what it could and should be; and, two, that it unduly accelerates the rate of technological improvement, thereby unsettling the peaceful course of society. We have seen that a free market will, as far as the knowledge and foresight of entrepreneurs permit, produce so that factors are best allocated to satisfy the wishes of consumers. Improvement in productivity through new techniques and locations will be balanced against the opportunity costs forgone in value product from using the existing old plant.35 And ability in entrepreneurial foresight will be assured as much as possible by the market’s process of “selection” in “rewarding” good forecasters and “penalizing” poor ones proportionately.

THE ENTREPRENEUR AND INNOVATION

Under the stimulus of the late Professor Schumpeter, it has been thought that the essence of entrepreneurship is innovation—the disturbance of peaceful, unchanging business routine by bold innovators who institute new methods and develop new products. There is, of course, no denying the importance of the discovery and institution of more productive methods of obtaining a product or of the development of valuable new products. Analytically, however, there is danger of overrating the importance of this process. For innovation is only one of the activities performed by the entrepreneur. As we have seen above, most entrepreneurs are not innovators, but are in the process of investing capital within a large framework of available technological opportunities. Supply of product is limited by supply of capital goods rather than by available technological know-how.

Entrepreneurial activities are derived from the presence of uncertainty. The entrepreneur is an adjuster of the discrepancies of the market toward greater satisfaction of the desires of the consumers. When he innovates he is also an adjuster, since he is adjusting the discrepancies of the market as they present themselves in the potential of a new method or product. In other words, if the ruling rate of (natural) interest return is 5 percent, and a business man estimates that he could earn 10 percent by instituting a new process or product, then he has, as in other cases, discovered a discrepancy in the market and sets about correcting it. By launching and producing more of the new process, he is pursuing the entrepreneurial function of adjustment to consumer desires, i.e., what he estimates consumer desires will be. If he succeeds in his estimate and reaps a profit, then he and others will continue in this line of activity until the income discrepancy is eliminated and there is no “pure” profit or loss in this area.

• 33And if there had been fewer land grants and other governmental subsidies to railroads! Thus, see E. Renshaw, “Utility Regulation: A Re-examination,” Journal of Business, October, 1958, pp. 339–40.
• 34See Mises, Human Action:
  The fact that not every technological improvement is instantly applied in the whole field is not more conspicuous than the fact that not everyone throws away his old car or his old clothes as soon as a better car is on the market or new patterns become fashionable. (p. 504) Also see ibid., pp. 502–10. Specifically, the old equipment will continue in use as long as its operating costs are lower than the total costs of installing the new equipment. If, in addition, total costs (including replacement costs for wear and tear on capital goods) are greater for the old equipment, then the firm will gradually abandon old equipment as it wears out and will invest in the new technique. For an extensive discussion, see Hayek, Pure Theory of Capital, pp. 310–20.
• 35“Technocrats” condemn the market for rewarding investments according to their (marginal) value-productivity instead of their (marginal) physical productivity. But we see here an excellent example of a technique more physically productive but less value-productive, and for a very good reason: that the given specific capital goods already produced lend an advantage to the old technique, so that “out-of-pocket” operating costs of the old technique are lower, until the equipment wears out, than total costs for the new project. Consumers are benefited by continuing the old techniques while they remain profitable, for then factors are spared for more valuable production elsewhere.

We have seen that an increase in saving and investment causes an increase in the real incomes of owners of labor and land factors. The latter is reflected in increases in the capital value of ground lands. The benefits to land factors, however, accrue only to particular lands. Other lands may lose in value, although there is an aggregate gain. This is so because usually lands are relatively specific factors. For the nonspecific factor par excellence, namely, labor, there is, on the contrary, a very general rise in real wages. These laborers are “external beneficiaries” of increased investment, i.e., they are beneficiaries of the actions of others without paying for these benefits. What benefits do the investors themselves acquire? In the long run, they are not great. In fact, their rate of interest return is reduced. This is not a loss, however, since it is the outcome of their changed time preferences. Their real interest return may well be increased, in fact, since the fall in the interest rate may be offset by the rise in the purchasing power of the monetary unit in an expanding economy.

The main benefits gained by the investors, therefore, are short-run entrepreneurial profits. These are earned by investors who see a profit to be gained by investing in a certain area. After a while, the profits tend to disappear as more investors enter this field, although changing data are always presenting new profit opportunities to enterprising investors. But the short-run benefits earned by the workers and landowners are more certain. The entrepreneur-capitalists take the risks of speculating on the uncertain market; their investment may result in profits, in breaking even with no profits at all, or in suffering outright losses. No one can guarantee profits to them.36 Aggregate new investment will result in aggregate net profits, to be sure, but no one can predict with certainty in what areas the profits will appear. On the other hand, the workers and landowners in the fields of new investment gain immediately, as new investment bids up wages and rents in the longer processes. They gain even if the investment turns out to have been uneconomic and unprofitable. For in that case, the error in satisfying consumers is borne by the heavy losses of the capitalist-entrepreneurs. In the meanwhile, the workers and landowners have reaped a gain. This is hardly a clear gain, however, since consumers have, as a whole, suffered in real income through entrepreneurial error in producing the wrong kind of goods. Yet it is obvious that the brunt of the loss from making the error is suffered by the entrepreneurs.

• 36As will be seen below, actuarial risks can be “insured” against, but not the entrepreneurial uncertainty of the market.

It is clear that a feature of the progressing economy must necessarily be a fall in the pure rate of interest. We have seen that in order for more capital to be invested, there must be a fall in the pure rate of interest, reflecting general declines in time preferences. If the pure rate remains the same, this is an indication that there will be no new investment or disinvestment, that time preferences are generally stable, and that the economy is stationary. A fall in the pure rate of interest is a corollary of a drop in time preferences and a rise in gross investment. A rise in the pure rate of interest is a corollary of a rise in time preferences and net disinvestment. Hence, for the economy to keep advancing, time preferences and the pure rate of interest must continue to fall. If the pure rate of interest remains the same, capital will only just be maintained at its same real level.

Since praxeology never establishes quantitative laws, there is no way by which we can determine any sort of quantitative relation between changes in the pure rate of interest and the amount that capital will change. All we can assert is the qualitative relation.

It should be noticed what we are not saying. We are not asserting that the pure rate of interest is determined by the quantity or value of capital goods available. We are not concluding, therefore, that an increase in the quantity or value of capital goods lowers the pure rate of interest because interest is the “price of capital” (or for any other reason). On the contrary, we are asserting precisely the reverse: namely, that a lower pure rate of interest increases the quantity and value of capital goods available. The causative principle is just the other way round from what is commonly believed. The pure rate of interest, then, can change at any time and is determined by time preferences. If it is lowered, the stock of invested capital will increase; if it is raised, the stock of invested capital will fall.

That a change in the pure rate of interest has an inverse effect on the stock of capital is discovered by deduction from accepted axioms and not inferred from uncertain and complex empirical data.37 The law is not deduced, for example, by observing that the market rate of interest in backward nations is higher than in advanced nations. It is clear that this phenomenon is at least partly due to the higher entrepreneurial risk component in the backward countries and is not necessarily caused by differences in the pure rate of interest.

• 37It is evident that Mises’ strictures in Human Action, p. 530, apply to the doctrine that the quantity of capital determines the pure rate of interest, and not to the present argument.

In the ERE, as we have seen, the interest rate throughout the economy will be uniform. In the real world there is an additional entrepreneurial (or “risk”) component, which adds to the interest rate in particularly risky ventures, and in accordance with the degree of risk. (Since “risk” has an actuarially “certain” connotation, we may better call it “degree of uncertainty.”) Thus, suppose that the basic social time-preference rate, or pure rate of interest, in the economy is 5 percent. Capitalists will buy 100 ounces of future goods to sell less remotely future goods one year later at 105 ounces. Thus, a 5-percent return is a “pure” return, i.e., it is the return assuming that the 105 ounces will definitely be accruing. The pure rate, in other words, abstracts from any entrepreneurial uncertainty. It gauges the premium of present over future goods on the assumption that the future goods are known as certain to be forthcoming.

In the real world, of course, nothing is absolutely certain, and therefore the pure rate of interest (the result of time preference) can never appear alone. Now suppose that in one particular venture or industry it is fairly certain that 105 ounces will be earned from the sale of a product one year in the future. Then, with a social time preference rate of 5 percent, the capitalist-entrepreneurs will be willing to pay 100 ounces for factors and reap a 5-percent return. But suppose that there is another possible venture considered very risky by entrepreneurs. The product is expected to sell for 105 ounces, but there are definite possibilities that the price of the product might plummet. In that case, the entrepreneurs will not be willing to pay 100 ounces for factors. They would have to be compensated for the extra risks that they run; the price of the factors might finally be 90 ounces. Thus, the riskier a given venture appears ex ante, the higher will be the expected interest return that capitalists will require before they make the investment.

On the market, then, a whole structure of interest rates will be superimposed on the pure rate, varying positively in accordance with the expected risks of each venture. The counterpart of this structure will be a similar variety of interest rates on the loan market, which, as usual, is derivative from the goods market.38 In the long run, of course, the tendency, given no changes of data, will be for people to realize that such and such a venture is pretty consistently yielding a higher than 5-percent return. The risk component for this venture will then fall, other entrepreneurs will enter this type of venture, and the interest rate will tend to fall back to 5 percent again. Thus, the varying risk structure of interest does not invalidate the tendency toward uniformity of the interest rate. On the contrary, any variety is something of an index of the various “risks” of uncertainty which still remain in the market and which would be eliminated if data were frozen and an ERE were reached. If data did remain constant, then the uniformity of the ERE would ensue. It is because data are always changing and thus setting up new uncertainties in place of the old that we do not have the uniformity of the ERE.

• 38The loan market will diverge from the “natural” market to the extent that conditions for repayment of loans, etc., establish such differences. The two would be the same if the loans were clearly recognized as entrepreneurial, so that in cases where there was no deliberate fraud, the borrower would not be considered criminal if he did not repay the loan. However, if, as discussed in chapter 2 above, there are no bankruptcy laws and defaulting borrowers are considered criminal, then obviously the “safety” of all loans would increase in relation to “natural” investments, and the interest rates on loans would decline accordingly. In the free society, however, there would be nothing to prevent borrowers and lenders from agreeing, at the time the contract is made, that borrowers would not be held criminally responsible and that the loan would really be an entrepreneurial one. Or they could make any sort of arrangement in dividing gains or losses that they might choose.

Entrepreneurship deals with the inevitable uncertainty of the future. Some forms of uncertainty, however, can be converted into actuarial risk. The distinction between “risk” and “uncertainty” has been developed by Professor Knight.39 “Risk” occurs when an event is a member of a class of a large number of homogeneous events and there is fairly certain knowledge of the frequency of occurrence of this class of events. Thus, a firm may produce bolts and know from long experience that a certain almost fixed proportion of these bolts will be defective, say 1 percent. It will not know whether any given bolt will be defective, but it will know the proportion of the total number defective. This knowledge can convert the percentage of defects into a definite cost of the firm’s operations, especially where enough cases occur within a firm. In other situations, a given loss or hazard may be large and infrequent in relation to a firm’s operations (such as the risk of fire), but over a large number of firms it could be considered as a “measurable” or actuarial risk. In such situations, the firms themselves could pool their risks, or a specialized firm, an “insurance company,” could organize the pooling for them.

The principle of insurance is that firms or individuals are subject to risks which, in the aggregate, form a class of homogeneous cases. Thus, out of a class of a thousand firms, no one firm has any idea whether it will suffer a fire next year or not; but it is fairly well known that ten of them will. In that case, it may be advantageous for each of the firms to “take out insurance,” to pool their risks of loss. Each firm will pay a certain premium, which will go into a pool to compensate those firms which suffer the fires.

As a result of competition, the firm organizing the insurance service will tend to obtain the usual interest income on its investment, no more and no less.

The contrast between risk and uncertainty has been brilliantly analyzed by Ludwig von Mises. Mises has shown that they can be subsumed under the more general categories of “class probability” and “case probability.”40 “Class probability” is the only scientific use of the term “probability,” and is the only form of probability subject to numerical expression.41 In the tangled literature on probability, no one has defined class probability as cogently as Ludwig von Mises:

Class probability means: We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.42

Insurable risk is an example of class probability. The businessmen knew how many bolts would be defective out of a total number of bolts, but had no knowledge as to which particular bolts would be defective. In life insurance the mortality tables reveal the proportion of mortality of each age group in the population, but they tell nothing about the particular life expectancy of any given individual.

Insurance firms have their problems. As soon as something specific is known about individual cases, firms break down the cases into subaggregates in an effort to maintain homogeneity of classes, i.e., the similarity, as far as is known, of all individual members in the class with respect to the attribute in question. Thus, certain subgroups within one age group may have a higher mortality rate because of their occupation; these will be segregated, and different premiums applied to the two cases. If there were knowledge about differences between subgroups, and insurance firms charged the same premium rate to all, then this would mean that the healthy or “less risky” groups would be subsidizing the riskier. Unless they specifically desire to grant such subsidies, this result will never be maintained in the competitive free market. In the free market each homogeneous group will tend to pay premium rates in proportion to its actuarial risk, plus a sum for interest income and for necessary costs for the insurance firms.

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. Individuals or entrepreneurs know something about the outcome of the particular case, but not everything. As Mises defines it:

Case probability means: We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.43

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.”

It is not accurate to apply terms like “gambling” or “betting” to situations either of risk or of uncertainty. These terms have unfavorable emotional implications, and for this reason: they refer to situations where new risks or uncertainties are created for the enjoyment of the uncertainties themselves. Gambling on the throw of the dice and betting on horse races are examples of the deliberate creation by the bettor or gambler of new uncertainties which otherwise would not have existed.44 The entrepreneur, on the other hand, is not creating uncertainties for the fun of it. On the contrary, he tries to reduce them as much as possible. The uncertainties he confronts are already inherent in the market situation, indeed in the nature of human action; someone must deal with them, and he is the most skilled or willing candidate. In the same way, an operator of a gambling establishment or of a race track is not creating new risks; he is an entrepreneur trying to judge the situation on the market, and neither a gambler nor a bettor.

Profit and loss are the results of entrepreneurial uncertainty. Actuarial risk is converted into a cost of business operation and is not responsible for profits or losses except in so far as the actuarial estimates are erroneous.

• 39Knight, Risk, Uncertainty, and Profit, pp. 212–55, especially p. 233.
• 40Mises, Human Action, pp. 106–16, which also contains a discussion of the fallacies of the “calculus of probability” as applied to human action.
• 41See Richard von Mises, Probability, Statistics, and Truth (2nd ed.; New York: Macmillan & Co., 1957).
• 42Mises, Human Action, p. 107.
• 43Ibid., p. 110.
• 44There is a distinction between gambling and betting. Gambling refers to wagering on events of class probability, such as throws of dice, where there is no knowledge of the unique event. Betting refers to wagering on unique event about which both parties to the bet know something—such as a horse race or a Presidential election. In either case, however, the wagerer is creating a new risk or uncertainty.