Man, Economy, and State with Power and Market

Why does a man purchase a consumers’ good? As we saw back in chapter 1, a consumers’ good is desired and sought because the actor believes that it will serve to satisfy his urgently valued desires, that it will enable him to attain his valued ends. In other words, the good is valuable because of the expected services that it will provide. Tangible commodities, then, such as food, clothing, houses, etc., and intangible personal services, such as medical attention and concert performances, are similar in the life of the consumer. Both are evaluated by the consumer in terms of their services in providing him with satisfactions.

Every type of consumers’ good will yield a certain amount of services per unit of time. These may be called unit services. When they are exchangeable, these services may be sold individually. On the other hand, when a good is a physical commodity and is durable, it may be sold to the consumer in one piece, thereby embodying an expected future accrual of many unit services. What are the interrelations among the markets for, and prices of, the unit services and the durable good as a whole?

Other things being equal, it is obvious that a more durable good is more valuable than a less durable good, since it embodies more future unit services. Thus, suppose that there are two television sets, each identical in service to the viewer, but that A has an expected life of five years, and B of 10. Though the service is identical, B has twice as many services as A to offer the consumer. On the market, then, the price of B will tend to be twice the price of A.30

For nondurable goods, the problem of the separate sale of the service of the good and of the good itself does not arise. Since they embody services over a relatively short span of time, they are almost always sold as a whole. Butter, eggs, Wheaties, etc., are sold as a whole, embodying all their services. Few would think of “renting” eggs. Personal services, on the other hand, are never sold as a whole, since, on the free market, slave contracts are not enforceable. Thus, no one can purchase a doctor or a lawyer or a pianist for life, to perform services at will with no further payment. Personal services, then, are always sold in their individual units.

The problem whether services should be sold separately or with the good as a whole arises in the case of durable commodities, such as houses, pianos, tuxedos, television sets, etc. We have seen that goods are sold, not as a total class, e.g., “bread” or “eggs,” but in separate homogeneous units of their supply, such as “loaves of bread,” or “dozens of eggs.” In the present discussion, a good can be sold either as a complete physical unit—a house, a television set, etc.—or in service units over a period of time. This sale of service units of a durable good is called renting or renting out or hiring out the good. The price of the service unit is called the rent.

Since the good itself is only a bundle of expected service units, it is proper to base our analysis on the service unit. It is clear that the demand for, and the price of, a service unit of a consumers’ good will be determined on exactly the same principles as those set forth in the preceding analysis of this chapter.

A durable consumers’ good embodies service units as they will accrue over a period of time. Thus, suppose that a house is expected to have a life of 20 years. Assume that a year’s rental of the house has a market price, as determined by the market supply and demand schedules, of 10 ounces of gold. Now, what will be the market price of the house itself should it be sold? Since the annual rental price is 10 ounces (and if this rental is expected to continue), the buyer of the house will obtain what amounts to 20 × 10, or 200 ounces, of prospective rental income. The price of the house as a whole will tend inexorably to equal the present value of the 200 ounces. Let us assume for convenience at this point that there is no phenomenon of time preference and that the present value of 200 ounces is therefore equal to 200 ounces. In that case, the price of the house as a whole will tend to equal 200 ounces.

Suppose that the market price of the house as a whole is 180 ounces. In that case, there will be a rush to buy the house, since there is an expected monetary profit to be gained by purchasing for 180 ounces and then renting out for a total income of 200 ounces. This action is similar to speculative purchasers’ buying a good and expecting to resell at a higher price. On the other hand, there will be a great reluctance by the present owners of such houses (or of the house, if there is no other house adjudged by the market as the same good), to sell at that price, since it is far more profitable to rent it out than to sell it. Thus, under these conditions, there will be a considerable excess of demand over supply of this type of house for sale, at a price of 180 ounces. The upbidding of the excess demand tends to raise the price toward 200. On the other hand, suppose that the market price is above 200. In that case, there will be a paucity of demand to purchase, since it would be cheaper to pay rental for it instead of paying the sum to purchase it. On the contrary, possessors will be eager to sell the house rather than rent it out, since the price for sale is better. The excess supply over demand at a price over 200 will drive the price down to the equilibrium point.

Thus, while every type of market price is determined as in the foregoing sections of this chapter, the market also determines price relations. We see that there is a definite relationship between the price of the unit services of a durable consumers’ good and the price of the good as a whole. If that relationship is disturbed or does not apply at any particular time, the actions of individuals on the market will tend to establish it, because prospects of monetary gain arise until it is established, and action to obtain such gain inevitably tends to eliminate the opportunity. This is a case of “arbitrage” in the same sense as the establishment of one price for a good on the market. If two prices for one good exist, people will tend to rush to purchase in the cheaper market and sell more of the good in the more expensive market, until the play of supply and demand on each market establishes an “equilibrium” price and eliminates the arbitrage opportunity. In the case of the durable good and its services, there is an equilibrium-price relation, which the market tends to establish. The market price of the good as a whole is equal to the present value of the sum of its expected (future) rental incomes or rental prices.

The expected future rental incomes are, of course, not necessarily a simple extrapolation of present rental prices. Indeed, since prices are always changing, it will almost always be the case that rental prices will change in the future. When a person buys a durable good, he is buying its services for a length of time extending into the future; hence, he is more concerned with future than with present rates; he merely takes the latter as a possible guide to the future.31 Now, suppose that the individuals on the market generally estimate that rents for this house over the next decade or so will be much lower than at present. The price of the house then will not be 20 × 10 ounces, but some correspondingly smaller amount.

At this point, we shall define the “price of the good as whole” as its capital value on the market, even though there is risk of confusion with the concept of “capital good.” The capital value of any good (be it consumers’ or capital good or nature-given factor) is the money price which, as a durable good, it presently sells for on the market. The concept applies to durable goods, embodying future services.32 The capital value of a consumers’ good will tend to equal the present value of the sum of expected unit rentals.

The capital value at any time is based on expectations of future rental prices. What happens when these expectations are erroneous? Suppose, for example, that the market expects the rental prices of this house to increase in the next few years and therefore sets the capital value higher than 200 ounces. Suppose, further, that the rental prices actually decline instead. This means that the original capital value on the market had overestimated the rental income from the house. Those who had sold the house at, say, 250, have gained, while those who bought the house in order to rent it out have lost on the transaction. Thus, those who have forecast better than their fellows gain, while the poorer forecasters lose, as a result of their speculative transactions.

It is obvious that such monetary profits come not simply from correct forecasting, but from forecasting more correctly than other individuals. If all the individuals had forecast correctly, then the original capital value would have been below 200, say, 150, to account for the eventually lower rental prices. In that case no such monetary profit would have appeared.33 It should be clear that the gains or losses are the consequences of the freely undertaken action of the gainers and losers themselves. The man who has bought a good to rent out at what proves to be an excessive capital value has only himself to blame for being overly-optimistic about the monetary return on his investment. The man who sells at a capital value higher than the eventual rental income is rewarded for his sagacity through decisions voluntarily taken by all parties. And since successful forecasters are, in effect, rewarded, and poor ones penalized, and in proportion to good and poor judgment respectively, the market tends to establish and maintain as high a quality of forecasting as is humanly possible to achieve.

The equilibrium relation between the capital value on the market and the sum of expected future rents is a day-to-day equilibrium that tends always to be set by the market. It is similar to the day-to-day market equilibrium price for a good set by supply and demand. On the other hand, the equilibrium relation between present capital value and actual future rents is only a long-range tendency fostered by the market’s encouragement of successful forecasters. This relation is a final equilibrium, similar to the final equilibrium prices that set the goal toward which the day-to-day prices tend.

Study of capital value and rental prices requires additional supply-demand analysis. The determination of the unit rental price presents no problem. Price determination of the capital value, however, needs to be modified to account for this dependence on, and relationship to, the rental price. The demand for the durable good will now be, not only for direct use, but also, on the part of others, demand for investment in future renting out. If a man feels that the market price of the capital value of a good is lower than the income he can obtain from future rentals, he will purchase the good and enter the renting-out market as a supplier. Similarly, the reserved demand for the good as a whole will be not only for direct use or for speculative price increases, but also for future renting out of the good. If the possessor of a durable good believes that the selling price (capital value) is lower than what he can get in rents, he will reserve the supply and rent out the good. The capital value of the good will be such as to clear the total stock, and the total of all these demands for the good will be in equilibrium. The reserved demand of the buyers will, as before, be due to their reserved demand for money, while the sellers of both the good as a whole and of its unit services will be demanding money in exchange.

In other words, for any consumers’ good, the possessors have the choice of either consuming it directly or selling it for money. In the case of durable consumers’ goods, the possessors can do any one of the following with the good: use it directly, sell it whole, or hire it out—selling its unit services over a period of time. We have already seen that if using it directly is highest on his value scale, then the man uses the good and reserves his stock from the market. If selling it whole is highest on his value scale, he enters the “capital” market for the good as a supplier. If renting it out is highest on his value scale, then he enters the “renting” market for the good as a supplier. Which of these latter alternatives will be higher on his value scale depends on his estimate of which course will yield him the higher money income. The shape of the supply curves in both the capital and rental markets will be either rightward- and upward-sloping or vertical, since the greater the expected income, the less will be the amount reserved for direct use. It is clear that the supply schedules on the two markets are interconnected. They will tend to come into equilibrium when the equilibrium-price relation is established between them.

Similarly, the nonpossessors of a good at any given time will choose between (a) not buying it and reserving their money, (b) buying it outright, and (c) renting it. They will choose the course highest on their value scales, which depends partially on their demand for money and on their estimate of which type of purchase will be cheaper. If they decide to buy, they will buy on what they estimate is the cheaper market; then they can either use the good directly or resell it on the more expensive market. Thus, if the capital value of the house is 200 and a buyer estimates that total rental prices will be 220, he buys outright at 200, after which he may either use it directly or enter the rental market as a supplier in order to earn the expected 220 ounces. The latter choice again depends on his value scale. This is another example of the arbitrage action already explained, and the effect is to link the demand curves for the two types of markets for durable goods.

Here it must be pointed out that in some cases the renting contract itself takes on the characteristics of a capital contract and the estimating of future return. Such is the case of a long-term renting contract. Suppose that A is planning to rent a house to B for 30 years, at a set annual price. Then, instead of continual changes in the rental price, the latter is fixed by the original contract. Here again, the demand and supply schedules are set according to the various individual estimates of the changing course of other varying rents for the same type of good. Thus, if there are two identical houses, and it is expected that the sum of the varying rents on house A for the next 30 years will be 300 ounces, then the long-term renting price for house B will tend to be set at 10 ounces per year. Here again, there is a similar connection between markets. The price of presently established long-term rents will tend to be equal to the present value of the sum of the expected fluctuating rents for identical goods. If the general expectation is that the sum of rents will be 360 ounces, then there will be a heavy demand for long-term rent purchases at 300 ounces and a diminished supply for rent at that price, until the long-term rental price is driven to 12 ounces per year, when the sum will be the same. And here again, the ever-present uncertainty of the future causes the more able forecasters to gain and the less able ones to lose.34

In actuality, time preference exists, and the present value of the future rentals is always less by a certain discount than the sum of these rentals. If this were not so, the capital value of very durable goods, goods which wear out only imperceptibly, would be almost infinite. An estate expected to last and be in demand for hundreds of years would have an almost infinitely high selling price. The reason this does not happen is that time preference discounts future goods in accordance with the length of time being considered. How the rate of time preference is arrived at will be treated in later chapters. However, the following is an illustration of the effect of time preference on the capital-value of a good. Assume a durable good, expected to last for 10 years, with an expected rental value of 10 ounces each year. If the rate of time preference is 10 percent per annum, then the future rents and their present value are as follows:

As the date of time recedes into the future, the compounded discount becomes greater, finally reducing the present value to a negligible amount.

It is important to recognize that the time-preference factor does not, as does relatively correct forecasting of an uncertain situation, confer monetary profits or losses. If the time-preference rate is 10 percent, purchasing the aforementioned good for 59.4 ounces, holding it, and renting it out for 10 years to acquire 100 ounces does not constitute a monetary profit. Present money was at this premium over future money, and what this man earned was simply the amount of future income that the market had evaluated as equal to 59.4 ounces of present money.

In general, we may sum up the action of entrepreneurs in the field of durable consumers’ goods by saying that they will tend to invest in the outright purchase of (already existing) durable consumers’ goods when they believe that the present capital value of the good on the market is less than the sum of future rentals (discounted by time preference) that they will receive. They will sell such goods outright when they believe that the present capital value is higher than the discounted sum of future rentals. Better forecasters will earn profits, and poorer ones will suffer losses. In so far as the forecasting is correct, these “arbitrage” opportunities will tend to disappear.

Although we have analyzed the arbitrage profits and losses of entrepreneurship in the case of selling outright as against renting, we have yet to unravel fully the laws that govern entrepreneurial incomes—the incomes that the producers strive to obtain in the process of production. This problem will be analyzed in later chapters.35

• 30Strictly, this is not correct, and the important qualification will be added below. Since, as a result of time preference, present services are worth more than the same ones in the future, and those in the near future more than those in the far future, the price of B will be less than twice the price of A.
• 31It needs to be kept in mind that, strictly, there is no such thing as a “present” price established by the market. When a man considers the price of a good, he is considering that price agreed upon in the last recorded transaction in the market. The “present” price is always, in reality the historically recorded price of the most immediate past (say, a half-hour ago). What always interests the actor is what various prices will be at various times in the future.
• 32On the different uses of the term “value,” see Appendix B, “On Value,” below.
• 33The concept of monetary profit and loss and their relation to capitalization will be explored below.
• 34Cf. Fetter, Economic Principles, pp. 158–60.
• 35For a discussion of the value of durable goods, see the brilliant treatment in Böhm-Bawerk, Positive Theory of Capital, pp. 339–57; Fetter, Economic Principles, pp. 111–21; and Wicksteed, Common Sense of Political Economy, I, 101–11.