Chapter 5—Production: The Structure (continued)
Ownership of the Product by Capitalists: Amalgamated Stages
Up to this point we have discussed the case in which the owners of land and labor, i.e., of the original factors, restrict their possible consumption and invest their factors in a production process, which, after a certain time, produces a consumers’ good to be sold to consumers for money. Now let us consider a situation in which the owners of the factors do not own the final product. How could this come about? Let us first forget about the various stages of the production process and assume for the moment that all the stages can be lumped together as one. An individual or a group of individuals acting jointly can then, at present, offer to pay money to the owners of land and labor, thus buying the services of their factors. The factors then work and produce the product, which, under the terms of their agreement, belongs to the new class of product-owners. These product-owners have purchased the services of the land and labor factors as the latter have been contributing to production; they then sell the final product to the consumers.
What has been the contribution of these product-owners, or “capitalists,” to the production process? It is this: the saving and restriction of consumption, instead of being done by the owners of land and labor, has been done by the capitalists. The capitalists originally saved, say, 95 ounces of gold which they could have then spent on consumers’ goods. They refrained from doing so, however, and, instead, advanced the money to the original owners of the factors. They paid the latter for their services while they were working, thus advancing them money before the product was actually produced and sold to the consumers. The capitalists, therefore, made an essential contribution to production. They relieved the owners of the original factors from the necessity of sacrificing present goods and waiting for future goods. Instead, the capitalists have supplied present goods from their own savings (i.e., money with which to buy present goods) to the owners of the original factors. In return for this supply of present goods, the latter contribute their productive services to the capitalists, who become the owners of the product. More precisely, the capitalists become the owners of the capital structure, of the whole structure of capital goods as they are produced. Keeping to our assumption that one capitalist or group of capitalists owns all the stages of any good’s production, the capitalists continue to advance present goods to owners of factors as the “year” goes on. As the period of time continues, highest-order capital goods are first produced, are then transformed into lower-order capital goods, etc., and ultimately into the final product. At any given time, this whole structure is owned by the capitalists. When one capitalist owns the whole structure, these capital goods, it must be stressed, do him no good whatever. Thus, suppose that a capitalist has already advanced 80 ounces over a period of many months to owners of labor and land in a line of production. He has in his ownership, as a result, a mass of fifth-, fourth-, and third-order capital goods. None of these capital goods is of any use to him, however, until the goods can be further worked on and the final product obtained and sold to the consumer.
Popular literature attributes enormous “power” to the capitalist and considers his owning a mass of capital goods as of enormous significance, giving him a great advantage over other people in the economy. We see, however, that this is far from the case; indeed, the opposite may well be true. For the capitalist has already saved from possible consumption and hired the services of factors to produce his capital goods. The owners of these factors have the money already for which they otherwise would have had to save and wait (and bear uncertainty), while the capitalist has only a mass of capital goods, a mass that will prove worthless to him unless it can be further worked on and the product sold to the consumers.
When the capitalist purchases factor services, what is the precise exchange that takes place? The capitalist gives money (a present good) in exchange for receiving factor services (labor and land), which work to supply him with capital goods. They supply him, in other words, with future goods. The capital goods for which he pays are way stations on the route to the final product—the consumers’ good. At the time when land and labor are hired to produce capital goods, therefore, these capital goods, and therefore the services of the land and labor, are future goods; they represent the embodiment of the expected yield of a good in the future—a good that can then be consumed. The capitalist who buys the services of land and labor in year one to work on a product that will eventually become a consumers’ good ready for sale in year two is advancing money (a present good) in exchange for a future good—for the present anticipation of a yield of money in the future from the sale of the final product. A present good is being exchanged for an expected future good.
Under the conditions of our example, we are assuming that the capitalists own no original factors, in contrast to the first case, in which the products were jointly owned by the owners of these factors. In our case, the capitalists originally owned money, with which they purchased the services of land and labor in order to produce capital goods, which are finally transformed by land and labor into consumers’ goods. In this example we have assumed that the capitalists do not at any time own any of the co-operating labor or land factors. In actual life, of course, there may be and are capitalists who both work in some managerial capacity in the production process and also own the land on which they operate. Analytically, however, it is necessary to isolate these various functions. We may call those capitalists who own only the capital goods and the final product before sale “pure capitalists.”
Let us now add another temporary restriction to our analysis—namely, that all producers’ goods and services are only hired, never bought outright. This is a convenient assumption that will be maintained long after the assumption of specific factors is dropped. We here assume that the pure capitalists never purchase as a whole a factor that in itself could yield several units of service. They can only hire the services of factors per unit of time. This situation is directly analogous to the conditions described in chapter 4, section 7 above, in which consumers bought or “rented” the unit services of goods rather than the goods as a whole. In a free economy, of course, this hiring or renting must always occur in the case of labor services. The laborer, being a free man, cannot be bought; i.e., he cannot be paid a cash value for his total future anticipated services, after which he is at the permanent command of his buyer. This would be a condition of slavery, and even “voluntary slavery,” as we have seen, cannot be enforced on the free market because of the inalienability of personal will. A laborer cannot be bought, then, but his services can be bought over a period of time; i.e., he can be rented or hired.
We are deferring until later the major part of the analysis of the pricing of productive services and factors. At this point we can see, however, that the purchasing of labor and land services are directly analogous. The classical discussion of productive income treats labor as earning wages whereas land earns rents, and the two are supposed to be subject to completely different laws. Actually, however, the earnings of labor and land services are analogous. Both are original and productive factors; and in the case in which land is hired rather than bought, both are rented per unit of time rather than sold outright. Generally, writers on economics have termed those capitalists “entrepreneurs” who buy labor and land factors in expectation of a future monetary return from the final product. They are entrepreneurs, however, only in the actual economy of uncertainty. In an evenly rotating economy, where all the market actions are repeated in an endless round and there is therefore no uncertainty, entrepreneurship disappears. There is no uncertain future to be anticipated and about which forecasts are made. To call these capitalists simply entrepreneurs, then, is tacitly to imply that in the evenly rotating economy there will be no capitalists, i.e., no group that saves money and hires the services of factors, thereby acquiring capital and consumers’ goods to be sold to the consumers. Actually, however, there is no reason why pure capitalists should not continue in the ERE (the evenly rotating economy). Even if final returns and consumer demand are certain, the capitalists are still providing present goods to the owners of labor and land and thus relieving them of the burden of waiting until the future goods are produced and finally transformed into consumers’ goods. Their function, therefore, remains in the ERE to provide present goods and to assume the burden of waiting for future returns over the period of the production process. Let us assume simply that the sum the capitalists paid out was 95 ounces and that the final sale was for 100 ounces. The five ounces accruing to the capitalists is payment for their function of supplying present goods and waiting for a future return. In short, the capitalists, in year one, bought future goods for 95 ounces and then sold the transformed product in year two for 100 ounces when it had become a present good. In other words, in year one the market price of an anticipated (certain) income of 100 ounces was only 95 ounces. It is clear that this arises out of the universal fact of time preference and of the resulting premium of a given good at present over the present prospect of its future acquisition.
In the monetary economy, since money enters into all transactions, the discount of a future good against a present good can, in all cases, be expressed in terms of one good: money. This is so because the money commodity is a present good and because claims to future goods are almost always expressed in terms of future money income.
The factors of production in our discussion have all been assumed to be purely specific to a particular line of production. When the capitalists have saved money (“money capital”), however, they are at liberty to purchase factor services in any line of production. Money, the general medium of exchange, is precisely nonspecific. If, for example, the saver sees that he can invest 95 ounces in the aforementioned production process and earn 100 ounces in a year, whereas he can invest 95 ounces in some other process and earn 110 ounces in a year, he will invest his money in the process earning the greater return. Clearly, the line in which he will feel impelled to invest will be the line that earns him the greatest rate of return on his investment.
The concept of rate of return is necessary in order for him to compare different potential investments for different periods of time and involving different sums of money. For any amount of money that he saves, he would like to earn the greatest amount of net return, i.e., the greatest rate of net return. The absolute amount of return has to be reduced to units of time, and this is done by determining the rate per unit of time. Thus, a return of 20 ounces on an investment of 500 ounces after two years is 2 percent per annum, while a return of 15 ounces on the same investment after one year is a return of 3 percent per annum.
After data work themselves out and continue without change, the rate of net return on the investment of money capital will, in the ERE, be the same in every line of production. If capitalists can earn 3 percent per annum in one production process and 5 percent per annum in another, they will cease investing in the former and invest more in the latter until the rates of return are uniform. In the ERE, there is no entrepreneurial uncertainty, and the rate of net return is the pure exchange ratio between present and future goods. This rate of return is the rate of interest. This pure rate of interest will be uniform for all periods of time and for all lines of production and will remain constant in the ERE.
Suppose that at some time the rates of interest earned are not uniform as between several lines of production. If capitalists are generally earning 5 percent interest, and a capitalist is obtaining 7 percent in a particular line, other capitalists will enter this line and bid away the factors of production from him by raising factor prices. Thus, if a capitalist is paying factors 93 ounces out of 100 income, a competing capitalist can offer 95 ounces and outbid the first for the use of the factors. The first, then, forced to meet the competition of other capitalists, will have to raise his bid eventually to 95 (disregarding for simplicity the variation in percentages based on the investment figure rather than on 100). The same equalization process will occur, of course, between capitalists and firms within the same line of production—the same “industry.” There is always competitive pressure, then, driving toward a uniform rate of interest in the economy. This competition, it must be pointed out, does not take place simply between firms in the same industry or producing “similar” products. Since money is the general medium of exchange and can be invested in all products, this close competition extends throughout the length and breadth of the production structure.
A fuller discussion of the determination of the rate of interest will take place in chapter 6 below. But one thing should here be evident. The classical writers erred grievously in their discussion of the income-earning process in production. They believed that wages were the “reward” of labor, rents the “reward” of land, and interest the “reward” of capital goods, the three supposedly co-ordinate and independent factors of production. But such a discussion of interest was completely fallacious. As we have seen and shall see further below, capital goods are not independently productive. They are the imputable creatures of land and labor (and time). Therefore, capital goods generate no interest income. We have seen above, in keeping with this analysis, that no income accrues to the owners of capital goods as such.
If the owners of land and labor factors receive all the income (e.g., 100 ounces) when they own the product jointly, why do their owners consent to sell their services for a total of five ounces less than their “full worth”? Is this not some form of “exploitation” by the capitalists? The answer again is that the capitalists do not earn income from their possession of capital goods or because capital goods generate any sort of monetary income. The capitalists earn income in their capacity as purchasers of future goods in exchange for supplying present goods to owners of factors. It is this time element, the result of the various individuals’ time preferences, and not the alleged independent productivity of capital goods, from which the interest rate and interest income arise.
The capitalists earn their interest income, therefore, by supplying the services of present goods to owners of factors in advance of the fruits of their production, acquiring their products by this purchase, and selling the products at the later date when they become present goods. Thus, capitalists supply present goods in exchange for future goods (the capital goods), hold the future goods, and have work done on them until they become present goods. They have given up money in the present for a greater sum of money in the future, and the interest rate that they have earned is the agio, or discount on future goods as compared with present goods, i.e., the premium commanded by present goods over future goods. We shall see below that this exchange rate between present and future goods is not only uniform in the production process, but throughout the entire market system. It is the “social rate of time preference.” It is the “price of time” on the market as the resultant of all the individual valuations of that good.
How the agio, or pure interest rate, is determined in the particular time-exchange markets, will be discussed below. Here we shall simply conclude by observing that there is some agio which will be established uniformly throughout the economy and which will be the pure interest rate on the certain expectation of future goods as against present goods.
In the ERE, therefore, every good sold to consumers will sell at a certain “final equilibrium” price and at certain total sales. These receipts will accrue in part to capitalists in the form of interest income, and the remainder to owners of land and labor. The payments of income to the producers have also been popularly termed “costs.” These are clearly money costs, or money expenses, and obviously are not the same thing as “costs” in the psychic sense of subjective opportunity forgone. Money costs may be ex post as well as ex ante. (In the ERE, of course, ex ante and ex post calculations are always the same.) However, the two concepts become linked when psychic costs are appraised as much as possible in monetary terms. Thus, payment to factors may be 95 ounces and recorded as a cost, while the capitalist who earns an interest of five ounces considers 100 as an opportunity cost, since he could have invested elsewhere and earned five (actually, a bit higher) percent interest.
If, for the moment, we include as money costs factor payments and interest, then in the ERE, money costs equal total money sales for every firm in every line of production. A firm earns entrepreneurial profits when its return is more than interest, suffers entrepreneurial losses when its return is less. In our production process, consumers will pay 100 ounces (money sales), and money costs are 100 ounces (factor plus interest income) and there will be similar equality for all other goods and processes. What this means, in essence, is that there are no entrepreneurial profits or losses in the ERE, because there is no change of data or uncertainty about possible change. If total money sales equal total money costs, then it evidently follows that total money sales per unit sold will equal total money costs per unit sold. This follows from elementary rules of arithmetic. But the money sales per unit are equal to the money price of the good, by definition; while we shall call the total money costs per unit the average money cost of the good. It likewise follows, therefore, that price will equal average money cost for every good in the ERE.
Strange as it may seem, a great many writers on economics have deduced from this a curious conclusion indeed. They have deduced that “in the long run” (i.e., in the ERE), the fact that costs equal sales or that “cost equals price” implies that costs determine price. The price of the good discussed above is 100 ounces per unit, allegedly because the cost (average money cost) is 100 ounces per unit. This is supposed to be the law of price determination “in the long run.” It would seem to be crystal clear, however, that the truth is precisely the reverse. The price of the final product is determined by the valuations and demands of the consumers, and this price determines what the cost will be. If the consumers value the product mentioned above so that its price is 50 ounces instead of 100 ounces, as a result, say, of a change in their valuations, then it is precisely in the “long run,” when the effects of uncertainty are removed, that “costs of production” (here, factor payment plus interest payment) will equal the final price. We have seen above how factor incomes are at the mercy of consumer demand and fluctuate according to that demand. Factor payments are the result of sales to consumers and do not determine the latter in advance. Costs of production, then, are at the mercy of final price, and not the other way around. It is ironic that it is precisely in the ERE that this causative phenomenon should be the clearest. For in the ERE we see quite evidently that consumers pay and determine the final price of the product; that it is through these payments and these payments alone that factors and interest are paid; that therefore the amount of the payments and the total “costs of production” are determined by price and not vice versa. Money costs are the opposite of a basic, determining factor; they are dependent on the price of the product and on consumer demands.
In the real world of uncertainty it is more difficult to see this, because factors are paid in advance of the sale of the product, since the capitalist-entrepreneurs speculatively advance money to the factors in the expectation of being able to recoup their money with a surplus for interest and profit after sale to the consumers. Whether they do so or not depends on their foresight regarding the state of consumer demand and the future prices of consumers’ goods. In the real world of immediate market prices, of course, the existence of entrepreneurial profit and loss will always prevent costs and receipts, cost and price, from being identical, and it is obvious to all that price is solely determined by valuations of stock—by “utilities”—and not at all by money cost. But although most economists recognize that in the real world (the so-called “short-run”) costs cannot determine price, they are seduced by the habit of the individual entrepreneur of dealing in terms of “cost” as the determining factor, and they apply this procedure to the case of the ERE and therefore to the inherent long-run tendencies of the economy. Their grave error, as will be discussed further below, comes from viewing the economy from the standpoint of an individual entrepreneur rather than from that of an economist. To the individual entrepreneur, the “cost” of factors is largely determined by forces outside himself and his own sales; the economist, however, must see how money costs are determined and, taking account of all the interrelations in the economy, must recognize that they are determined by final prices reflecting consumer demands and valuations.
The source of the error will become clearer below when we consider a world of nonspecific as well as specific factors. However, the essentials of our analysis and its conclusion remain the same in that more complex and realistic case.
The classical economists were under the delusion that the price of the final product is determined by “costs of production,” or rather they fluctuated between this doctrine and the “labor theory of value,” which isolated the money costs of labor and picked that segment of the cost of production as the determinant of price. They slurred over the determination of the prices of such goods as old paintings that already existed and needed no further production. The correct relation between prices and costs, as outlined above, was developed, along with other outstanding contributions to economics, by the “Austrian” economists, including the Austrians Carl Menger, Eugen von Böhm-Bawerk, and Friedrich von Wieser, and the Englishman W. Stanley Jevons. It was with the writings of the Austrian School in the 1870’s and 1880’s that economics was truly established as a science.
Unfortunately, in the science of economics, retrogression in knowledge has taken place almost as often as progression. The enormous advance provided by the Austrian School, on this point as on others, was blocked and reversed by the influence of Alfred Marshall, who attempted to rehabilitate the classicists and integrate them with the Austrians, while disparaging the contributions of the latter. It was unfortunately the Marshallian and not the Austrian approach that exerted the most influence over later writers. This influence is partly responsible for the current myth among economists that the Austrian School is effectively dead and has no more to contribute and that everything of lasting worth that it had to offer was effectively stated and integrated in Alfred Marshall’s Principles.
Marshall tried to rehabilitate the cost-of-production theory of the classicists by conceding that, in the “short run,” in the immediate market place, consumers’ demand rules price. But in the long run, among the important reproducible goods, cost of production is determining. According to Marshall, both utility and money costs determine price, like blades of a scissors, but one blade is more important in the short run, and another in the long run. He concludes that
as a general rule, the shorter the period we are considering, the greater must be the share of our attention which is given to the influence of demand on value; and the longer the period, the more important will be the influence of cost of production on value. . . . The actual value at any time, the market value as it is often called, is often more influenced by passing events and by causes whose action is fitful and shortlived, than by those which work persistently. But in long periods these fitful and irregular causes in large measure efface one another’s influence; so that in the long run persistent causes dominate value completely.
The implication is quite clear: if one deals with “short-run” market values, one is being quite superficial and dwelling only on fitful and transient causes—so much for the Austrians. But if one wants to deal with the “really basic” matters, the really lasting and permanent causes of prices, he must concentrate on costs of production—pace the classicists. This impression of the Austrians—their alleged neglect of the “long period,” and “one-sided neglect of costs”—has been stamped on economics ever since.
Marshall’s analysis suffers from a grave methodological defect—indeed, from an almost hopeless methodological confusion as regards the “short run” and the “long run.” He considers the “long run” as actually existing, as being the permanent, persistent, observable element beneath the fitful, basically unimportant flux of market value. He admits (p. 350) that “even the most persistent causes are, however, liable to change,” but he clearly indicates that they are far less likely to change than the fitful market values; herein, indeed, lies their long-run nature. He regards the long-run data, then, as underlying the transient market values in a way similar to that in which the basic sea level underlies the changing waves and tides. For Marshall, then, the long-run data are something that can be spotted and marked by an observer; indeed, since they change far more slowly than the market values, they can be observed more accurately.
Marshall’s conception of the long run is completely fallacious, and this eliminates the whole groundwork of his theoretical structure. The long run, by its very nature, never does and never can exist. This does not mean that “long-run,” or ERE, analysis is not important. On the contrary, only through the concept of the ERE can we subject to catallactic analysis such critical problems as entrepreneurial profit, the structure of production, the interest rate, and the pricing of productive factors. The ERE is the goal (albeit shifting in the concrete sense) toward which the market moves. But the point at issue is that it is not observable, or real, as are actual market prices.
We have seen above the characteristics of the evenly rotating economy. The ERE is the condition that comes into being and continues to obtain when the present, existing market data (valuations, technology, resources) remain constant. It is a theoretical construct of the economist that enables him to point out in what directions the economy tends to be moving at any given time; it also enables the economist to isolate various elements in his analysis of the economy of the real world. To analyze the determining forces in a world of change, he must construct hypothetically a world of nonchange. This is far different from, indeed, it is the reverse of, saying that the long run exists or that it is somehow more permanently or more persistently existent than the actual market data. The actual market prices, on the contrary, are the only ones that ever exist, and they are the resultants of actual market data (consumer demands, resources, etc.) that themselves change continually. The “long run” is not more stable; its data necessarily change along with the data on the market. The fact that costs equal prices in the “long run” does not mean that costs will actually equal prices, but that the tendency exists, a tendency that is continually being disrupted in reality by the very fitful changes in market data that Marshall points out.
In sum, rather than being in some sense more persistent and more real than the actual market, the “long run” of the ERE is not real at all, but a very useful theoretical construct that enables the economist to point out the direction in which the market is moving at any given time—specifically, toward the elimination of profits and losses if existing market data remain the same. Thus, the ERE concept is especially helpful in the analysis of profits and losses as compared to interest. But the market data are the only actual reality.
This is not to deny, and the Austrians never did deny, that subjective costs, in the sense of opportunity costs and utilities forgone, are important in the analysis of production. In particular, the disutilities of labor and of waiting—as expressed in the time-preference ratios—determine how much of people’s energies and how much of their savings will go into the production process. This, in the broadest sense, will determine or help to determine the total supply of all goods that will be produced. But these costs are themselves subjective utilities, so that both “blades of the scissors” are governed by the subjective utility of individuals. This is a monistic and not a dualistic causal explanation. The costs, furthermore, have no direct influence on the relative amount of the stock of each good to be produced. Consumers will evaluate the various stocks of goods available. How much productive energy and savings will go into producing stock of one particular good and how much into producing another, in other words, the relative stocks of each product, will depend in turn on entrepreneurial expectations of where the greatest monetary profit will be found. These expectations are based on the anticipated direction of consumer demand.
As a result of such anticipations, the nonspecific factors will move to the production of those goods where, ceteris paribus, their owners will earn the highest incomes. An exposition of this process will be presented below.
Marshall’s treatment of subjective costs was also highly fallacious. Instead of the idea of opportunity costs, he had the notion that they were “real costs” that could be added in terms of measurable units. Money costs of production, then, became the “necessary supply prices” that entrepreneurs had to pay in order “to call forth an adequate supply of the efforts and waitings” to produce a supply of the product. These real costs were then supposed to be the fundamental, persisting element that backstops money costs of production, and allowed Marshall to talk of the more persisting, long-run, normal situation.
Marshall’s great error here, and it has permeated the works of his followers and of present-day writers, is to regard costs and production exclusively from the point of view of an isolated individual entrepreneur or an isolated individual industry, rather than viewing the whole economy in all its interrelations. Marshall is dealing, of necessity, with particular prices of different goods, and he is attempting to show that alleged “costs of production” determine these prices in the long run. But it is completely erroneous to tie up particular goods with labor vs. leisure and with consuming vs. waiting costs, for the latter are only general phenomena, applying and diffusing throughout the entire economic system. The price necessary to call forth a nonspecific factor is the highest price this factor can earn elsewhere—an opportunity cost. What it can attain elsewhere is basically determined by the state of consumer demand elsewhere. The forgone leisure-and-consumption costs, in general, only help to determine the size—the general stock—of labor and savings that will be applied to production. All this will be treated further below.
We have seen that, for all goods, total receipts to sellers will tend to equal total payments to factors, and this equality will be established in the evenly rotating economy. In the ERE, interest income will be earned at the same uniform rate by capitalists throughout the economy. The remainder of income from production and sale to consumers will be earned by the owners of the original factors: land and labor.
Our next task will be to analyze the determination of the prices of factor services and the determination of the interest rate, as they tend to be approached in the economy and would be reached in the ERE. Until now, discussion has centered on the capital-goods structure, treated as if it were in one composite stage of production. Clearly, there are numerous stages, but we have seen above that earnings in production ultimately resolve themselves, and certainly do so in the ERE, into the earnings of the original factors: land and labor. Later on, we shall expand the analysis to include the case of many stages in the production process, and we shall defend this type of temporal analysis of production against the very fashionable current view that production is “timeless” under modern conditions and that the original-factor analysis might have been useful for the primitive era but not for a modern economy. As a corollary to this, we shall develop further an analysis of the nature of capital and time in the production process.
What will be the process of pricing productive factors in a world of purely specific factors? We have been assuming that only services and not whole goods can be acquired. In the case of labor this is true because of the nature of the free society; in the case of land and capital goods, we are assuming that the capitalist product-owners hire or rent rather than own any of the productive factors outright. In our example above, the 95 ounces went to all the factor-owners jointly. By what principles can we determine how the joint income is allocated to the various individual factor services? If all the factors are purely specific, we can resort to what is usually called the theory of bargaining. We are in a very analogous situation to the two-person barter of chapter 2. For what we have is not relatively determinate prices, or proportions, but exchange ratios with wide zones between the “marginal pairs” of prices. The maximum price of one is widely separated from the minimum price of the other.
In the present case, we have, say, 12 labor and land factors, each of which is indispensable to the production of the good. None of the factors, furthermore, can be used anywhere else, in any other line of production. The question for these factor-owners to solve is the proportionate share of each in the total joint income. Each factor-owner’s maximum goal is something slightly less than 100 percent of the income from the consumers. What the final decision will be cannot be indicated by praxeology. There is, for all practical purposes, no theory of bargaining; all that can be said is that since the owner of each factor wants to participate and earn some income, all will most likely arrive at some sort of voluntary contractual arrangement. This will be a formal type of partnership agreement if the factors jointly own the product; or it will be the implicit result if a pure capitalist purchases the services of the factors.
Economists have always been very unhappy about bargaining situations of this kind, since economic analysis is estopped from saying anything more of note. We must not pursue the temptation, however, to condemn such situations as in some way “exploitative” or bad, and thereby convert barrenness for economic analysis into tragedy for the economy. Whatever agreement is arrived at by the various individuals will be beneficial to every one of them; otherwise, he would not have so agreed.
It is generally assumed that, in the jockeying for proportionate shares, labor factors have less “bargaining power” than land factors. The only meaning that can be seen in the term “bargaining power” here is that some factor-owners might have minimum reservation prices for their factors, below which they would not be entered in production. In that case, these factors would at least have to receive the minimum, while factors with no minimum, with no reservation price, would work even at an income of only slightly more than zero. Now it should be evident that the owner of every labor factor has some minimum selling price, a price below which he will not work. In our case, where we are assuming (as we shall see, quite unrealistically) that every factor is specific, it is true that no laborer would be able to earn a return in any other type of work. But he could always enjoy leisure, and this sets a minimum supply price for labor service. On the other hand, the use of land sacrifices no leisure. Except in rare cases where the owner enjoys a valuable esthetic pleasure from contemplating a stretch of his own land not in use, there is no revenue that the land can bring him except a monetary return in production. Therefore, land has no reservation price, and the landowner would have to accept a return of almost zero rather than allow his land to be idle. The bargaining power of the owner of labor, therefore, is almost always superior to that of the owner of land.
In the real world, labor, as will be seen below, is uniquely the nonspecific factor, so that the theory of bargaining could never apply to labor incomes.
Thus, when two or more factors are specific to a given line of production, there is nothing that economic analysis can say further about the allocation of the joint income from their product; it is a matter of voluntary bargaining between them. Bargaining and indeterminate pricing also take place even between two or more nonspecific factors in the rare case where the proportions in which these factors must be used are identical in each employment. In such cases, also, there is no determinate pricing for any of the factors separately, and the result must be settled by mutual bargaining.
Suppose, for example, that a certain machine, containing two necessary parts, can be used in several fields of production. The two parts, however, must always be combined in use in a certain fixed proportion. Suppose that two (or more) individuals owned these two parts, i.e., two different individuals produced the different parts by their labor and land. The combined machine will be sold to, or used in, that line of production where it will yield the highest monetary income. But the price that will be established for that machine will necessarily be a cumulative price so far as the two factors—the two parts—are concerned. The price of each part and the allocation of the income to the two owners must be decided by a process of bargaining. Economics cannot here determine separate prices. This is true because the proportions between the two are always the same, even though the combined product can be used in several different ways.
Not only is bargaining theory rarely applicable in the real world, but zones of indeterminacy between valuations, and therefore zones of indeterminacy in pricing, tend to dwindle radically in importance as the economy evolves from barter to an advanced monetary economy. The greater the number and variety of goods available, and the greater the number of people with differing valuations, the more negligible will zones of indeterminacy become.
At this point, we may introduce another rare, explicitly empirical, element into our discussion: that on this earth, labor has been a far scarcer factor than land. As in the case of Crusoe, so in the case of a modern economy, men have been able to choose which land to use in various occupations, and which to leave idle, and have found themselves with idle “no-rent” land, i.e., land yielding no income. Of course, as an economy advances, and population and utilization of resources grow, there is a tendency for this superfluity of land to diminish (barring discoveries of new, fertile lands).
The term “pure rate of interest” corresponds to Mises’ term “originary rate of interest.” See Mises, Human Action, passim.
Here the reader is referred to one of the great works in the history of economic thought, Eugen von Böhm-Bawerk’s Capital and Interest (New York: Brentano’s, 1922), where the correct theory of interest is outlined; in particular, the various false theories of interest are brilliantly dissected. This is not to say that the present author endorses all of Böhm-Bawerk’s theory of interest as presented in his Positive Theory of Capital.
Strictly, this assumption is incorrect, and we make it in this section only for purposes of simplicity. For interest may be an opportunity cost for an individual investor, but it is not a money cost, nor is it an opportunity cost for the aggregate of capitalists. For the implications of this widely held error in economic literature, see André Gabor and I.F. Pearce, “The Place of Money Capital in the Theory of Production,” Quarterly Journal of Economics, November, 1958, pp. 537–57; and Gabor and Pearce, “A New Approach to the Theory of the Firm,” Oxford Economic Papers, October, 1952, pp. 252–65.
Cf. Menger, Principles of Economics, pp. 149ff.
The very interesting researches by Emil Kauder indicate that the essentials of the Austrian marginal utility theory (the basis of the view that price determines cost and not vice versa or mutually) had already been formulated by French and Italian economists of the seventeenth and eighteenth centuries and that the English classical school shunted economics onto a very wrong road, a road from which economics was extricated only by the Austrians. See Emil Kauder, “Genesis of the Marginal Utility Theory,” Economic Journal, September, 1953, pp. 638–50; and Kauder, “Retarded Acceptance of the Marginal Utility Theory.”
Alfred Marshall, Principles of Economics (8th ed.; London: Macmillan & Co., 1920), pp. 349ff.
This analogy, though not used in this context, was often used by classical economists as applied to prices and “the price level,” an application equally erroneous.
On this error in Marshall, see F.A. Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, 1941), pp. 21, 27–28. Marshall is here committing the famous fallacy of “conceptual realism,” in which theoretical constructs are mistaken for actually existing entities. For other examples, cf. Leland B. Yeager, “Some Questions on Growth Economics,” American Economic Review, March, 1954, p. 62.
Marshall, Principles of Economics, pp. 338ff.
We must hasten to point out that this is by no means the same criticism as the neo-Keynesian charge that economists must deal in broad aggregates, and not with individual cases. The latter approach is even worse, since it begins with “wholes” that have no basis in reality whatever. What we are advocating is a theory that deals with all the individuals as they interact in the economy. Furthermore, this is the “Austrian,” and not the Walrasian approach, which has recently come into favor. The latter deals with interrelations of individuals (“the general equilibrium approach”) but only in the ERE and with mathematical abstractions in the ERE.
Little of value has been said about bargaining since Böhm-Bawerk. See Böhm-Bawerk, Positive Theory of Capital, pp. 198–99. This can be seen in J. Pen’s “A General Theory of Bargaining,” American Economic Review, March, 1952, pp. 24ff. Pen’s own theory is of little worth because it rests explicitly on an assumption of the measurability of utility. Ibid., p. 34 n.
Contrast the discussion in most textbooks, where bargaining occupies an important place in explanation of market pricing only in the discussion of labor incomes.
See Mises, Human Action, p. 336.
Any zone of indeterminacy in pricing must consist of the coincidence of an absolutely vertical supply curve with an absolutely vertical market demand curve for the good or service, so that the equilibrium price is in a zone rather than at a point. As Hutt states, “It depends entirely upon the fortuitous coincidence of . . . an unusual and highly improbable demand curve with an absolutely rigid supply curve.” W.H. Hutt, The Theory of Collective Bargaining (Glencoe, Ill.: The Free Press, 1954), pp. 90, and 79–109.