Chapter 8—Production: Entrepreneurship and
Change
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8
PRODUCTION: ENTREPRENEURSHIP AND CHANGE
1.
Entrepreneurial Profit and Loss
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.”
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.
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.
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.
2.
The Effect of Net Investment
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.
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.
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 stepwise fashion—the
steps in these diagrams accounting for the interest spreads—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.
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 elsewhere—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.
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.
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.
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.
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 “roundaboutness” 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.
3.
Capital Values and Aggregate Profits in a Changing Economy
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.
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,
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 100
to 80. 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.
The case of decreasing gross capital investment is defined as a retrogressing
economy.
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.
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.
The ruins of Rome are mute
illustrations of the error of this assumption.
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.
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.”
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.
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.
We 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.
On 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.
Mises, Planning for
Freedom, p. 114.
Hayek, Prices and
Production, pp. 48–49.
See Hayek,
“The ‘Paradox’ of Saving” in Profits,
Interest, and Investment, pp. 199–263.
This 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).
Hayek, Prices and
Production, pp. 75–76.
Of 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.
See below for discussion of this
point.
Historically, 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.
The 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.
For 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.
This is not the same as assuming
an ERE, for in the ERE there are no changes to be
foreseen.
The 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.
The 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.
It 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.
It 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).
The 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.”
An 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)
It 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. 47ff., for a
contrast between the correct and the fashionable approaches toward
capital.
Frank 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.
Very few writers have realized
this. See Hayek, “The
‘Paradox’ of Saving,” pp. 214ff., 253ff.
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