Particular Factor Prices
and Productive Incomes (continued)
E. Productivity and Marginal Productivity
Great care must be taken in dealing with the productivity concept. In particular, there is danger in using a term such as “productivity of labor.” Suppose, for example, we state that “the productivity of labor has advanced in the last century.” The implication is that the cause of this increase came from within labor itself, i.e., because current labor is more energetic or personally skillful than previous labor. This, however, is not the case. An advancing capital structure increases the marginal productivity of labor, because the labor supply has increased less than the supply of capital goods. This increase in the marginal productivity of labor, however, is not due to some special improvement in the labor energy expended. It is due to the increased supply of capital goods. The causal agents of increased wage rates in an expanding economy, then, are not primarily the workers themselves, but the capitalist-entrepreneurs who have invested in capital goods. The workers are provided with more and better tools, and so their labor becomes relatively scarcer as compared to the other factors.
That each man receives his marginal value product means that each man is paid what he is worth in producing for consumers. But this does not mean that increases in his worth over the years are necessarily caused by his own improvement. On the contrary, as we have seen, the rise is primarily due to the increasing abundance of capital goods provided by the capitalists.
It is, then, clearly impossible to impute absolute “productivity” to any productive factor or class of factors. In the absolute sense, it is meaningless to try to impute productivity to any factor, since all the factors are necessary to the product. We can discuss productivity only in marginal terms, in terms of the productive contribution of a single unit of a factor, given the existence of other factors. This is precisely what entrepreneurs do on the market, adding and subtracting units of factors in an attempt to achieve the most profitable course of action.
Another illustration of the error in attempting to attribute increased “productivity” to the workers themselves occurs within the various segments of the labor market. As we have seen, there is a definite connexity between all the occupations on the labor market, since labor is the prime nonspecific factor. As a result, while wage rates are not equalized, psychic wage rates will all tend, in the long run, to move together and maintain a given skill-differential between each occupation. Therefore, when a certain branch of industry expands its capital and production, an increase in DMVP, and therefore in wage rates, is not confined to that particular branch. Because of the connexity of the supply of labor, labor tends to leave other industries and enter the new ones, until finally all the wage rates throughout the labor market have risen, while maintaining the same differentials as before.
Suppose, for example, that there is an expansion of capital in the steel industry. The MVP of the steel worker increases, and his wage rates go up. The increase in wage rates, however, is governed by the fact that the rise will attract workers from more poorly paid industries. For example, suppose that steel workers are receiving 25 grains of gold per hour, while domestic servants receive 15 grains per hour. Now, under the impetus of expansion, the MVP and hence the wage rate of the steel workers go up to 30 grains. The differential has been increased, inducing domestic servants to enter the steel industry, lowering steel wages, and especially raising servants’ wages, until the differential is re-established. Thus, a rise in capital investment in steel will increase the wages of workers in domestic service. The latter increase is clearly not caused by some sort of increase in the “productivity” or in the quality of the output of the domestic servants. Rather, their marginal value productivity has increased as a result of the greater scarcity of labor in the service trades.
The differentials will not remain precisely constant in practice, of course, since changing investment and changing methods also alter the types of skills required in the economy.
The shift in labor supply will not usually be as abrupt as in our example. Generally, it will take place from one occupation or one grade to a closely similar grade or occupation. Thus, more ditchdiggers might become foremen, more foremen supervisors, etc., so that shifts will take place from grade to grade. It is as if the labor market consisted of linked segments, a change in one segment transmitting itself throughout the chain from each link to the next.
It is “total wage rates” that are determined on the market. They tend to be equalized on the market and to be set at the DMVP of the worker. Total wage rates are the money paid out by the employer for labor services. They do not necessarily correspond to the “take-home pay” of the worker. The latter may be called the “overt wage rates.” Thus, suppose that there are two competing employers bidding for the same type of labor. One employer, Mr. A, pays out a certain amount of money, not in direct wages, but in pension funds or other “welfare” benefits. These benefits, it must be realized, will not be added as a gift from the employer to the workers. They will not be additions to the total wage rates. Overt wage rates paid out by Mr. A will instead be correspondingly lower than those paid out by his rival, Mr. B, who does not have to spend on the “welfare” benefits.
To the employer, in other words, it makes no difference in what form workers cost him money, whether in “take-home pay” or in welfare benefits. But he cannot pay more than the worker’s DMVP; i.e., the worker’s total wage income is set by this amount. The worker, in effect, chooses in what form he would like his pay and in what proportion of net wage rates to “welfare” benefits. Part of these benefits is money that the employer might spend to provide particularly pleasant or plush working conditions for all or some of his employees. This cost is part of the total and is deducted from the overt wage rates of the employee.
The institutional manner of paying wage rates is a matter of complete indifference to our analysis. Thus, while “piece rates” or “time rates” may be more convenient in any given industry, they do not differ in essentials; both are wage rates paid for a certain amount of work. With time rates, the employer has in mind a standard of performance which he expects from a worker, and he pays according to that rate.
An economic bugbear of our times is “unemployment.” Not only is this considered the preeminent problem of the “depression” in the “business cycle”; it is also generally considered the primary “problem” of the “capitalist system,” i.e., of the developed free-market economy. “Well, at least socialism solves the unemployment problem,” is supposed to be the most persuasive argument for socialism.
Of particular interest to us is the sudden emergence of the “unemployment problem” in economic theory. The Keynesians, in the mid-1930’s, inaugurated the fashion of declaiming: Neoclassical economics is all right for its special area, but it assumes “full employment.” Since “orthodox” economics “assumes full employment,” it holds true only so long as “full employment” prevails. If it does not, we enter a Keynesian wonderland where all economic truths are vitiated or reversed.
“Full employment” is supposed to be the condition of no unemployment and therefore the goal at which everyone aims.
In the first place, it should be emphasized that economic theory does not “assume” full employment. Economics, in fact, “assumes” nothing. The whole discussion of alleged “assumptions” reflects the bias of the epistemology of physics, where “assumptions” are made without originally knowing their validity and are eventually tested to see whether or not their consequents are correct. The economist does not “assume”; he knows. He concludes on the basis of logical deduction from self-evident axioms, i.e., axioms that are either logically or empirically incontrovertible.
Now what does economics conclude on the matter of unemployment or “full employment”? In the first place, there is no “problem” involved in the unemployment of either land or capital goods factors. (The latter condition is often known as “idle” or “unused capacity.”) We have seen above that a crucial distinction between land and labor is that labor is relatively scarce. As a result, there will always be land factors remaining unused, or “unemployed.” As a further result, labor factors will always be fully employed on the free market to the extent that laborers are so willing. There is no problem of “unemployed land,” since land remains unused for a good reason. Indeed, if this were not so (and it is conceivable that some day it will not be), the situation would be most unpleasant. If there is ever a time when land is scarcer than labor, then land will be fully employed, and some labor factors will either get a zero wage or else a wage below minimum subsistence level. This is the old classical bugbear of population pressing the food supply down to below-subsistence levels, and certainly this is theoretically possible in the future.
This is the only case in which an “unemployment problem” might be said to apply in the free market. But even here, if we consider the problem carefully, we see that there is no unemployment problem per se. For if what a man wants is simply a “job,” he could work for zero wages, or even pay his “employer” to work for him. In other words, he could earn a “negative wage.” Now this could never happen, for the good reason that labor is a disutility, especially as compared to leisure or “play.” Yet all the worry about “full employment” makes it appear that the “job,” and not the income from the job, is the great desideratum. If that were really the case, then there would be negative wages, and there would be no unemployment problem either. The fact that no one will work for zero or negative wages implies that in addition to whatever enjoyment he receives, the laborer requires a monetary income from his work. So what the worker wants is not just “employment” (which he could always get in the last resort by paying for it) but employment at a wage.
But once this is recognized, the whole modern and Keynesian emphasis on employment has to be revalued. For the great missing link in their discussion of unemployment is precisely the wage rate. To talk of unemployment or employment without reference to a wage rate is as meaningless as talking of “supply” or “demand” without reference to a price. And it is precisely analogous. The demand for a commodity makes sense only with reference to a certain price. In a market for goods, it is obvious that whatever stock is offered as supply, it will be “cleared,” i.e., sold, at a price determined by the demand of the consumers. No good need remain unsold if the seller wants to sell it; all he need do is lower the price sufficiently, in extreme cases even below zero if there is no demand for the good and he wants to get it off his hands. The situation is precisely the same here. Here we are dealing with labor services. Whatever supply of labor service is brought to market can be sold, but only if wages are set at whatever rate will clear the market.
We conclude that there can never be, on the free market, an unemployment problem. If a man wishes to be employed, he will be, provided the wage rate is adjusted according to his DMVP. But since no one wants to be simply “employed” without getting what he considers sufficient payment, we conclude that employment per se is not even a desired goal of human action, let alone a “problem.”
The problem, then, is not employment, but employment at an above-subsistence wage. There is no guarantee that this situation will always obtain on the free market. The case mentioned above—scarcity of land in relation to labor—can lead to a situation where a worker’s DMVP is below a subsistence wage for him. There also may be so little capital invested per worker that any wage will be below-subsistence for many people. Even in a relatively prosperous society there may be individual workers so infirm or lacking in skill that their particular talents could not command an above-subsistence wage. In that case, they could survive only through the gifts of those who are making above-subsistence wages.
But what of the able-bodied worker who “can’t find a job”? This situation cannot obtain. In those cases, of course, where a worker insists on a certain type of job or a certain minimum wage rate, he may well remain “unemployed.” But he does so only of his own volition and on his own responsibility. Thus, suppose that perhaps half the labor force suddenly insisted that they would not work unless they received a job in New York City in the television industry. Obviously, “unemployment” would suddenly become enormous. This is only a large-scale example of something that is always going on. There may be a shift of industry away from one town or region and toward another. A worker may decide that he wants to remain in the old town and insists on looking for a job there. If he fails to get one, however, the fault lies with himself and not with the “capitalist system.” The same is true of a clerk who insists on working only in the TV industry, or of a radio employee who refuses to leave for television and insists on working only in radio. We are not condemning these workers here. We are simply saying that by their decisions they are themselves choosing not to be employed.
The able-bodied in a developed economy can always find work, and work that will pay an over-subsistence wage. This is so because labor is scarcer than land, and enough capital has been invested to raise the marginal value product of laborers sufficiently to pay such a wage. But while this is true in the general labor market, it is not necessarily true for particular labor markets, for particular regions or occupations, as we have just seen.
If a worker can withdraw from the labor market by insisting on a certain type of work or location of work, he can also withdraw by insisting on a certain minimum wage payment. Suppose a man insisted that he would not work at any job unless he is paid 500 gold ounces per year. If his best available DMVP is only 100 gold ounces per year, he will remain unemployed. Whenever a man insists on a wage higher than his DMVP, he will remain unemployed, i.e., unemployed at the wage that he insists upon. But then this unemployment is not a “problem,” but a voluntary choice on the part of the idle person.
The “full employment” provided by the free market is employment to the extent that workers wish to be employed. If they refuse to be employed except at places, in occupations, or at wage rates they would like to receive, then they are likely to be choosing unemployment for substantial periods.
It might be objected that workers often do not know what job opportunities await them. This, however, applies to the owner of any goods up for sale. The very function of marketing is the acquisition and dissemination of information about the goods or services available for sale. Except to those writers who posit a fantastic world where everyone has “perfect knowledge” of all relevant data, the marketing function is a vital aspect of the production structure. The marketing function can be performed in the labor market, as well as in any other, through agencies or other means for the discovery of who or where the potential buyers and sellers of a particular service may be. In the labor market this has been done through “want ads” in the newspapers, employment agencies used by both employer and employee, etc.
Of course “full employment,” as an absolute ideal, is absurd in a world where leisure is a positive good. A man may choose idleness in order to obtain leisure; he benefits (or believes he benefits) more from this than from working at a job. We can see this truth more clearly if we consider the hours of the work week. Will anyone maintain that an 80-hour work week is necessarily better than a 40-hour week? Yet the former clearly represents a fuller employment of labor than the latter.
One alleged example of a possible case of involuntary unemployment on the free market has been suggested by Professor Hayek. Hayek maintains that when there is a shift from investment to consumption, and therefore a shortening of the production structure on the market, there will be a necessary temporary unemployment of workmen thrown out of work in the higher stages, lasting until they can be reabsorbed in the shorter processes of the later stages. It is true that there is a loss in income, as well as a loss in capital, from a shift to shorter processes. It is also true that the shortening of the structure means that there is a transition period when, at final wage rates, there will be unemployment of the men displaced from the longer processes. However, during this transition period there is no reason why these workers cannot bid down wage rates until they are low enough to enable the employment of all the workers during the transition. This transition wage rate will be lower than the new equilibrium wage rate. But at no time is there a necessity for unemployment.
The ever-recurring doctrine of “technological unemployment”—man displaced by the machine—is hardly worthy of extended analysis. Its absurdity is evident when we look at the advanced economy and compare it with the primitive one. In the former there is an abundance of machines and processes completely unknown to the latter; yet in the former, standards of living are far higher for far greater numbers of people. How many workers have been “displaced” because of the invention of the shovel? The technological unemployment motif is encouraged by the use of the term “labor-saving devices” for capital goods, which to some minds conjure up visions of laborers being simply discarded. Labor needs to be “saved” because it is the pre-eminently scarce good and because man’s wants for exchangeable goods are far from satisfied. Furthermore, these wants would not be satisfied at all if the capital-goods structure were not maintained. The more labor is “saved,” the better, for then labor is using more and better capital goods to satisfy more of its wants in a shorter amount of time.
Of course, there will be “unemployment” if, as we have stated, workers insist on their own terms for work, and these terms cannot be met. This applies to technological changes as well as any other. The clerk who, for some reason, insists nowadays on working only for a blacksmith or in an old-fashioned general store may well have chosen a large dose of idleness. Any workers who insisted on working in the buggy industry or nothing found themselves, no doubt, unemployed after the development of the automobile.
A technological improvement in an industry will tend to increase employment in that industry if the demand for the product is elastic downward, so that the greater supply of goods induces greater consumer spending. On the other hand, an innovation in an industry with inelastic demand downward will cause consumers to spend less on the more abundant products, contracting employment in that industry. In short, the process of technological innovation shifts workers from the inelastic-demand to the elastic-demand industries. One of the major sources of new employment demand is in the industry making the new machines.
A. Costs to the Firm
We have seen the basis on which the prices of the factors of production and the interest rate are determined. Looked at from the point of view of an individual entrepreneur, payments to factors are money costs. It is clear that we cannot simply rest on the old classical law that prices of products tend, in the long run, to be equal to their costs of production. Costs are not fixed by some Invisible Hand, but are determined precisely by the total force of entrepreneurial demand for factors of production. Basically, as Böhm-Bawerk and the Austrians pointed out, costs conform to prices, and not vice versa. Confusion may arise because, looked at from the point of view of the individual firm rather than of the economist, it appears as if costs (at least in the sense of the prices of factors) are somehow given, and beyond one’s control.If a firm can command a selling price that will more than cover its costs, it remains in business; if not, it will have to leave. The illusion of externally determined costs is prevalent because, as we shall presently see, most factors can be employed in a wide variety of firms, if not industries. If we take the broader view of the economist, however, the various “costs,” i.e., prices of factors, determined by their various DMVPs in alternative uses, are ultimately determined solely by consumers’ demand for all uses. It must not be forgotten, furthermore, that changes in demand and selling price will change the prices and incomes of specialized factors in the same direction. The “cost curves” so fashionable in current economics assume fixed factor prices, thereby ignoring their variability, even for the single firm.
It might be noted that, in this work, there is none of that plethora and tangle of “cost curves” which fill the horizon of almost every recent “neoclassical” work in economics. This omission has been deliberate, since it is our contention that the cost curves are at best redundant (thus violating the simplicity principle of Occam’s Razor), and at worst misleading and erroneous.
As an explanation of the pricing of factors and the allocation of output it is obvious that cost curves add nothing new to discussion in terms of marginal productivity. At best, the two are reversible. This can be clearly seen in such texts as E.T. Weiler’s The Economic System and George J. Stigler’s Theory of Price. But, in addition, the shift brings with it many grave deficiencies and errors. This is revealed in the very passage in which Stigler explains the reasons for his switch from a perfunctory discussion of productivity to a lengthy treatment of cost curves:
The law of variable proportions has now been explored sufficiently to permit a transition to the cost curves of the individual firm. The fundamentally new element in the discussion will, of course, be the introduction of prices of the productive services. The transition is made here only for the case of competition—that is, the prices of the productive services are constant because the firm does not buy enough of any service to affect its price.
But by introducing given prices of productive services, the contemporary theorist really abandons any attempt to explain these prices. This is one of the cardinal errors of the currently fashionable theory of the firm. It is highly superficial. One of the aspects of this superficiality is the assumption that prices of productive services are given, without any attempt to explain them. To furnish an explanation, marginal productivity analysis is necessary.
Marginal productivity analysis and the profit motive are sufficient to explain the prices of productive factors and their allocation to various firms and industries in the economy. Furthermore, there are in production theory two important and interesting concepts involving periods of time. One is what we may call the “immediate run”—the market prices of commodities and factors on the basis of given stocks and speculative demands and given consumer valuations. The immediate run is important, since it provides an explanation of the actual market prices of all goods at any time. The other important concept is that of the “final price,” or the long-run equilibrium price, i.e., the price that would be established in the ERE. This is important because it reveals the direction in which the immediate-run market prices tend to move. It also permits the analytic isolation of interest, as compared to profit and loss, in entrepreneurial incomes. In the ERE all factors will receive their discounted marginal value product, and interest will be pure time preference; there will be no profit and loss.
The interesting phases, then, are the immediate run and the long run. Yet cost-curve analysis deals almost exclusively with a hybrid intermediate phase known as the “short run.” In this short run, “costs” are sharply divided into two categories: fixed (which must be incurred regardless of the amount produced) and variable (which vary with output). This whole construction is a highly artificial one. There is no actual “fixity” of costs. Any alleged fixity depends purely on the length of time involved. In fact, suppose that production is zero. The “cost-curve theorists” would have us believe that even at zero output there are fixed costs that must be incurred: rent of land, payment of management, etc. However, it is clear that if data are frozen—as they should be in such an analysis—and the entrepreneurs expect a situation of zero output to continue indefinitely, these “fixed” costs would become “variable” and disappear very quickly. The rent contract for land would be terminated, and management fired, as the firm closed its doors.
There are no “fixed” costs; rather there are different degrees of variability for different productive factors. Some factors are best used in a certain quantity over a certain range of output, while others yield best results over other ranges of output. The result is not a dichotomy into “fixed” and “variable” costs, but a condition of many degrees of variability for the various factors.
Even if none of these difficulties existed, it is hard to see why the “short run” should be picked out for detailed analysis, when it is merely one way station, or rather a series of way stations, between the important periods of time: the immediate run and the long run. Analytically, the cost-curve approach is at best of little interest.
With these caveats, let us now turn to an analysis of the costs of the firm. Let us consider what will happen to costs at alternate hypothetical levels of output. There are two elements that determine the behavior of average costs, i.e., total costs per unit output.
(a) There are “physical costs”—the amounts of factors that must be purchased in order to obtain a certain physical quantity of output. These are the obverse of “physical productivity”—the amounts of the physical product that can be produced with various amounts of factors. This is a technological problem. Here the question is not marginal productivity, where one factor is varied while others remain constant in quantity. Here we concentrate on the scale of output when all factors are permitted to vary. Where all factors and the product are completely divisible, a proportionate increase in the quantities of all the factors must lead to an equally proportionate increase in physical output. This may be called the law of “constant returns to scale.”
(b) The second determinant of average costs is factor prices. “Pure competition” theorists assume that these prices remain unchanged with a changing scale of output, but this is impossible. As any firm’s scale of output increases, it necessarily bids factors of production away from other firms, raising their prices in the process. And this is particularly true for labor and land factors, which cannot be increased in supply via new production. The increase in factor prices as output increases, combined with constant physical costs, raises the average money cost per unit output. We may therefore conclude that if factors and product were perfectly divisible, average cost would always be increasing.
In the productive world, perfect divisibility does not always, or even usually, obtain. Units of factors and of output are indivisible, i.e., they are not purely divisible into very small units. First, the product may be indivisible. Thus, suppose that three units of factor A + 2 units of factor B may combine to produce one refrigerator. Now it may be true that 6A + 4B will produce two refrigerators, according to our law of returns to scale. But it is also true that 4A + 3B will not produce one-and-a-fraction refrigerators. There are bound to be gaps where an increased supply of factors will not lead to an increased product, because of the technological indivisibility of the unit product.
In the areas of the gaps, average costs increase rapidly, since new factors are being hired with no product forthcoming; then, when expenditures on factors are increased sufficiently to produce more of the product, there is a precipitate decline in average cost compared to the situation during the gap. As a result, no businessman will knowingly invest in the area of the gaps. To invest more without yielding a product is sheer waste, and so businessmen will invest only in the trough points outside the gap areas.
Secondly, and more important, the productive factors may be indivisible. Because of this indivisibility, it is not possible simply to double or halve the quantities of input of every one of the productive services simultaneously. Each factor has its own technological unit size. As a result, almost all business decisions take place in zones in which many factors have to remain constant while others (the more divisible ones) may vary. And these relative divisibilities and indivisibilities are due, not to variations in periods of time, but to the technological size of the various units. In any productive operation there will be many varieties of indivisibility.
Professor Stigler presents the example of a railroad track, a factor capable of handling up to 200 trains a day. The track is most efficiently utilized when train runs total precisely 200 a day. This is the technologically “ideal” output and may be the one for which the track was designed. Now what happens when output is below 200? Suppose output is only 100 per day. The divisible factors of production will then be cut in half by the owners of the railroad. Thus, if engineers are divisible, the railroad will hire half as many engineers or hire its engineers for half their usual number of hours. But (and this is the critical point here) the railroad cannot cut the track in half and operate on half a track. The technological unit of “track” being what it is, the number of tracks has to remain at one. Conversely, when output increases to 200 again, other productive services may be doubled, but the quantity of track remains the same.
What happens should output increase to 250 trains a day—a 25-percent increase over the planned quantity? Divisible services such as engineers may be increased by one-fourth; but the track must either remain at one—and be overutilized—or be increased to two. If it is increased, the tracks will again be underutilized at 250, because the “ideal” output from the point of view of utilizing the tracks is now 400.
When an important indivisible factor is becoming less and less underutilized, the tendency will be for “increasing returns,” for decreasing average costs as output increases. When an important indivisible factor is becoming more and more overutilized, there is a tendency for increasing average costs.
In some spheres of production, indivisibilities may be such that full utilization of one indivisible factor requires full utilization of all. In that case, all the indivisible factors move together and can be lumped together for our purposes; they become the equivalent of one indivisible factor, such as the railroad track. In such cases again, average costs will first decline with an increase in output, as the increased output remedies an underutilization of the lumped indivisible factors. After the technologically most efficient point is reached, however, costs will increase, given the indivisible factors. The tendency for costs to decline will, in addition, be offset by the rise in factor prices caused by the increase in output.
In the overwhelming majority of cases, however, each factor will differ from the others in size and degree of divisibility. As a consequence, any size or combination chosen might utilize one indivisible factor most efficiently, but at the expense of not utilizing some other indivisible factor at peak efficiency. Suppose we consider a hypothetical schedule of average money cost at each alternative output. When we start at a very low level of output, all the indivisible factors will be underutilized. Then, as we expand production, average costs will decrease unless offset by the price rise for those divisible factors needed to expand production. As soon as one of the indivisible factors is fully utilized and becomes overworked, average costs will rise sharply. Later, a tendency toward decreasing costs sets in again as another underutilized factor becomes more fully utilized. The result is an alternating series of decreases and increases in average costs as output increases. Eventually, a point will be reached at which more indivisible factors will be overutilized than underutilized, and from then on the general trend of average cost as output increases will be upward. Before that point, the trend will be downward.
Mingling with these influences from the technological side of costs are the continuing rises in factor prices, which also become more important as output increases.
In sum, as Mises states:
Other things being equal, the more the production of a certain article increases, the more factors of production must be withdrawn from other employments in which they would have been used for the production of other articles. Hence—other things being equal—average production costs increase with the increase in the quantity produced. But this general law is by sections superseded by the phenomenon that not all factors of production are perfectly divisible and that, as far as they can be divided, they are not divisible in such a way that full utilization of one of them results in full utilization of the other imperfectly divisible factors.
Some indivisible factors, such as the railroad track, can be available in only one particular size. Other indivisible factors, such as machinery, can be built in various sizes. Cannot a small factory, then, use small-scale machinery which will be just as efficient as large-scale machinery in a larger factory, and would this not eliminate indivisibilities and result in constant costs? No, for here too, one particular size will probably be most efficient. Below the most efficient size, operating the machine will be more costly. Thus, as Stigler says, “fitting together of the parts of a ten-horsepower motor does not require ten times the labor necessary to fit those of a one-horsepower motor. Similarly, a truck requires one driver, whether it has a half-ton or two-ton capacity.”
It is also true that an oversized machine will be more costly than the optimum. But this will be no limitation on the size of the firm, for a large firm can simply use several (smaller) optimum-sized machines instead of one huge machine.
Labor is usually treated as a perfectly divisible factor, as one that varies directly with the size of the output. But this is not true. As we have seen, the truck driver is not divisible into fractions. Further, management tends to be an indivisible production factor. So also salesmen, advertising, cost of borrowing, research expenditures, and even insurance for actuarial risk. There are certain basic costs in borrowing which simply arise from investigating, paperwork, etc. These will tend to be proportionately smaller the larger the size—another indivisibility, with returns increasing over a certain area. Also, the broader the coverage, the lower insurance premiums will be.
Then there are the well-known gains from the increase in the division of labor with larger outputs. The benefits from the division of labor may be considered indivisible. They arise from the specialized machines that must first be used with a larger product, and similarly from the increased labor skills of specialists. Here too, however, there is a point beyond which no further specialization is possible or where specialization is subject to increasing costs. Management has usually been stressed as particularly subject to overutilization. Even more important is the factor of ultimate-decision-making ability, which cannot be enlarged to the extent that management can.
What any given firm’s size and output will be is therefore subject to a host of conflicting determinants, some impelling a limitation, some an expansion, of size. At what point any firm will settle depends on the concrete data of the actual case and cannot be decided by economic analysis. Only the actual entrepreneur, through the give and take of the market, can decide where the maximum-profit size is and can set the firm at that point. This is the task of the businessman and not of the economist.
Furthermore, the cost-curve diagrams, so simple and smooth in the textbooks, misinterpret real conditions. We have seen that there are a whole host of determinants which tend at any point toward increasing and toward decreasing costs. It is, of course, true that an entrepreneur will seek to produce at the point of maximum profit, i.e., of maximum net returns over costs. But the factors that influence his decision are too numerous and their interactions too complex to be captured in cost-curve diagrams.
It is clear to almost everyone that the optimum size of a firm in some industries is larger than in others. The economic optimum for a steel plant is larger than the optimum barbershop. In industries where large-scale firms have demonstrated the most efficiency, however, many people have worried a great deal about an alleged tendency for decreasing costs to continue permanently and therefore for “monopoly” to result from ever- larger firms. It should be obvious, however, that there is no infinite tendency for ever-larger size; this is clear from the very fact that every firm, at any time, always has a finite size and that, therefore, an economic limit must have been imposed upon it from some direction. Furthermore, we have seen that the general rule of operating in a zone of diminishing marginal productivity for each factor, as well as the tendency for product prices to decline and factor prices to increase as output increases, establishes limits on the size of each firm. And, as a neglected point, we shall see that ultimate limits are set on the relative size of the firm by the necessity for markets to exist in every factor, in order to make it possible for the firm to calculate its profits and losses.
Money costs will equal opportunity costs to the businessman only when he plans an investment in factors. To the extent that his money costs are “sunk” in any production process, they are committed irrevocably, and any future plans must consider them as irretrievably spent. The businessman’s market-supply curve will depend on his present opportunity cost, not his past money cost. For the businessman sells his goods at any price that will more than cover any further costs that must be incurred in selling them. As capital goods move toward final output in any stage of the production structure, more and more investment has been sunk into the process. Therefore, the marginal cost of further production (roughly the opportunity cost) becomes ever lower as the product moves toward final output and sale. This is the simple meaning of the usual cost-curve morass. When, for example, some costs are not “fixed,” but irrevocable from the point of view of further short-run production, they are not included in the businessman’s estimated costs of such further production. As we have seen above, the sale of immediate stock completely ready for sale is virtually “costless,” since there are no further costs for its production—in the immediate run. In the ERE, of course, all costs and investments will be adjusted, and irrevocably incurred costs will present no problem. In the ERE average money costs for all firms will equal the price of the product minus pure interest return to the capitalist-entrepreneurs, and also, as we shall see, minus the return to the “discounted marginal productivity of the owner,” a factor which does not enter into the firm’s money costs.
It should be understood throughout that when we refer to increases in wage rates or ground rents in the expanding economy, we are referring to real, and not necessarily to money, wage rates or ground rents.
This assumes, of course, that there is no offsetting decline in capital elsewhere. If there is, then there will be no general rise in wages.
For a discussion of these problems, see Mises, Human Action, pp. 598– 600.
Capital goods will remain unemployed because of previous entrepreneurial error, i.e., investing in the wrong type of capital goods.
 See Mises, Human Action, pp. 595–98. As Mises concludes, “Unemployment in the unhampered market is always voluntary.” Particularly recommended is Mises’ critique of the theory of “frictional unemployment.”
Economics does not “assume mobility of labor.” It simply analyzes the consequences of a laborer’s decision to be “mobile” or “immobile,” the latter amounting to a voluntary choice of at least temporary unemployment.
The “idleness” referred to here is catallactic, and not necessarily total. In other words, it means that a man does not seek to sell his labor services for money and therefore does not enter the societal labor market. He might well be very “busy” working at hobbies, etc.
Hayek, Prices and Production, pp. 91–93.
Cf. Fred R. Fairchild and Thomas J. Shelly, Understanding Our Free Economy (New York: D. Van Nostrand, 1952), pp. 478–81.
Hence, when the economist considers only the single firm (as in recent years), he goes completely astray by ignoring the generality of economic interrelations. To analyze means-ends relations logically, as economics does, requires taking all relations into account. Failure to do so, either by treating the single firm only or by treating unreal holistic aggregates or by taking refuge in the irrelevant mathematics of the Lausanne “general equilibrium” school, is equivalent to abandoning economics.
Many beginning students come away with the impression that economics consists of an indigestible brew of “cost curves” to be memorized by rote and drawn neatly on the blackboard.
E.T. Weiler, The Economic System (New York: Macmillan & Co., 1952), pp. 141–61; Stigler, Theory of Price, pp. 126ff.
Stigler, Theory of Price, p. 126.
Robbins points out that the length of a period of productive activity depends upon the expectations of entrepreneurs concerning the permanence of a change and the technical obstacles to a change. Robbins, “Remarks upon Certain Aspects of the Theory of Costs,” pp. 17–18.
For a critique of cost-curve theory, see the articles by Robbins, Thirlby, and Gabor and Pearce cited above, especially Gabor and Pearce, “A New Approach to the Theory of the Firm.” Also see Milton Friedman, “Survey of the Empirical Evidence on Economies of Scale: Comment” in Business Concentration and Price Policy (Princeton, N.J.: National Bureau of Economic Research, 1955), pp. 230–38; Armen Alchian, “Costs and Outputs” in The Allocation of Economic Resources (Stanford: Stanford University Press, 1959), pp. 23–40; F.A. Hayek, “Unions, Inflation, and Prices” in Philip D. Bradley, ed., The Public Stake in Union Power (Charlottesville: University of Virginia Press, 1959), pp. 55f.; Hayek, Pure Theory of Capital, pp. 14, 20–21; Harrod, “Theory of Imperfect Competition Revised” in Economic Essays, pp. 139–87; G. Warren Nutter, “Competition: Direct and Devious,” American Economic Review, Papers and Proceedings, May, 1954, pp. 69ff.; Scott, Natural Resources: The Economics of Conservation, p. 5.
This law follows from the natural law that every quantitatively observable cause-effect relation can be duplicated. For example, if x + 2y + 3z are necessary and sufficient to form 1p, another set will form another p, so that 2x + 4y + 6z will yield 2p.
See chapter 10 for more on the theory of pure competition.
For example, suppose that 1,000 gold ounces invested in factors yield 100 units of product and that 1,100 ounces yield 101 units. All the points in the gap between 1,000 and 1,100 will yield no more than 100 units. The excess of investment over 1,000 and under 1,100 ounces is clearly sheer waste, and no businessman will invest within the gap. Instead, investments will be made at such trough points for average cost as 1,000 and 1,100.
 Stigler, Theory of Price, pp. 132ff.
We are not discussing the fact that the railroad could, of course, cut down or increase the mileage of its track by including less or more geographic area in its service. The example assumes a given geographic area in which the railroad operates.
See Mises, Human Action, pp. 338–40. This is the unrealistic condition implicitly assumed by textbook “cost curves.”
Ibid., p. 340.
Stigler, Theory of Price, p. 136.
It is particularly important not to limit possible efficiencies from large-scale production to narrow technological factors such as the “size of the plant.” There are also efficiencies derived from the organization of a firm owning several plants—e.g., management utilization, specialization, efficiency of large-scale purchasing and selling, research expenditures, etc. Cf. George G. Hagedorn, Studies on Concentration (New York: National Association of Manufacturers, 1951), pp. 14ff.
See Friedman, “Survey of the Empirical Evidence on Economies of Scale: Comment,” pp. 230–38.
For a good, largely empirical, study of size of firm, see George G. Hagedorn, Business Size and the Public Interest (New York: National Association of Manufacturers, 1949). Also see idem, Studies on Concentration, and John G. McLean and Robert W. Haigh, “How Business Corporations Grow,” Harvard Business Review, November–December, 1954, pp. 81–93.
Plans are relevant, not only in the ERE, but also to all decisions on maintenance or replacement, as well as additions to capital goods when they wear out or fall into disrepair.
It is costless only if no rise in the price of the good is foreseen for the near future. If it is, then there will arise the opportunity cost of forgoing a higher price. Hence, if there is no hope of a higher price, the businessman will sell, however low the price (adjusting for the costs of selling minus the costs of continued storage).
Conventional “cost-curve” analysis depicts average cost and demand curves as tangential in the ERE—i.e., that price = average cost. But (aside from the unreality of assuming smooth curves rather than discontinuous angles), interest return—as well as return to the owner’s decision-making ability—will accrue to the entrepreneurs even in the ERE. Hence, no such tangency can arise. See chapter 10 below for the implications of this revision for “monopolistic competition” theory.
For further readings on cost, see G.F. Thirlby, “The Marginal Cost Controversy: A Note on Mr. Coase’s Model,” Economica, February, 1947, pp. 48–53; F.A. Fetter’s classic “The Passing of the Old Rent Concept,” p. 439; R.H. Coase, “Business Organization and the Accountant,” The Accountant, October l–November 26, 1938; and idem, “Full Costs, Cost Changes, and Prices” in Business Concentration and Price Policy, pp. 392–94; John E. Hodges, “Some Economic Implications of Cost-Plus Pricing,” Southwestern Social Science Quarterly, December, 1954, pp. 225–34; I.F. Pearce, “A Study in Price Policy,” Economica, May, 1956, pp. 114–27; I.F. Pearce and Lloyd R. Amey, “Price Policy with a Branded Product,” Review of Economic Studies, Vol. XXIV (1956–57), No. 1, pp. 49–60; James S. Earley, “Recent Developments in Cost Accounting and the ‘Marginal Analysis’,” Journal of Political Economy, June, 1955, pp. 227–42; and David Green, Jr., “A Moral to the Direct-Costing Controversy,” Journal of Business, July, 1960, pp. 218–26.