Chapter 9—Production: Particular Factor Prices
and Productive Incomes (continued)
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Chapter
9—Production: Particular Factor Prices
and Productive Incomes (continued)
B.
Business Income
The net incomes in the economy accrue to labor in wages, to landowners
in ground rents (both wages and ground rents being
“rents,” i.e., unit-prices of productive factors),
to capitalists in interest—all of which continue in the
ERE—and profits and losses to entrepreneurs, which do not.
(Ground rents are capitalized in the capital value of land,
which therefore earns the interest rate in the ERE.) But what
of the owners? Are their incomes exhausted by the category of
entrepreneurial profit and loss, which we have studied in chapter 8, or
will they continue to earn income beyond interest in the ERE?
So far we have seen that owners of businesses perform an entrepreneurial
function: the function of uncertainty-bearing in an ever-changing
world. Owners are also capitalists, who advance present funds to labor
and land factors and earn interest. They may also be their own
managers; in that case, they earn an implicit wage
of management, since they are performing work which could
also be performed by employees.
We have seen that,
catallactically, labor is the personal energy of nonowners in
production, and that this factor receives wages. When the
owner does laboring work himself, then he too earns an implicit wage.
This wage, of course, continues also in the ERE.
But is there a function which owning businessmen perform, and would
still perform in the ERE, beyond the advancing of capital or possible
managerial work? The answer is that they do execute another function
for which they cannot hire other factors.
It goes beyond the simple capital-advancing function, and it still
continues in the ERE. For want of a better term, it may be called the decision-making
function, or the ownership function.
Hired managers may successfully direct production or choose production
processes. But the ultimate responsibility and control of production
rests inevitably with the owner, with the
businessman whose property the product is until it is sold. It
is the owners who make the decision concerning how much capital to
invest and in what particular processes. And particularly, it is the owners
who must choose the managers. The ultimate decisions
concerning the use of their property and the choice of the men to
manage it must therefore be made by the owners and by no one else. It
is a function necessary to production, and one that continues in the
ERE, since even in the ERE there are skills needed to hire proper
managers and invest in the most efficient processes; and even though
these skills remain constant, the efficiency with which they
are performed will differ from one firm to another, and differing
returns will be received accordingly.
The decision-making factor is necessarily specific
to each firm. We cannot call what it earns a wage
because it can never be hired, and thus it does not earn an implicit
wage. We may therefore call the income of this factor, the
“rent of decision-making ability.”
It is clear that this rent
will be equal to the factor’s DMVP, the amount which it
specifically contributes to the firm’s revenue. Since this
ability differs from one owner to the next, the rents will differ
accordingly. This difference accounts for the phenomena of
“high-cost” and “low-cost”
firms in any industry and indicates that differences in efficiency
among firms are not solely functions of ephemeral uncertainty, but
would persist even in the ERE.
Granting that the “supramarginal”
(i.e., the lower-cost) firms in an industry are earning rents
of decision-making ability for their owners, what of the
“marginal” firms in the industry, the
“high-cost” firms just barely in business? Are their
owners earning rents of decision-making ability? Many
economists have believed that these marginal firms earn no
such income, just as they have believed that the marginal land earns
zero rent. We have seen, however, that the marginal land earns some
rent, even if “close to” zero. Similarly, the
marginal firm earns some rent of decision-making
ability. We can never say quantitatively how much it will be, only that
it will be less than the corresponding “decision
rents” of the supramarginal firms.
The belief that marginal firms earn no decision rents whatever
seems to stem from two errors: (1) the assumption of
mathematical continuity, so that successive points blend
together; and (2) the assumption that “rent” is
basically differential and therefore that the most inferior
working land or firm must earn zero to establish the differential. We
have seen, however, that rents are
“absolute”—the earnings and marginal
value products of factors. There is no necessity, therefore,
for the poorest factor to earn zero, as we can see when we realize that
wages are a subdivision of rents and that
there is clearly no one making a zero wage. And so neither does the
marginal firm earn a decision rent of zero.
That the decision rent earned by the marginal firm must
be positive and not zero becomes evident if we consider a firm whose
decision rent is only zero. Its owner would then be performing certain
functions—making and bearing responsibility for ultimate
decisions about his property and choosing the top
managers—and yet receiving no return. And this in the ERE,
where it cannot be simply the unforeseen result of entrepreneurial
mistakes! But there will be no reason for the owner to continue
performing these functions without a return. He will not continue to
earn what is psychically a negative return, for
while he remained in business he would continue to expend energy in
ownership while receiving nothing in return.
To sum up, the income accruing to a business owner, in a changing
economy, will be a composite of four elements:
We have, so far, been dealing almost exclusively with capitalist-entrepreneurs.
Since the entrepreneur is the actor in relation to natural
uncertainty, the capital investor, who hires and makes advances to
other factors, plays a peculiarly important entrepreneurial
role. Making decisions concerning how much and where to invest, he is
the driving force of the modern economy. Laborers
are also entrepreneurs in the sense of predicting demand in
the markets for labor and choosing to enter certain markets
accordingly. Someone who emigrates from one country to another in
expectation of a higher wage is in this sense an entrepreneur and may
obtain a monetary profit or loss from his move. One important
distinction between capitalist-entrepreneurs and laborer-entrepreneurs
is that only the former may suffer negative incomes
in production. Even if a laborer emigrates to a nation where pay turns
out to be lower than expected, he absorbs only a differential,
or “opportunity,” loss from what he might have
earned elsewhere. But he still earns a positive wage in production.
Even in the unlikely event of a labor surplus vis-à-vis
land, the laborer earns zero and not negative
wages. But the capitalist-entrepreneur, the man who hires the other
factors, can and does incur actual monetary losses from his
entrepreneurial effort.
C.
Personal Consumer Service
A particularly important category of laborer-entrepreneurs is that of
the sellers of personal services to consumers. These laborers
are generally capitalists as well. The sellers of such
services—doctors, lawyers, concert artists,
servants, etc.—are self-employed businessmen, who,
in addition to interest on whatever capital they have invested, earn an
implicit “managerial” wage for their labor. Thus, they earn a peculiar type of
income: a business return consisting almost exclusively of labor
income. We may call this type of work direct labor,
since it is labor that serves directly as a
consumers’ good rather than hired as a factor of production.
And since it is a consumers’ good, this labor
service is priced directly on the market.
The determination of the prices of these goods will be similar on the
demand side to that of any consumers’ good. Consumers
evaluate marginal units of the service on their value scales and decide
how much, if any, to purchase. There is a difference, however,
on the supply side. The market-supply curves for most
consumers’ goods are vertical straight lines, since
the sale of the product, once produced, is costless
to the entrepreneur. He has no alternative use for it. The case of personal
service, however, is different. In the first place, leisure
is a definite alternative to work. In the second place, as a result of
the connexity of the labor market, the worker can shift to a
higher-paying occupation further up on the structure of production if
his income in this occupation is unsatisfactory. As a result, for this
type of consumers’ good, the supply curve is likely to be a
rather flat, forward-sloping one.
The seller of the service, or the direct laborer,
earns, as do all factors, his DMVP to the consumer. He will allocate
his labor to whatever branch, whether high or low in the structure of
production, where his DMVP will be the highest, and where, as
a consequence, his wage rate will be the greatest. The principles of
allocation, then, between direct labor and indirect labor in production
are the same as those among the various branches of indirect productive
use.
D.
Market Calculation and Implicit Earnings
We have seen that a musician or a doctor earns wages without
being an employee; the wages of each are implicit
in the income that he receives, even though they are received directly
from the consumers.
In the real world, each function is not necessarily
performed by a different person. The same person can be a landowner and
a worker. Similarly, a particular firm, or rather its owner or owners,
may own land and participate in the production of capital
goods. The owner may also manage his own firm. In
practice, the different sources of income can be separated only by
referring to these incomes as determined by prices on the
market. For example, suppose that a man owns a firm
which invests its capital, owns its own ground land, and produces a
capital good, and that he manages the plant himself. He receives a net
income over a year’s period of 1,000 gold ounces. How can he
estimate the different sources of his
income? Suppose that he had invested 5,000 gold ounces in the business.
He looks around at the economy and finds that what he can pretty well
call the ruling rate of interest, toward which the economy is tending,
is 5 percent. He then concludes that 250 gold ounces of his
net income was implicit interest. Next, he estimates approximately what
he would have received in wages of management if he had gone to work
for a competing firm rather than engaging in this business. Suppose he
estimates that this would have been 500 gold ounces. He then looks to
his ground land. What could he have received for the land if he had
rented it out instead of using it himself in the business? Let us say
that he could have received 400 ounces in rental income for the land.
Now, our owner received a net money income, as
landowner-capitalist-laborer-entrepreneur, of 1,000 gold
ounces for the year. He then estimates what his costs
were, in money terms. These costs are not his explicit money expenses,
which have already been deducted to find his net income, but his
implicit expenses, i.e., his opportunities forgone by engaging in the
business. Adding up these costs, he finds that they total:
Thus, the entrepreneur suffered a loss of 150
ounces over the period. If his opportunity costs had been less than
1,000, he would have gained an entrepreneurial profit.
It is true that such estimates are not precise. The estimates of what
he would have received can never be wholly accurate. But this tool of ex
post calculation is an indispensable one.
It is the only way by which a man can guide his ex ante
decisions, his future actions. By means of this calculation, he may
realize that he is suffering a loss in this business. If the loss
continues much longer, he will be impelled to shift his various
resources to other lines of production. It is only by means of such
estimates that an owner of more than one type of factor in the firm can
determine his gains or losses in any situation and then allocate his
resources to strive for the greatest gains.
A very important aspect of such estimates of implicit incomes has been
overlooked: there can be no implicit estimates without an
explicit market! When an entrepreneur receives income, in
other words, he receives a complex of various functional incomes. To
isolate them by calculation, there must be in existence an
external market to which the entrepreneur can refer.
This is an extremely important point, for, as we shall soon see in
detail, this furnishes a most important limitation on the relative
potential size of a single firm on the market.
For example, suppose we return for a moment to our old
hypothetical example in which each firm is owned jointly by
all its factor-owners. In that case, there is no separation at all
between workers, landowners, capitalists, and entrepreneurs. There
would be no way, then, of separating the wage incomes received from the
interest or rent incomes or profits received. And now we finally arrive
at the reason why the economy cannot consist completely of
such firms (called “producers’
co-operatives”). For, without an
external market for wage rates, rents, and interest, there would be no
rational way for entrepreneurs to allocate factors in
accordance with the wishes of the consumers. No one would know where he
could allocate his land or his labor to provide the maximum
monetary gains. No entrepreneur would know how to arrange factors in
their most value-productive combinations to earn the greatest
profit. There could be no efficiency in production because the
requisite knowledge would be lacking. The productive system would be in
complete chaos, and everyone, whether in his capacity as consumer or as
producer, would be injured thereby. It is clear that a world of
producers’ co-operatives would break down for any economy but
the most primitive, because it could not calculate and
therefore could not arrange productive factors to meet the
desires of the consumers and hence earn the highest incomes for the
producers.
E.
Vertical Integration and the Size of the Firm
In the free economy, there is an explicit time
market, labor market, and land-rent market. It is clear that while
chaos would ensue from a world of producers’ co-operatives,
other critical points even before that would, as it were, introduce little
bits of chaos into the productive system. Thus, suppose that
workers are separated from capitalists, but that all
capitalists own their own ground land. Further, suppose, that for one
reason or another, no capitalist will be able to rent out his land to
some other firm. In that case, land and a
particular capital and production process are indissolubly wedded to
each other. There would be no rational way to allocate land in
production, since it would have no explicit price anywhere.
Since producers would suffer heavy losses, the free market
would never establish such a situation. For the free market
always tends to conduct affairs so that entrepreneurs make the greatest
profit through serving the consumer best and most efficiently. Since
absence of calculation creates grave inefficiencies in the
system, it also causes heavy losses. Such a situation (absence
of calculation) would therefore never be established on a free market,
particularly after an advanced economy has already developed
calculation and a market.
If this is true for such cases as a world of producers’
co-operatives and the absence of a rent market, it also holds
true, on a smaller scale, for “vertical
integration” and the size of a firm. Vertical integration
occurs when a firm produces not only at one stage
of production, but over two or more stages. For example, a firm becomes
so large that it buys labor, land, and capital goods of the fifth
order, then works on these capital goods, producing other capital goods
of the fourth order. In another plant, it then works on the
fourth-order capital goods until they become third-order capital goods.
It then sells the third-order product.
Vertical integration, of course, lengthens the production period for any
firm, i.e., it lengthens the time before the firm
can recoup its investment in the production process. The interest
return then covers the time for two or more stages rather than one.
There is a more important
question involved, however. This is the role of implicit earnings and
calculation in a vertically integrated firm. Let us take the case of
the integrated firm mentioned in Figure 65.
Figure 65 depicts a vertically integrated firm; the arrows represent
the movement of goods and services (not of money). The firm buys labor
and land factors at both the fifth and the fourth stages; it also makes
the fourth-stage capital goods itself and uses them in another plant to
make a lower-stage good. This movement internal to
the firm is expressed by the dotted arrow.
Does such a firm employ calculation within itself, and if so, how? Yes.
The firm assumes that it sells itself the
fourth-rank capital good. It separates its net income as a producer of
fourth-rank capital from its role as producer of third-rank
capital. It calculates the net income for each separate division of its
enterprise and allocates resources according to the profit or
loss made in each division. It is able to make such an
internal calculation only because it can refer to an existing explicit
market price for the fourth-stage capital good. In other
words, a firm can accurately estimate the profit or loss it makes in a
stage of its enterprise only by finding out the implicit
price of its internal product, and it can do this only if an external
market price for that product is established elsewhere.
To illustrate, suppose that a firm is vertically integrated over two
stages, with each stage covering one year’s time. The general
rate of interest in the economy tends towards 5 percent (per
annum). This particular firm, say, the Jones Manufacturing Company,
buys and sells its factors as shown in Figure 66.
This vertically integrated firm buys factors at the fifth rank for 100
ounces and original factors at the fourth rank for 15 ounces; it sells
the final product at 140 ounces. It seems that it
has made a handsome entrepreneurial profit on its operations, but can
it find out which stage or stages is making this profitable showing? If
there is an external market for the product of the stage that the firm
has vertically integrated (stage 4), the Jones Company is able to
calculate the profitability of specific stages of
its operations. Suppose, for example, that the price of the
fourth-order capital good on the external market is 103 ounces. The
Jones Company then estimates its implicit price for
this intermediate product at what it would have brought on
the market if it had been sold there. This price will be
about 103 ounces. Assuming that
the price is estimated at 103, then the total amount of money spent by
Jones’ lower-order plant on factors is 15 (explicit, on
original factors) plus 103 (implicit, on capital goods) for a total of
118.
Now the Jones Company can calculate the profits or losses made at each
stage of its operations. The “higher”
stage bought factors for 100 ounces and “sold” them
at 103 ounces. It made a 3-percent return on its investment. The lower
stage bought its factors for 118 ounces and sold the product for 140
ounces, making a 29-percent return. It is obvious that, instead of
enjoying a general profitability, the Jones Company suffered a
2-percent entrepreneurial loss on its earlier stage and gained a 24-
percent profit on its later stage. Knowing this, it will shift
resources from the higher to the lower stage in accordance with their
respective profitabilities—and therefore in
accordance with the desires of consumers. Perhaps it will abandon its
higher stage altogether, buying the capital good from an external firm
and concentrating its resources in the more profitable lower
stage.
On the other hand, suppose that there is no external market, i.e., that
the Jones Company is the only producer of the intermediate
good. In that case, it would have no way of knowing which stage was
being conducted profitably and which not. It would therefore have no
way of knowing how to allocate factors to the various stages. There
would be no way for it to estimate any implicit price or opportunity
cost for the capital good at that particular stage. Any estimate would
be completely arbitrary and have no meaningful relation to economic
conditions.
In short, if there were no market for a product, and all of its
exchanges were internal, there would be no way for a firm or for anyone
else to determine a price for the good. A firm can estimate an implicit
price when an external market exists; but when a market is absent, the
good can have no price, whether implicit or explicit. Any figure could
be only an arbitrary symbol. Not being able to calculate a price, the
firm could not rationally allocate factors and resources from one stage
to another.
Since the free market always tends to establish the most efficient and
profitable type of production (whether for type of good, method of
production, allocation of factors, or size of firm), we must conclude
that complete vertical integration for a capital-good product
can never be established on the free market (above the primitive
level). For every capital good, there must be a definite
market in which firms buy and sell that good. It is obvious
that this economic law sets a definite maximum to the
relative size of any particular firm on the free market.Because of this law, firms cannot
merge or cartelize for complete vertical integration of stages
or products. Because of this law, there can never be One Big Cartel
over the whole economy or mergers until One Big Firm owns all the
productive assets in the economy. The force of this law multiplies as
the area of the economy increases and as islands of noncalculable chaos
swell to the proportions of masses and continents. As the area of
incalculability increases, the degrees of irrationality, misallocation,
loss, impoverishment, etc., become greater. Under one
owner or one cartel for the whole productive
system, there would be no possible areas of calculation at all, and
therefore complete economic chaos would prevail.
Economic calculation becomes ever more important as the market economy
develops and progresses, as the stages and the complexities of type and
variety of capital goods increase. Ever more important for the
maintenance of an advanced economy, then, is the preservation of markets
for all the capital and other producers’ goods.
Our analysis serves to expand the famous discussion of the possibility
of economic calculation under socialism, launched by Professor Ludwig
von Mises over 40 years ago.
Mises, who has had the
last as well as the first word in this debate, has
demonstrated irrefutably that a socialist economic system
cannot calculate, since it lacks a market, and hence lacks
prices for producers’ and especially for capital
goods.
Now we see that,
paradoxically, the reason why a socialist economy cannot
calculate is not specifically because it is
socialist! Socialism is that system in which the State forcibly seizes
control of all the means of production in the economy. The reason for
the impossibility of calculation under socialism is that one
agent owns or directs the use of all the resources in the
economy. It should be clear that it does not make any difference
whether that one agent is the State or one private individual or
private cartel. Whichever occurs, there is no possibility of
calculation anywhere in the production structure, since
production processes would be only internal and without markets. There
could be no calculation, and therefore complete economic irrationality
and chaos would prevail, whether the single owner is the State
or private persons.
The difference between the State and the private case is that our
economic law debars people from ever establishing such a system in a
free-market society. Far lesser evils prevent entrepreneurs
from establishing even islands of incalculability, let alone infinitely
compounding such errors by eliminating calculability altogether. But
the State does not and cannot follow such guides of profit and loss;
its officials are not held back by fear of losses from setting up
all-embracing cartels for one or more vertically integrated products.
The State is free to embark upon socialism without considering such
matters. While there is therefore no possibility of a one-firm economy
or even a one-firm vertically integrated product, there is much danger
in an attempt at socialism by the State. A further discussion
of the State and State intervention will be found in chapter 12 of this
book.
A curious legend has become quite popular among the writers on the
socialist side of the debate over economic calculation. This runs as
follows: Mises, in his original article, asserted
“theoretically” that there could be no
economic calculation under socialism; Barone proved
mathematically that this is false and that calculation is possible;
Hayek and Robbins conceded the validity of this proof but then asserted
that calculation would not be “practical.” The
inference is that the argument of Mises has been disposed of and that
all socialism needs is a few practical devices (perhaps calculating
machines) or economic advisers to permit calculation and the
“counting of the equations.”
This legend is almost completely wrong from start to finish. In the
first place, the dichotomy between “theoretical”
and “practical” is a false one. In economics, all
arguments are theoretical. And, since economics discusses the
real world, these theoretical arguments are by their nature
“practical” ones as well.
The false dichotomy disposed of, the true nature of the Barone
“proof” becomes apparent. It is not so much
“theoretical” as irrelevant. The
proof-by-listing-of-mathematical-equations is no proof at all. It
applies, at best, only to the evenly rotating economy.
Obviously, our whole discussion of the calculation problem applies to
the real world and to it only. There can be no
calculation problem in the ERE because no calculation there is
necessary. Obviously, there is no need to calculate
profits and losses when all future data are known from the beginning
and where there are no profits and losses. In the
ERE, the best allocation of resources proceeds automatically. For
Barone to demonstrate that the calculation difficulty does not exist in
the ERE is not a solution; it is simply a mathematical belaboring of
the obvious.
The difficulty of
calculation applies to the real world only.
This implicit wage will equal the
DMVP of the owner’s managerial services, which will tend to
equal the “opportunity wage forgone” that he could
be earning as a manager elsewhere.
This implicit wage will equal the
DMVP of the owner’s managerial services, which will tend to
equal the “opportunity wage forgone” that he could
be earning as a manager elsewhere.
For an interesting contribution to
the theory of business income, though not coinciding with the one
presented here, see Harrod, “Theory of
Profit” in Economic Essays, pp.
190–95. Also see Friedman,
“Survey of the Empirical Evidence on Economies of Scale:
Comment.”
Since the scope of their business
property and decisions is relatively negligible compared to their labor
services, we may neglect their decision rents here.
It is a managerial wage, even
though the only employee may be the owner himself. It may seem strange
to classify a domestic servant as “self-employed,”
but actually he is no different from a doctor or a lawyer to
the extent that the latter sells his services to consumers
rather than to capitalists.
Another reason why an economy of
producers’ co-operatives could not calculate is that every
original factor would be tied indissolubly to a specific line of
production. There can be no calculation where all factors are purely
specific.
Vertical integration, we might
note, tends to reduce the demand for money (to “turn
over” at various stages) and thereby to lower the
purchasing power of the monetary unit. For the effect of
vertical integration on the analysis of investment and the production
structure, see Hayek, Prices and
Production, pp. 62–68.
The implicit price, or opportunity
cost of selling to oneself, might be less than the existing market
price, since the entry of the Jones Company on the market might have
lowered the price of the good, say to 102 ounces. There would be no way
at all, however, to estimate the implicit price if there were no
external market and external price.
On the size of a firm, see the
challenging article by R.H. Coase, “The Nature of the
Firm” in George J. Stigler and Kenneth E. Boulding, eds., Readings
in Price Theory (Chicago: Richard D. Irwin, 1952), pp.
331–51. In an illuminating passage Coase pointed out that
State “planning is imposed on industry, while firms
arise voluntarily because they represent a more efficient method of
organizing production. In a competitive system there is an
‘optimum’ amount of planning.” Ibid.,
p. 335 n.
Capital goods are stressed here
because they are the product for which the calculability problem
becomes important. Consumers’ goods per se
are no problem, since there are always many consumers buying goods, and
therefore consumers’ goods will always have a market.
See the classic presentation of
the position in Ludwig von Mises, “Economic
Calculation in the Socialist Commonwealth,” reprinted in F.A.
Hayek, ed., Collectivist Economic Planning (London:
George Routledge & Sons, 1935), pp. 87–130. Also
see in the Hayek volume the other essays by Hayek, Pierson,
and Halm. Mises continued his argument in Socialism
(2nd ed.; New Haven: Yale University Press, 1951), pp.
135–63, and refutes more recent criticisms in his Human
Action, pp. 694–711. Aside from these works, the
best book on the subject of economic calculation under
socialism is Trygve J.B. Hoff, Economic Calculation in the
Socialist Society (London: William Hodge, 1949). Also
see F.A. Hayek, “Socialist Calculation III, the
Competitive ‘Solution’” in Individualism
and the Economic Order, pp. 181–208, and Henry
Hazlitt’s remarkable essay in fictional form, The
Great Idea (New York: Appleton-Century-Crofts, 1951).
It is remarkable that so many
antisocialist writers have never become aware of this critical point.
Far from being refuted, Mises had
already disposed of this argument in his original article. See
Hayek, Collectivist Economic Planning, p. 109.
Further, Barone’s article was written in 1908, 12 years
before Mises’. A careful perusal of Mises’
original article, in fact, reveals that he there disposed of almost all
the alleged “solutions” which decades later were
brought forth as “new” attempts to refute his
argument.
Part of the confusion
stems from an unfortunate position taken by two followers of Mises in
this debate—Hayek and Robbins. They argued that a socialist
government could not calculate because it simply could not compute the
millions of equations that would be necessary. This left them open to
the obvious retort that now, with high-speed computers available to the
government, this practical objection is no longer relevant. In reality,
the job of rational calculation has nothing to do with
computing equations. Nobody has to worry about
“equations” in real life except mathematical
economists. Cf. Lionel Robbins, The Great Depression
(New York: Macmillan & Co., 1934), p. 151, and Hayek in Collectivist
Economic Planning, pp. 212f.
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