Particular Factor Prices
and Productive Incomes (continued)
4. The Economics of Location and Spatial Relations
One very popular subdivision of economics has been “international trade.” In a purely free market, such as we are analyzing in the bulk of this work, there can be no such thing as an “international trade” problem. For nations might then possibly continue as cultural expressions, but not as economically meaningful units. Since there would be neither trade nor other barriers between nations nor currency differences, “international trade” would become a mere appendage to a general study of interspatial trade. It would not matter whether the trade was within or outside a nation.
The laws of the free market that we have been enunciating apply, therefore, to the whole extent of the market, i.e., to the “world” or the “civilized world.” In the case of a completely isolated country, the laws would apply throughout that area. Thus, the pure interest rate will tend to be uniform throughout the world, prices for the same good will tend to be uniform throughout, and, therefore, so will wages for the same type of labor.
Wage rates will tend toward uniformity for the same labor in different geographical areas in precisely the same way as from industry to industry or firm to firm. Any temporary differential will induce laborers to move from the low- to the high-wage area and businesses to move from the latter to the former, until equilibrium is reached. Once again, just as in the more general case considered above, workers may have particular positive or negative attachments toward working in a certain area, just as we saw they may have toward working in a certain industry. There may be a general psychic benefit from living and working in a certain place, and a psychic disutility involved in working at some other location. Since it is psychic, not money, wage rates that are being equalized, money wage rates will be equalized throughout the world plus or minus negative or positive psychic attachment components.
That the prices of each good will be uniform throughout the world rests on a precise definition of the term “good.” Suppose, for example, that wheat is grown in Kansas and that the bulk of the consumers of the wheat are in New York. The wheat in Kansas, even when ready for shipment, is not the same good as the wheat in New York. It may be the same physical-chemical bundle, but it is not the same good vis-à-vis its objective use-value to the consumers. In short, wheat in Kansas is a higher-stage capital good than wheat in New York (when the consumer is in New York rather than in Kansas). Transporting the wheat to New York is a stage in the process of production. The price of wheat in Kansas will then tend to equal the price of wheat in New York minus the necessary costs of transport from Kansas to New York.
What determines how people and businesses will be distributed over the face of the earth? Obviously, the major factor is the marginal productivity of labor. This will differ from location to location in accordance with the distribution of natural resources and the distribution of capital equipment inherited from ancestors. Another factor influencing location will be positive or negative attachments to certain areas, as we have seen above. The actual dispersal over the face of the earth is caused chiefly by the distribution of productive land and natural resources over the earth’s surface. This has been one of the chief forces limiting the concentration of industry, the size of each firm, and population in purely industrial areas.
In considering the location of industry, entrepreneurs must account for costs of transportation from raw material sites to the centers of consumer population. Certain areas of the world will tend to have higher costs of transportation than other parts. Wheat is further away in New York than in Kansas, and the theater further away in Kansas. Some areas may enjoy lower transport costs for the bulk of consumers’ goods, while others may have higher transport costs. Thus, Alaska will probably have higher transport costs for its consumers’ goods than less remote areas such as San Francisco. Therefore, to obtain the same products, Alaskan consumers must be willing to pay higher prices in Alaska than in San Francisco, even though purchasing power and prices are uniform throughout the world. As a result, the “cost component” for anyone working in Alaska will be a certain positive amount. Because of the transport problem, the same money wage in Alaska will buy fewer goods than in San Francisco. This increased “cost of living” establishes a positive cost component in the wage, so that for similar labor a worker would require a higher money wage to work in Alaska than elsewhere.
If the costs attached to a geographical area are particularly high or low, a positive or a negative cost component will be attached to the wage rate in that area. Instead of saying that money wage rates for the same type of labor will be equalized throughout the world, we must say rather that there will be a tendency for equalization of money wage rates plus or minus the attachment component, and plus or minus the cost component, for every geographic area.
The purchasing power of the monetary unit will also be equalized throughout the world. This case will be treated below in chapter 11 on Money.
The tendency of an advancing market economy, of course, is to lower transportation costs, i.e., to increase labor productivity in the transport field. Other things being equal, then, the cost components tend to become relatively less important as the economy progresses.
We have seen that a “good” must be considered as homogeneous in use-value, and not in physical substance. Wheat in Kansas was a different good from wheat in New York. Some economists have taken the law that all goods tend to be uniform in price throughout the world economy to mean that all physically homogeneous things will be equal in price. But a difference in position with respect to consumers makes a physically identical thing a different good. Suppose, for example, that two firms are producing a certain product, say cement, and that one is located in Rochester and one in Detroit. Let us say that the bulk of the consumers of cement are in New York City.
Let us call the cement produced in Rochester, Cr, and the cement produced in Detroit, Cd. Now, in equilibrium, the price of Cr in New York City will equal the price of Cr in Rochester plus the freight cost from Rochester to New York. Also, in equilibrium, the price of Cd in New York City will equal the price of Cd in Detroit plus the freight cost from Detroit to New York. Which cement prices will be equal to each other in equilibrium? Many writers maintain that the price of Cr in Rochester will be equal to the price of Cd in Detroit, i.e., that the “mill prices,” or the “f.o.b. prices,” of cement will be equal in each of the two localities in equilibrium. But it is clear that these writers have adopted the confusion of treating “good” in the technological rather than in the use-value sense.
We must, in short, take the point of view of the consumer— the man who uses the good—and he is in New York City. From his point of view, cement in Detroit is a far different good from cement in Rochester, since Rochester is closer to him and freight costs are greater from Detroit. From his point of view, the homogeneous goods are: Cr in New York City and Cd in New York City. Wherever it comes from, cement at the place where he must use it is the homogeneous good for the consumer.
Therefore, in equilibrium, it is Cr in New York City that will be equal to Cd in New York City—and these are the “delivered prices” of cement to the consumer. Substituting this equality in the above equations, we see that it implies that the price of Cr in Rochester, plus freight cost from Rochester to New York, will equal the price of Cd in Detroit, plus freight cost from Detroit to New York. The freight costs at any time are readily calculable, and ceteris paribus, they will be greater for longer distances. In other words, in equilibrium on the free market, the price of Cr in Rochester is equal to the price of Cd in Detroit plus the differential in freight costs for the longer as compared to the shorter distance to the consumer. Generalizing, the “mill price” of cement at a shorter distance from the consumer will equal the “mill price” of cement at the longer distance plus the freight differential. This is applicable not only to cement, but to every product in the economic system, and not only to products serving ultimate consumers, but also to those to be “consumed” by lower-order capitalists.
In proportion as firms are more distantly located from the consumer, they will then not be able to remain in business unless their average costs at the mill are sufficiently lower than those of their competitors to compensate for the increased freight costs. This is not, as might be thought, a “penalty” on the “technological superiority” of the distant firm, for the latter is inferior with respect to the important economic factor of location. It is precisely this mechanism that helps to determine the location of firms and assures that firms will be economically located in relation to the consumer. The influence of the location-difference factor in the price of a product will, of course, depend upon the proportion that freight costs bear to the other costs of producing the good. The higher the proportion, the greater the influence.
A firm with a location closer to the consumer market therefore has a spatial advantage conferred by its location. Given the same costs in other fields as its competitors, it earns a profit from its superior location. The gains of location will be imputed to the site value of the ground land of the plant. The owner of the site obtains its marginal value product. Therefore, gains to a firm resulting from improvement in locational advantage, as well as losses resulting from a locational disadvantage, will accrue as changes in ground rent and capital value to the owner of the specific site, whether the owner be the firm itself or someone else.
Ever since the days of early classical economics, many writers have discussed “distribution theory” as if it were completely separate and isolated from production theory.Yet we have seen that “distribution” theory is simply production theory. The receivers of income earn wages, rent, interest, and increases in capital values; and these earnings are the prices of productive factors. The theory of the market determines the prices and incomes accruing to productive factors, thereby also determining the “functional distribution” of the factors. “Personal distribution”—how much money each person receives from the productive system—is determined, in turn, by the functions that he or his property performs in that system. There is no separation between production and distribution, and it is completely erroneous for writers to treat the productive system as if producers dump their product onto some stockpile, to be later “distributed” in some way to the people in the society. “Distribution” is only the other side of the coin of production on the market.
Many people criticize the free market as follows: Yes, we agree that production and prices will be allocated on the free market in a way best fitted to serve the needs of the consumers. But this law is necessarily based on a given initial distribution of income among the consumers; some consumers begin with only a little money, others with a great deal. The market system of production can be commended only if the original distribution of income meets with our approval.
This initial distribution of income (or rather of money assets) did not originate in thin air, however. It, too, was the necessary consequence of a market allocation of prices and production. It was the consequence of serving the needs of previous consumers. It was not an arbitrarily given distribution, but one that itself emerged from satisfying consumer needs. It too was inextricably bound up with production.
As we saw in chapter 2, a person’s presently owned property could have been ultimately obtained in only one of the following ways: through personal production, voluntary exchange for a personal product, the finding and first using of unappropriated land, or theft from a producer. On a free market, only the first three can obtain, so that any “distribution” served by producers was in itself the result of free production and exchange.
Suppose, however, that at some preceding time the bulk of the wealthy consumers had acquired their property through theft and not through serving other consumers on the free market. Does this not instill a “built-in bias” into the market economy, since future producers must satisfy demands ensuing from unjust incomes?
The answer is that after the initial period, the effect of unjust incomes becomes less and less important. For in order to keep and increase their ill-gotten gains, the former robbers, now that a free economy is established, have to invest and recoup their funds so as to serve consumers correctly. If they are not fit for this task, and their exploits in predation have certainly not trained them for it, then entrepreneurial losses will diminish their assets and shift them to more able producers.
The explanation of the free economic system constitutes a great architectural edifice. Starting from human action and its implications, proceeding to individual value scales and a money economy, we have demonstrated that the quantity of goods produced, the prices of consumers’ goods, the prices of productive factors, the interest rate, profits and losses, all can be explained by the same deductive apparatus. Given a stock of land and labor factors, given existing capital goods inherited from the past, given individual time preferences (and, more broadly, technological knowledge), the capital goods structure and total production is determined. Individual preferences set prices for the various consumers’ goods, and the alternative combinations of various factors in their production set the marginal value-productivity schedules of these factors. Ultimately, the marginal value product accruing to capital goods is resolved into returns to land, labor, and interest for time. The point at which a land or labor factor will settle on its DMVP schedule will be determined by the stock available. Since each factor will operate in an area of diminishing physical and certainly diminishing value returns, any increased stock of the factor, other things being equal, will enter at a lower DMVP point. The intersecting points on the DMVP schedules will yield the prices of the factors, also known as “rents” and “wage rates” (in the case of labor factors). The pure interest rate will be determined by the time-preference schedules of all individuals in the economy. Its chief expression will be not in the loan market, but in the discounts between prices in the various stages of production. Interest on the loan market will be a reflection of this “natural” interest rate. All the prices of each good, as well as the interest rate, will be uniform throughout the entire market. The capital value of every durable good will equal the discounted value of the sum of future rents to be obtained from the good, the discount being the rate of interest.
All this is a picture of the evenly rotating economy—the equilibrium situation toward which the real economy is always tending. If consumer valuations and the supply of resources remained constant, the relevant ERE would be reached. The forces driving toward the ERE are the profit-seeking entrepreneurs, who take the lead in meeting the uncertainties of the real world. By seeking out discrepancies between existing conditions and the equilibrium situation and remedying them, entrepreneurs make profits; those businessmen who unwittingly add to the maladjustments on the market are penalized with losses. Thus, to the extent that producers wish to make money, they drive toward ever more efficient servicing of the desires of the consumers—allocating resources to the most value-productive areas and away from the least value-productive. The (monetary) value productivity of a course of action depends on the extent to which it serves consumer needs.
But consumer valuations and supplies of resources are always changing, so that the ERE goal always changes as well and is never reached. We have analyzed the implications of changing elements in the economy. An increase in the labor supply may lower the DMVP of labor and hence wage rates, or raise them because of the further advantages of the division of labor and a more extended market. Which will occur depends on the optimum population level. Since labor is relatively more scarce than land, and relatively nonspecific, there will always be idle and zero-rent land, while there will never be involuntarily idle or zero-wage labor. An increase or decrease in the supply of “submarginal” land will have no effect on production; an increase in supramarginal land will increase production and render hitherto marginal land submarginal.
Lower time preferences will increase capital investment and thereby lengthen the structure of production. Such lengthening of the production structure, increasing the supply of capital goods, is the only way for man to advance from his bare hands and empty acres of land to more and more civilized standards of living. These capital goods are the necessary way stations on the road to higher total production. But they must be maintained and replaced as well as initially produced if people wish to keep their higher standard over any length of time.
To expand production, the important consideration is not so much technological improvement as greater capital investment. At no time has invested capital exhausted the best technological opportunities available. Many firms still use old, unimproved processes and techniques simply because they do not have the capital to invest in new ones. They would know how to improve their plant if capital were available. Thus, while the state of technology is ultimately a very important consideration, at no given time does it play a direct role, since the narrower limit on production is always the supply of capital.
In a progressing economy, given a constant supply of money, increased investment and a longer capital structure bring about lower money prices for factors and still lower prices for consumers’ goods. “Real” factor prices (corrected for changes in the purchasing power of the monetary unit) increase. In net terms, this means that real land rents and real wage rates will increase in the progressing economy. Interest rates will fall as time-preference rates drop and the proportion of gross investment to consumption increases.
If rents are earned by a durable factor, they can be and are “capitalized” on the market, i.e., they have a capital value equivalent to the discounted sum of their expected future rents. Since land is a form of investment on the market just as are shares of a firm, its future rents will be capitalized so that land will tend to earn the same uniform interest rate as any other investment. In a progressing economy, the real capital value of land will increase, although the value will fall in money terms. To the extent that future changes in the value of land can be foreseen, they will be immediately incorporated into its present capital value. Therefore, future owners of land will benefit by future increases in its real capital value only to the extent that previous owners failed to anticipate the increase. To the extent that it was anticipated, the future owners will have paid it in their purchase price.
The course of change in a retrogressing economy will be the opposite. In a stationary economy, total production, the capital structure, real wages per capita, real capital values of land, and the rate of interest will remain the same, while the allocation of factors of production and the relative prices of various products will vary.
See Gottfried von Haberler, The Theory of International Trade (London: William Hodge, 1936), pp. 3–8.
See Mises, Human Action:
The fact that the production of raw materials and foodstuffs cannot be centralized and forces people to disperse over the various parts of the earth’s surface enjoins also upon the processing industries a certain degree of decentralization. It makes it necessary to consider the problems of transportation as a particular factor of production costs. The costs of transportation must be weighed against the economies to be expected from more thoroughgoing specialization. (pp. 341–42)
See Mises, Human Action, pp. 622–24.
For the weighty implications of this “Misesian” analysis for the theory of “international trade,” cf. not only Mises’ Theory of Money and Credit, but also the excellent, though neglected, Chi-Yuen Wu, An Outline of International Price Theories (London: George Routledge & Sons, 1939), pp. 115, 233–35, and passim.
This error lies at the root of attacks on the “basing-point system” of pricing in some industries. The critics assume that uniform pricing of a good means uniform pricing at the various mills, whereas it really implies uniform “delivered prices” of the various firms at any given consumer center. On the basing-point question, see also the analysis in United States Steel Corporation T.N.E.C. Papers (New York: United States Steel Corporation, 1940), II, pp. 102–35.
For purposes of simplification, we have omitted the consumers in Rochester, Detroit, and elsewhere, but the same law applies to them. For consumers in Rochester and Detroit, in equilibrium:
P(Cr) in Rochester = P(Cd)
in Rochester, and
P(Cr) in Detroit
= P(Cd) in Detroit, etc.
For a critique of some aspects of this separation in the “new welfare economics,” see B.R. Rairikar, “Welfare Economics and Welfare Criteria,” Indian Journal of Economics, July, 1953, pp. 1–15.
The last few years have seen signs of a revival of “Austrian” production theory—the tradition in which these chapters have been written. In addition to works cited above, see Ludwig M. Lachmann, Capital and Its Structure (London: London School of Economics, 1956) and idem, “Mrs. Robinson on the Accumulation of Capital,” South African Journal of Economics, June, 1958, pp. 87–100. Robert Dorfman’s “Waiting and the Period of Production,” Quarterly Journal of Economics, August, 1959, pp. 351–72, and his “A Graphical Exposition of Böhm-Bawerk’s Interest Theory,” Review of Economic Studies, February, 1959, pp. 153–58, are interesting chiefly as a groping attempt by a leading mathematical economist to return to the Austrian road. For an incisive critique of Dorfman, see Egon Neuberger, “Waiting and the Period of Production: Comment,” Quarterly Journal of Economics, February, 1960, pp. 150–53.