Mises Daily Articles
How the Free Market Works
In the great book Man, Economy, and State, Rothbard's vast compendium of economic wisdom, we read much that has not yet been properly popularized. Rothbard's production theory, for example, is quite different from the standard account. I have tried to distill this theory into the following synopsis, although it is by no means the only part of the book that warrants exposition.
Economics is about using our available means to achieve the best possible ends. Achieving an end is called consumption and applying a means towards an end is called production.
There are four broad categories of means, or factors of production, which are involved in achieving our ends. The first is labor, which refers to our own exertions, whether mental or physical. The second is land, which refers to any natural resource as it exists in nature. The third is time. At least a small amount of each of these is required in any production process.
Together, these three factors are called the original factors of production because they exist in nature prior to any human production. The fourth kind of factor is that which is produced, not because it directly brings satisfaction, but because it can be used in a different production process. The fourth factor is capital goods.
Since the time spent producing a good could have been consumed immediately as leisure, all production requires that one forgo present consumption for future consumption. In addition, one must have savings of some kind, enough to sustain one's self until the production is complete.
For example, a hunter-gatherer, feeling the pangs of hunger, must renounce laziness immediately if he is to hunt any food. If, however, he has already indulged himself too long, he might not have enough energy saved up in his body to complete a single hunt.
One not only has the choice of whether or not to produce at all, but whether to produce via a longer or a shorter process. A hunter-gatherer might choose to gather fruits around him with his bare hands, or to fashion weapons and hunt animals, or to farm a plot of land.
Since, all things being equal, people will tend to prefer present over future consumption, it is necessary that a longer production process result in a superior set of consumer goods than a shorter one — enough so to induce people to wait to reap its benefits. The hunter-gatherer will choose hunting over gathering only if he finds the meat he will gain in the future, after presently constructing and using a spear, sufficiently more enticing than the leisure he could enjoy in the present.
An unavoidable feature of capital is that it wears out and therefore must be replaced. An economy that relies on capital must expend work simply to maintain its capital. In an economy that relies on capital, therefore, people must be continually willing to forgo present consumption to maintain their standard of living.
On the other hand, it is not necessary to save again; this is only necessary for the economy to grow, not to stay the same. The original savings are still around, embodied in the capital goods on which the economy relies. An economy with an abundance of capital goods has a long history of saving and thrift behind it, and as a result has a production process that is long, many-staged, and very productive.
One aspect of any production process that I have not yet mentioned is risk. Since the decision of what to produce takes place in the present whereas consumption is not available until the future, it is always possible that a person could choose incorrectly, and later realize that what he decided to produce was not the best use of his time and resources.
As we see, production requires the convergence of several conceptually different elements. There must first be savings. Then there must be factors of production (land, labor, and capital), which are combined over a period of time into a good that (we hope) will satisfy our desires. Each of these contributions is necessary regardless of whether the economy is capitalist or socialist, and if one contribution is not rewarded sufficiently, it will not be given.
Although a real person can contribute in more than one way, we can embody each of these contributions in a separate hypothetical person as a means to better conceptualize the value of each:
The laborer labors in exchange for wages and the landlord allows the use of his land in exchange for rent. In Austrian economics, the capitalist is the one who owns capital and rents it out; he does not own the business and he does not earn profits, only interest off the use of his capital good. The moneylender deals in the initial act of saving, which makes production possible. He must work now and wait for his reward later on. The landlord and capitalist have similar functions, so I refer to them together as proprietors.
Finally, the entrepreneur assumes the risk should the venture fail. He retains whatever, if anything, is leftover after the laborer, capitalist, and landlord are paid and his product is sold; and he pays the debt if there is not enough. The entrepreneur earns profits and losses based on his success in estimating the desires of his customers.
On the free market, goods can be valued in terms of prices, which say what sum of money might be exchanged for them. Prices tend toward the level at which demand equals supply and all the available stock is sold. If the price is higher than this, a seller has the incentive to bid lower to ensure that they sell their stock, and if it is lower, buyers have the incentive to bid higher so as to make sure they can get the goods they desire.
Consumer goods directly satisfy our desires, so the fact that they are demanded needs no explanation. Their demand and the available supply determine their prices.
Capital goods are not able to satisfy our desires directly when used, so the demand for them on the market is determined by the prices of the consumer goods that they produce. The demand for capital goods used earlier in production are determined by the prices of capital goods used later on, and so on.
The original factors of production (land, labor, and time) can be directly consumed because people can live on land and consume leisure time (instead of laboring). Therefore, the demand for original factors is caused both by their immediate use and their indirect uses in production.
There will also be a price for savings on the market, to induce people to become moneylenders and give up a given sum of money for a given length of time. This price will be determined by peoples' preference for present consumption over future consumption, and it is called the interest rate. The interest rate is determined by peoples' time preference, that is, the degree to which they prefer present consumption over later.
The rents of land and capital goods are determined by the interest rate as well as by their prices. If the rent is too low to enable the proprietor to maintain his property and earn enough on top of that, he will have the incentive to sell his property and go into moneylending or into some other kind of property. If the rent is too high, others have the incentive to become proprietors as well, thereby raising the price of land.
The entrepreneur will always attempt to earn the highest profits he can, and he is thereby induced to produce whatever is the most urgently demanded. Since the entrepreneur's function is to accept risk, he does not receive any set price, but he gains profits or suffers losses depending on how successful he is at forecasting demand.
He provides laborers and proprietors with certainty in exchange for the hope of having correctly anticipated some new consumer demand. There will be profits available in an economy to the extent that such opportunities are available, but as the entrepreneurs alter an economy to better satisfy a given set of preferences, profits will become more and more difficult to earn.
With an idea of the overall workings of the free market, let us now discuss how the economy grows and shrinks. The ultimate size of the economy is limited by peoples' time preference. Once the economy has reached its maximum size, the point where all the best uses of the available capital have been found by the entrepreneurs, then the economy can grow no more.
However, if peoples' time preference decreases, and people find themselves more willing to invest rather than consume, more of them will become moneylenders. This competition causes the interest rate to decline and in turn enables the entrepreneurs to engage in newly profitable production processes.
Some productive processes, those that require more time or are more reliant on capital, then become feasible due to the lower cost of loans. There will tend to be positive overall profits in the economy because there are lots of new opportunities to take advantage of.
On the other hand, if time preference should increase, then fewer people will become moneylenders, the interest rate will increase, and the economy will become less productive overall.
What about the effect of a progressing economy on the laborers and the proprietors? If a factor of production becomes more productive, entrepreneurs will be willing to bid higher for it. In fact, each one must bid higher so as to prevent another entrepreneur from outproducing him.
In an economy that relies heavily on capital, factors of production will tend to be more productive. Factors whose supply cannot be readily increased, such as land and labor, will command a higher price in a more advanced economy. On the other hand, capital goods, though they might well be more productive, may become cheaper due to being produced in greater quantity.
The laborer, in particular, benefits from the progressing economy. Labor is an especially nonspecific factor, so that even those who have chosen to specialize in professions no longer needed in an advanced economy are still capable of doing much and of learning new skills.
As the economy improves, therefore, so will the productivity of labor, and hence so will its price. This does not necessarily mean that the price of labor will rise in terms of gold, dollars, or whatever money is in use; but rather that the price of labor will be exchanged for a larger amount of real wealth in an advanced economy than in a primitive one.
It is a common error in economics to believe the opposite, that more-productive labor will have a lower price, due to the fact that the same quantity of consumer goods can be produced with less labor. However, there is not some specific set of goods that is appropriate under all circumstances; the production of consumer goods is a decision limited by what is economically feasible.
Therefore, if labor becomes more productive, people will not simply go on producing the same goods they did before; they will produce more goods, and of a greater variety. Since an entrepreneur in a more-advanced economy stands to lose more production when he loses one employee, he will necessarily be more willing to pay higher wages to keep him.
Among anticapitalists, the contribution of the laborer is often seen as being somehow more legitimate than the others. Since the laborer physically builds the good that is produced, his contribution is often thoughtlessly seen as more real, more legitimate, than the others; but we have seen that production cannot take place without the contributions of the rest. Any attempt to give to the laborer what was meant for any of the other contributors makes production in an economy more difficult, and ultimately restricts or reduces the wages of labor.
The laborers, necessarily, are always paid immediately in any venture, whereas the landlord and moneylender must wait. The laborers, in addition, take on no risk in the venture. For each pay period, the laborers are paid the same amount whether the venture shows a profit or loss. Attempts to give the laborer what would otherwise have gone to the entrepreneur or moneylender reduces the incentive of people to become entrepreneurs or moneylenders.
There is no reason, therefore, that the laborers ought to share in the profits and losses of the ventures they work for. Laborers are perfectly able to buy stock in their own companies, yet generally they do not; this demonstrates that they are more interested in receiving the wages of labor than in contributing risk.
But what of the capitalist and landlord? Why should they get money for simply owning something? Yet the very fact that the capitalist and landlord own their goods and wish to obtain the highest rents for them ensures that these goods go to their most productive and most urgent uses.
It is necessary that the owner gain through his service as "gatekeeper" to the use of these goods; if he did not, he would prefer to use them for his own consumption rather than for productive uses more urgent to the economy as a whole.
Very well, but couldn't this job be done by any rube, any idiot capable of identifying the highest bidder? Why should the benefits go to this person simply because of some historical circumstance that puts it in his possession, especially since he may have inherited his land or capital rather than earned it himself?
But as we have seen, the entire economy is built upon historical circumstances: without the historical act of saving, which is now embodied in capital goods, or the original act of appropriation which brought heretofore unused land into productive use, there would be no economy at all. So there is no particular reason why a person should not benefit because of history; we all do this every day simply by participating in the economy.
It is this very history that is negated by any attempt to prevent the rightful factor-owner from gaining his rent. Capital goods can be consumed without being replaced, and land can be abandoned and left unproductive. When the proprietor is prevented from earning his rent, he has an incentive to do precisely this. Why should he build or maintain what does not provide benefits, when he could instead focus on immediate consumption?
Someone might try to appropriate property and extract the maximum rent from it; he would therefore perform the job of the original proprietor. However, why would other proprietors maintain their property if they believe that property can be taken away?
Why would the appropriator maintain his property if he can just take more instead? If no rent can be extracted from a capital good, there is no reason to save up and buy it, and therefore there is no profit to entice an entrepreneur to produce it. Though we might be envious of the wealthy proprietors, no one can better allocate a factor of production than its rightful owner.
To own capital or land (whether bought or bequeathed) and to live off its rents should not be seen as unfair or illegitimate; when we honor the property of a person who has inherited all his wealth, we are not honoring his right to lead a privileged existence as if he were a king, but rather honoring the original saver who bequeathed this property. In so doing, we demonstrate to other savers that their thrift will not be in vain.
Living off of capital can be seen as no different from living off a talent. Whether proprietors ever did anything to "deserve" their capital is irrelevant.
Their property helps to make us all more productive. We should appreciate that they have taken on the responsibility of owning and maintaining it. We should not look enviously upon the proprietors as somehow illegitimate or unfair; for when we infringe upon their property, ultimately we harm ourselves.