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2. Direct Exchange

10. Specialization and Production of Stock

We have analyzed the exchanges that take place in existing stock and the effect of changes in the stock of a good. The question still remains: On what principles is the size of the stock itself determined? Aside from the consumers’ or producers’ goods given directly by nature, all goods must be produced by man. (And even seemingly nature-given products must be searched for and then used by man, and hence are ultimately products of human effort.) The size of the stock of any good depends on the rate at which the good has been and is being produced. And since human wants for most goods are continuous, the goods that are worn out through use must constantly be replaced by new production. An analysis of the rate of production and its determinants is thus of central importance in an analysis of human action.

A complete answer to this problem cannot be given at this point, but certain general conclusions on production can be made. In the first place, while any one individual can at different times be both a buyer and a seller of existing stock, in the production of that stock there must be specialization. This omnipresence of specialization has been treated above, and the further an exchange economy develops, the further advanced will be the specialization process. The basis for specialization has been shown to be the varying abilities of men and the varying location of natural resources. The result is that a good comes first into existence by production, and then is sold by its producer in exchange for some other good, which has been produced in the same way. The initial sales of any new stock will all be made by original producers of the good. Purchases will be made by buyers who will use the good either for their direct use or for holding the good in speculative anticipation of later reselling it at a higher price. At any given time, therefore, new stock will be sold by its original producers. The old stock will be sold by: (a) original producers who through past reservation demand had accumulated old stock; (b) previous buyers who had bought in speculative anticipation of reselling at a higher price; and (c) previous buyers on whose value scales the relative utility of the good for their direct use has fallen.

At any time, then, the market supply schedule is formed by the addition of the supply schedules of the following groups of sellers:30

(a) The supply offered by producers of the good.

  1. The initial supply of new stock.
  2. The supply of old stock previously reserved by the producers.

(b) The supply of old stock offered by previous buyers.

  1. Sales by speculative buyers who had anticipated reselling at a higher price.
  2. Sales by buyers who had purchased for direct use, but on whose value scales the relative utility of the good has fallen.

The market demand schedule at any time consists of the sum of the demand schedules of:

(c) Buyers for direct use.
(d) Speculative buyers for resale at a higher price.

Since the good consists of equally serviceable units, the buyers are necessarily indifferent as to whether it is old or new stock that they are purchasing. If they are not, then the “stock” refers to two different goods, and not the same good.

The supply curve of the class (b) type of sellers has already been fully analyzed above, e.g., the relationship between stock and reservation demand for speculative resellers and for those whose utility position has changed. What more can be said, however, of the supply schedule of the class (a) sellers—the original producers of the good?

In the first place, the stock of newly produced goods in the hands of the producers is also fixed for any given point in time Say that for the month of December the producers of copper decide to produce 5,000 tons of copper. At the end of that month their stock of newly produced copper is 5,000 tons. They might regret their decision and believe that if they could have made it again, they would have produced, say, 1,000 tons. But they have their stock, and they must use it as best they can. The distinguishing feature of the original producers is that, as a result of specialization, the direct use-value of their product to them is likely to be almost nonexistent. The further specialization proceeds, the less possible use-value the product can have for its producer. Picture, for example, how much copper a copper manufacturer could consume in his personal use, or the direct use-value of the huge number of produced automobiles to the Ford family. Therefore, in the supply schedule of the producers, the direct-use element in their reservation demand disappears. The only reason for a producer to reserve, to hold on to, any of his stock is speculative—in anticipation of a higher price for the good in the future. (In direct exchange, there is also the possibility of exchange for a third good—say cows instead of fish, in our example.)

If, for the moment, we make the restrictive assumptions that there are no class (b) sellers on the market and that the producers have no present or accumulated past reservation demand, then the market supply-demand schedules can be represented as SS, DD in Figure 29. Thus, with no reservation demand, the supply curve will be a vertical straight line (SS) at the level of the new stock.

It seems more likely, however, that a price below equilibrium will tend to call forth a reservation demand to hold by the producers in anticipation of a higher price (called “building up inventory”), and that a price above equilibrium will result in the unloading of old stock that had been accumulated as a result of past reservation demand (called “drawing down inventory”). In that case, the supply curve assumes a more familiar shape (the broken line above—S′S′).

The removal of direct use-value from the calculation of the sellers signifies that all the stock must eventually be sold, so that ultimately none of the stock can be reserved from sale by the producers. The producers will make their sales at that point at which they expect the market price to be the greatest that they can attain—i.e., at the time when the market demand for the given stock is expected to be the greatest.31 The length of time that producers can reserve supply is, of course, dependent on the durability of the good; a highly perishable good like strawberries, for example, could not be reserved for long, and its market supply curve is likely to be a vertical line.

Suppose that an equilibrium price for a good has been reached on the market. In this case, the speculative element of reservation demand drops out. However, in contrast to the market in re-exchange of existing stock, the market for new production does not end. Since wants are always being renewed in each successive period of time, new stock will also be produced in each period, and if the amount of stock is the same and the demand schedule given, the same amount will continue to be sold at the same equilibrium price. Thus, suppose that the copper producers produce 5,000 tons in a month; these are sold (no reservation demand) at the equilibrium price of 0X on the foregoing diagram. The equilibrium quantity is 0S. The following month, if 5,000 tons are produced, the equilibrium price will be the same. If more is produced, then, as we saw above, the equilibrium price is lower; if less, the equilibrium price will be higher.

If the speculative elements are also excluded from the demand schedule, it is clear that this schedule will be determined solely by the utility of the good in direct use (as compared with the utility of the sale-good). The only two elements in the value of a good are its direct use-value and its exchange-value, and the demand schedule consists of demand for direct use plus the speculative demand in anticipation of reselling at a higher price. If we exclude the latter element (e.g., at the equilibrium price), the only ultimate source of demand is the direct use-value of the good to the purchaser. If we abstract from the speculative elements in a market, therefore, the sole determinant of the market price of the stock of a good is its relative direct use-value to its purchasers.

It is clear, as has been shown in previous sections, that production must take place over a period of time. To obtain a certain amount of new stock at some future date, the producer must first put into effect a series of acts, using labor, nature, and capital goods, and the process must take time from the initial and intermediary acts until the final stock is produced. Therefore, the essence of specialized production is anticipation of the future state of the market by the producers. In deciding whether or not to produce a certain quantity of stock by a future date, the producer must use his judgment in estimating the market price at which he will be able to sell his stock. This market price is likely to be at some equilibrium, but an equilibrium is not likely to last for more than a short time. This is especially true when (as a result of ever-changing value scales), the demand curve for the good continually shifts. Each producer tries to use his resources—his labor and useful goods—in such a way as to obtain, in the production of stock, the maximum psychic revenue and hence a psychic profit. He is ever liable to error, and errors in anticipating the market will bring him a psychic loss. The essence of production for the market, therefore, is entrepreneurship. The key consideration is that the demand schedules, and consequently the future prices, are not and can never be definitely and automatically known to the producers. They must estimate the future state of demand as best they can.

Entrepreneurship is also the dominant characteristic of buyers and sellers who act speculatively, who specialize in anticipating higher or lower prices in the future. Their entire action consists in attempts to anticipate future market prices, and their success depends on how accurate or erroneous their forecasts are. Since, as was seen above, correct speculation quickens the movement toward equilibrium, and erroneous speculation tends to correct itself, the activity of these speculators tends to hasten the arrival of an equilibrium position.

The direct users of a good must also anticipate their desires for a good when they purchase it. At the time of purchase, their actual use of a good will be at some date in the future, even if in the very near future. The position of the good on their value scales is an estimate of its expected future value in these periods, discounted by time preferences. It is very possible for the buyer to make an erroneous forecast of the value of the good to him in the future, and the more durable the good, the greater the likelihood of error. Thus, it is more likely that the buyer of a house will be in error in forecasting his own future valuation than the buyer of strawberries. Hence, entrepreneurship is also a feature of the buyer's activity—even in direct use. However, in the case of specialized producers, entrepreneurship takes the form of estimating other people's future wants, and this is obviously a far more difficult and challenging task than forecasting one's own valuations.

Human action occurs in stages, and at each stage an actor must make the best possible use of his resources in the light of expected future developments. The past is forever bygone. The role of errors in different stages of human action may be considered in the comparatively simple case of the man who buys a good for direct use. Say that his estimate of his future uses is such that he purchases a good—e.g., 10 quarts of milk—in exchange for 100 barrels of fish, which also happens to be his maximum buying price for 10 quarts of milk. Suppose that after the purchase is completed he finds, for some reason, that his valuations have changed and that the milk is now far lower on his value scale. He is now confronted with the question of the best use to make of the 10 quarts of milk. The fact that he has made an error in using his resources of 100 barrels of fish does not remove the problem of making the best use of the 10 quarts of milk. If the price is still 100 barrels of fish, his best course at present would be to resell the milk and reobtain the 100 barrels of fish. If the price is now above 100, he has made a speculative gain, and he can resell the milk for more fish. And if the price of milk has fallen, but the fish is still higher on his value scale than the 10 quarts of milk, it would maximize his psychic revenue to sell the milk for less than 100 barrels of fish.

It is important to recognize that it is absurd to criticize such an action by saying that he suffered a clear loss of X barrels of fish from the two exchanges. To be sure, if he had correctly forecast later developments, the man would not have made the original exchange. His original exchange can therefore be termed erroneous in retrospect. But once the first exchange has been made, he must make the best possible present and future use of the milk, regardless of past errors, and therefore his second exchange was his best possible choice under the circumstances.

If, on the other hand, the price of milk has fallen below his new minimum buying price, then his best alternative is to use the milk in its most valuable direct use.

Similarly, a producer might decide to produce a certain amount of stock, and, after the stock has been made, the state of the market turns out to be such as to make him regret his decision. However, he must do the best he can with the stock, once it has been produced, and obtain the maximum psychic revenue from it. In other words, if we consider his action from the beginning—when he invested his resources in production—his act in retrospect was a psychic loss because it did not yield the best available alternative from these resources. But once the stock is produced, this is his available resource, and its sale at the best possible price now nets him a psychic gain.

At this point, we may summarize the expected (psychic) revenue and the expected (psychic) cost, factors that enter into the decision of buyers and sellers in any direct exchange of two goods.

If we eliminate the temporary speculative element, we are left with factors: revenue A, cost A, cost C for buyers; and revenue A, cost A, cost B for sellers. Similarly, if we consider the sellers as the specialized original producers—and this will be more true the greater the proportion of the rate of production to accumulated stock—cost A drops out for the sellers. If we also remember that, since the exchange involves two goods, the set of buyers for one good is the set of sellers for the other good, cost A is eliminated as a factor for buyers as well. Only the factors asterisked above ultimately remain. The revenue for both the buyers and the sellers is the expected direct use of the goods acquired; the costs are the exchange for a third good that is forgone because of this exchange.

The revenue and costs that are involved in making the original decision regarding the production of stock are, as we have indicated, of a different order, and these will be explored in subsequent chapters.

  • 30. The addition of supply schedules is a simple process to conceive: if at a price X, the class (a) sellers will supply T tons of a good and the class (b) sellers will supply T′ the total market supply for that price is T + T′ tons. The same process applies to each hypothetical price.
  • 31. Strictly, of course, costs of storage will have to be considered in their calculations.