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5. Production: The Structure

8. Money Costs, Prices, and Alfred Marshall

In the ERE, therefore, every good sold to consumers will sell at a certain “final equilibrium” price and at certain total sales. These receipts will accrue in part to capitalists in the form of interest income, and the remainder to owners of land and labor. The payments of income to the producers have also been popularly termed “costs.” These are clearly money costs, or money expenses, and obviously are not the same thing as “costs” in the psychic sense of subjective opportunity forgone. Money costs may be ex post as well as ex ante. (In the ERE, of course, ex ante and ex post calculations are always the same.) However, the two concepts become linked when psychic costs are appraised as much as possible in monetary terms. Thus, payment to factors may be 95 ounces and recorded as a cost, while the capitalist who earns an interest of five ounces considers 100 as an opportunity cost, since he could have invested elsewhere and earned five (actually, a bit higher) percent interest.

If, for the moment, we include as money costs factor payments and interest,19 then in the ERE, money costs equal total money sales for every firm in every line of production. A firm earns entrepreneurial profits when its return is more than interest, suffers entrepreneurial losses when its return is less. In our production process, consumers will pay 100 ounces (money sales), and money costs are 100 ounces (factor plus interest income) and there will be similar equality for all other goods and processes. What this means, in essence, is that there are no entrepreneurial profits or losses in the ERE, because there is no change of data or uncertainty about possible change. If total money sales equal total money costs, then it evidently follows that total money sales per unit sold will equal total money costs per unit sold. This follows from elementary rules of arithmetic. But the money sales per unit are equal to the money price of the good, by definition; while we shall call the total money costs per unit the average money cost of the good. It likewise follows, therefore, that price will equal average money cost for every good in the ERE.

Strange as it may seem, a great many writers on economics have deduced from this a curious conclusion indeed. They have deduced that “in the long run” (i.e., in the ERE), the fact that costs equal sales or that “cost equals price” implies that costs determine price. The price of the good discussed above is 100 ounces per unit, allegedly because the cost (average money cost) is 100 ounces per unit. This is supposed to be the law of price determination “in the long run.” It would seem to be crystal clear, however, that the truth is precisely the reverse. The price of the final product is determined by the valuations and demands of the consumers, and this price determines what the cost will be. If the consumers value the product mentioned above so that its price is 50 ounces instead of 100 ounces, as a result, say, of a change in their valuations, then it is precisely in the “long run,” when the effects of uncertainty are removed, that “costs of production” (here, factor payment plus interest payment) will equal the final price. We have seen above how factor incomes are at the mercy of consumer demand and fluctuate according to that demand. Factor payments are the result of sales to consumers and do not determine the latter in advance. Costs of production, then, are at the mercy of final price, and not the other way around. It is ironic that it is precisely in the ERE that this causative phenomenon should be the clearest. For in the ERE we see quite evidently that consumers pay and determine the final price of the product; that it is through these payments and these payments alone that factors and interest are paid; that therefore the amount of the payments and the total “costs of production” are determined by price and not vice versa. Money costs are the opposite of a basic, determining factor; they are dependent on the price of the product and on consumer demands.

In the real world of uncertainty it is more difficult to see this, because factors are paid in advance of the sale of the product, since the capitalist-entrepreneurs speculatively advance money to the factors in the expectation of being able to recoup their money with a surplus for interest and profit after sale to the consumers.20 Whether they do so or not depends on their foresight regarding the state of consumer demand and the future prices of consumers’ goods. In the real world of immediate market prices, of course, the existence of entrepreneurial profit and loss will always prevent costs and receipts, cost and price, from being identical, and it is obvious to all that price is solely determined by valuations of stock—by “utilities”—and not at all by money cost. But although most economists recognize that in the real world (the so-called “short-run”) costs cannot determine price, they are seduced by the habit of the individual entrepreneur of dealing in terms of “cost” as the determining factor, and they apply this procedure to the case of the ERE and therefore to the inherent long-run tendencies of the economy. Their grave error, as will be discussed further below, comes from viewing the economy from the standpoint of an individual entrepreneur rather than from that of an economist. To the individual entrepreneur, the “cost” of factors is largely determined by forces outside himself and his own sales; the economist, however, must see how money costs are determined and, taking account of all the interrelations in the economy, must recognize that they are determined by final prices reflecting consumer demands and valuations.

The source of the error will become clearer below when we consider a world of nonspecific as well as specific factors. However, the essentials of our analysis and its conclusion remain the same in that more complex and realistic case.

The classical economists were under the delusion that the price of the final product is determined by “costs of production,” or rather they fluctuated between this doctrine and the “labor theory of value,” which isolated the money costs of labor and picked that segment of the cost of production as the determinant of price. They slurred over the determination of the prices of such goods as old paintings that already existed and needed no further production. The correct relation between prices and costs, as outlined above, was developed, along with other outstanding contributions to economics, by the “Austrian” economists, including the Austrians Carl Menger, Eugen von Böhm-Bawerk, and Friedrich von Wieser, and the Englishman W. Stanley Jevons. It was with the writings of the Austrian School in the 1870's and 1880's that economics was truly established as a science.21

Unfortunately, in the science of economics, retrogression in knowledge has taken place almost as often as progression. The enormous advance provided by the Austrian School, on this point as on others, was blocked and reversed by the influence of Alfred Marshall, who attempted to rehabilitate the classicists and integrate them with the Austrians, while disparaging the contributions of the latter. It was unfortunately the Marshallian and not the Austrian approach that exerted the most influence over later writers. This influence is partly responsible for the current myth among economists that the Austrian School is effectively dead and has no more to contribute and that everything of lasting worth that it had to offer was effectively stated and integrated in Alfred Marshall's Principles.

Marshall tried to rehabilitate the cost-of-production theory of the classicists by conceding that, in the “short run,” in the immediate market place, consumers’ demand rules price. But in the long run, among the important reproducible goods, cost of production is determining. According to Marshall, both utility and money costs determine price, like blades of a scissors, but one blade is more important in the short run, and another in the long run. He concludes that

as a general rule, the shorter the period we are considering, the greater must be the share of our attention which is given to the influence of demand on value; and the longer the period, the more important will be the influence of cost of production on value. ... The actual value at any time, the market value as it is often called, is often more influenced by passing events and by causes whose action is fitful and shortlived, than by those which work persistently. But in long periods these fitful and irregular causes in large measure efface one another's influence; so that in the long run persistent causes dominate value completely.22

The implication is quite clear: if one deals with “short-run” market values, one is being quite superficial and dwelling only on fitful and transient causes—so much for the Austrians. But if one wants to deal with the “really basic” matters, the really lasting and permanent causes of prices, he must concentrate on costs of production—pace the classicists. This impression of the Austrians—their alleged neglect of the “long period,” and “one-sided neglect of costs”—has been stamped on economics ever since.

Marshall's analysis suffers from a grave methodological defect—indeed, from an almost hopeless methodological confusion as regards the “short run” and the “long run.” He considers the “long run” as actually existing, as being the permanent, persistent, observable element beneath the fitful, basically unimportant flux of market value. He admits (p. 350) that “even the most persistent causes are, however, liable to change,” but he clearly indicates that they are far less likely to change than the fitful market values; herein, indeed, lies their long-run nature. He regards the long-run data, then, as underlying the transient market values in a way similar to that in which the basic sea level underlies the changing waves and tides.23 For Marshall, then, the long-run data are something that can be spotted and marked by an observer; indeed, since they change far more slowly than the market values, they can be observed more accurately.

Marshall's conception of the long run is completely fallacious, and this eliminates the whole groundwork of his theoretical structure. The long run, by its very nature, never does and never can exist. This does not mean that “long-run,” or ERE, analysis is not important. On the contrary, only through the concept of the ERE can we subject to catallactic analysis such critical problems as entrepreneurial profit, the structure of production, the interest rate, and the pricing of productive factors. The ERE is the goal (albeit shifting in the concrete sense) toward which the market moves. But the point at issue is that it is not observable, or real, as are actual market prices.

We have seen above the characteristics of the evenly rotating economy. The ERE is the condition that comes into being and continues to obtain when the present, existing market data (valuations, technology, resources) remain constant. It is a theoretical construct of the economist that enables him to point out in what directions the economy tends to be moving at any given time; it also enables the economist to isolate various elements in his analysis of the economy of the real world. To analyze the determining forces in a world of change, he must construct hypothetically a world of nonchange. This is far different from, indeed, it is the reverse of, saying that the long run exists or that it is somehow more permanently or more persistently existent than the actual market data. The actual market prices, on the contrary, are the only ones that ever exist, and they are the resultants of actual market data (consumer demands, resources, etc.) that themselves change continually. The “long run” is not more stable; its data necessarily change along with the data on the market. The fact that costs equal prices in the “long run” does not mean that costs will actually equal prices, but that the tendency exists, a tendency that is continually being disrupted in reality by the very fitful changes in market data that Marshall points out.24

In sum, rather than being in some sense more persistent and more real than the actual market, the “long run” of the ERE is not real at all, but a very useful theoretical construct that enables the economist to point out the direction in which the market is moving at any given time—specifically, toward the elimination of profits and losses if existing market data remain the same. Thus, the ERE concept is especially helpful in the analysis of profits and losses as compared to interest. But the market data are the only actual reality.

This is not to deny, and the Austrians never did deny, that subjective costs, in the sense of opportunity costs and utilities forgone, are important in the analysis of production. In particular, the disutilities of labor and of waiting—as expressed in the time-preference ratios—determine how much of people's energies and how much of their savings will go into the production process. This, in the broadest sense, will determine or help to determine the total supply of all goods that will be produced. But these costs are themselves subjective utilities, so that both “blades of the scissors” are governed by the subjective utility of individuals. This is a monistic and not a dualistic causal explanation. The costs, furthermore, have no direct influence on the relative amount of the stock of each good to be produced. Consumers will evaluate the various stocks of goods available. How much productive energy and savings will go into producing stock of one particular good and how much into producing another, in other words, the relative stocks of each product, will depend in turn on entrepreneurial expectations of where the greatest monetary profit will be found. These expectations are based on the anticipated direction of consumer demand.

As a result of such anticipations, the nonspecific factors will move to the production of those goods where, ceteris paribus, their owners will earn the highest incomes. An exposition of this process will be presented below.

Marshall's treatment of subjective costs was also highly fallacious. Instead of the idea of opportunity costs, he had the notion that they were “real costs” that could be added in terms of measurable units. Money costs of production, then, became the “necessary supply prices” that entrepreneurs had to pay in order “to call forth an adequate supply of the efforts and waitings” to produce a supply of the product. These real costs were then supposed to be the fundamental, persisting element that backstops money costs of production, and allowed Marshall to talk of the more persisting, long-run, normal situation.25

Marshall's great error here, and it has permeated the works of his followers and of present-day writers, is to regard costs and production exclusively from the point of view of an isolated individual entrepreneur or an isolated individual industry, rather than viewing the whole economy in all its interrelations.26 Marshall is dealing, of necessity, with particular prices of different goods, and he is attempting to show that alleged “costs of production” determine these prices in the long run. But it is completely erroneous to tie up particular goods with labor vs. leisure and with consuming vs. waiting costs, for the latter are only general phenomena, applying and diffusing throughout the entire economic system. The price necessary to call forth a nonspecific factor is the highest price this factor can earn else-where—an opportunity cost. What it can attain elsewhere is basically determined by the state of consumer demand elsewhere. The forgone leisure-and-consumption costs, in general, only help to determine the size—the general stock—of labor and savings that will be applied to production. All this will be treated further below.

  • 19. Strictly, this assumption is incorrect, and we make it in this section only for purposes of simplicity. For interest may be an opportunity cost for an individual investor, but it is not a money cost, nor is it an opportunity cost for the aggregate of capitalists. For the implications of this widely held error in economic literature, see André Gabor and I.F. Pearce, “The Place of Money Capital in the Theory of Production,” Quarterly Journal of Economics, November, 1958, pp. 537–57; and Gabor and Pearce, “A New Approach to the Theory of the Firm,” Oxford Economic Papers, October, 1952, pp. 252–65.
  • 20. Cf. Menger, Principles of Economics, pp. 149ff.
  • 21. The very interesting researches by Emil Kauder indicate that the essentials of the Austrian marginal utility theory (the basis of the view that price determines cost and not vice versa or mutually) had already been formulated by French and Italian economists of the seventeenth and eighteenth centuries and that the English classical school shunted economics onto a very wrong road, a road from which economics was extricated only by the Austrians. See Emil Kauder, “Genesis of the Marginal Utility Theory,” Economic Journal, September, 1953, pp. 638–50; and Kauder, “Retarded Acceptance of the Marginal Utility Theory.”
  • 22. Alfred Marshall, Principles of Economics (8th ed.; London: Macmillan & Co., 1920), pp. 349 ff.
  • 23. This analogy, though not used in this context, was often used by classical economists as applied to prices and “the price level,” an application equally erroneous.
  • 24. On this error in Marshall, see F.A. Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, 1941), pp. 21, 27–28. Marshall is here committing the famous fallacy of “conceptual realism,” in which theoretical constructs are mistaken for actually existing entities. For other examples, cf. Leland B. Yeager, “Some Questions on Growth Economics,” American Economic Review, March, 1954, p. 62.
  • 25. Marshall, Principles of Economics, pp. 338 ff.
  • 26. We must hasten to point out that this is by no means the same criticism as the neo-Keynesian charge that economists must deal in broad aggregates, and not with individual cases. The latter approach is even worse, since it begins with “wholes” that have no basis in reality whatever. What we are advocating is a theory that deals with all the individuals as they interact in the economy. Furthermore, this is the “Austrian,” and not the Walrasian approach, which has recently come into favor. The latter deals with interrelations of individuals (“the general equilibrium approach”) but only in the ERE and with mathematical abstractions in the ERE.