Prices, Part 1
1. The Pricing Process
In an occasional act of barter in which men who ordinarily do not resort to trading with other people exchange goods ordinarily not negotiated, the ratio of exchange is determined only within broad margins. Catallactics, the theory of exchange ratios and prices, cannot determine at what point within these margins the concrete ratio will be established. All that it can assert with regard to such exchanges is that they can be effected only if each party values what he receives more highly than what he gives away.
The recurrence of individual acts of exchange generates the market step by step with the evolution of the division of labor within a society based on private property. As it becomes a rule to produce for other people's consumption, the members of society must sell and buy. The multiplication of the acts of exchange and the increase in the number of people offering or asking for the same commodities narrow the margins between the valuations of the parties. Indirect exchange and its perfection through the use of money divide the transactions into two different parts: sale and purchase. What in the eyes of one party is a sale, is for the other party a purchase. The divisibility of money, unlimited for all practical purposes, makes it possible to determine the exchange ratios with nicety. The exchange ratios are now as a rule money prices. They are determined between extremely narrow margins: the valuations on the one hand of the marginal buyer and those of the marginal offerer who abstains from selling, and the valuations on the other hand of the marginal seller and those of the marginal potential buyer who abstains from buying.
The concatenation of the market is an outcome of the activities of entrepreneurs, promoters, speculators, and dealers in futures and in arbitrage. It has been asserted that catallactics is based on the assumption — contrary to reality — that all parties are provided with perfect knowledge concerning the market data and are therefore in a position to take best advantage of the most favorable opportunities for buying and selling. It is true that some economists really believed that such an assumption is implied in the theory of prices. These authors not only failed to realize in what respects a world peopled with men perfectly equal in knowledge and foresight would differ from the real world which all economists wanted to interpret in developing their theories; they also erred in being unaware of the fact that they themselves did not resort to such an assumption in their own treatment of prices.
In an economic system in which every actor is in a position to recognize correctly the market situation with the same degree of insight, the adjustment of prices to every change in the data would be achieved at one stroke. It is impossible to imagine such uniformity in the correct cognition and appraisal of changes in data except by the intercession of superhuman agencies. We would have to assume that every man is approached by an angel informing him of the change in data which has occurred and advising him how to adjust his own conduct in the most adequate way to this change. Certainly the market that catallactics deals with is filled with people who are to different degrees aware of the changes in data and who, even if they have the same information, appraise it differently. The operation of the market reflects the fact that changes in the data are first perceived only by a few people and that different men draw different conclusions in appraising their effects. The more enterprising and brighter individuals take the lead; others follow later. The shrewder individuals appreciate conditions more correctly than the less intelligent and therefore succeed better in their actions. Economists must never disregard in their reasoning the fact that the innate and acquired inequality of men differentiates their adjustment to the conditions of their environment.
The driving force of the market process is provided neither by the consumers nor by the owners of the means of production — land, capital goods, and labor — but by the promoting and speculating entrepreneurs. These are people intent upon profiting by taking advantage of differences in prices. Quicker of apprehension and farther-sighted than other men, they look around for sources of profit. They buy where and when they deem prices too low, and they sell where and when they deem prices too high. They approach the owners of the factors of production, and their competition sends the prices of these factors up to the limit corresponding to their anticipation of the future prices of the products. They approach the consumers, and their competition forces prices of consumers' goods down to the point at which the whole supply can be sold. Profit-seeking speculation is the driving force of the market as it is the driving force of production.
On the market, agitation never stops. The imaginary construction of an evenly rotating economy has no counterpart in reality. There can never emerge a state of affairs in which the sum of the prices of the complementary factors of production, due allowance being made for time preference, equals the prices of the products and no further changes are to be expected. There are always profits to be earned by somebody. The speculators are always enticed by the expectation of profit.
The imaginary construction of the evenly rotating economy is a mental tool for comprehension of entrepreneurial profit and loss. It is, to be sure, not a design for comprehension of the pricing process. The final prices corresponding to this imaginary conception are by no means identical with the market prices. The activities of the entrepreneurs or of any other actors on the economic scene are not guided by consideration of any such things as equilibrium prices and the evenly rotating economy. The entrepreneurs take into account anticipated future prices, not final prices or equilibrium prices. They discover discrepancies between the height of the prices of the complementary factors of production and the anticipated future prices of the products, and they are intent upon taking advantage of such discrepancies. These endeavors of the entrepreneurs would finally result in the emergence of the evenly rotating economy if no further changes in the data were to appear.
The operation of the entrepreneurs brings about a tendency toward an equalization of prices for the same goods in all subdivisions of the market, due allowance being made for the cost of transportation and the time absorbed by it. Differences in prices which are not merely transitory and bound to be wiped out by entrepreneurial action are always the outcome of particular obstacles obstructing the inherent tendency toward equalization. Some check prevents profit-seeking business from interfering. An observer not sufficiently familiar with actual commercial conditions is often at a loss to recognize the institutional barrier hindering such equalization. But the merchants concerned always know what makes it impossible for them to take advantage of such differences.
Statisticians treat this problem too lightly. When they have discovered differences in the wholesale price of a commodity between two cities or countries, not entirely accounted for by the cost of transportation, tariffs, and excise duties, they acquiesce in asserting that the purchasing power of money and the "level" of prices are different.1 On the basis of such statements people draft programs to remove these differences by monetary measures. However, the root cause of these differences cannot lie in monetary conditions. If prices in both countries are quoted in terms of the same kind of money, it is necessary to answer the question as to what prevents businessmen from embarking upon dealings which are bound to make price differences disappear. Things are essentially the same if the prices are expressed in terms of different kinds of money. For the mutual exchange ratio between various kinds of money tends toward a point at which there is no further margin left to profitable exploitation of differences in commodity prices. Whenever differences in commodity prices between various places persist, it is a task for economic history and descriptive economics to establish what institutional barriers hinder the execution of transactions which must result in the equalization of prices.
All the prices we know are past prices. They are facts of economic history. In speaking of present prices we imply that the prices of the immediate future will not differ from those of the immediate past. However, all that is asserted with regard to future prices is merely an outcome of the understanding of future events.
The experience of economic history never tells us more than that at a definite date and definite place two parties A and B traded a definite quantity of the commodity a against a definite number of units of the money p. In speaking of such acts of buying and selling as the market price of a, we are guided by a theoretical insight, deduced from an aprioristic starting point. This is the insight that, in the absence of particular factors making for price differences, the prices paid at the same time and the same place for equal quantities of the same commodity tend toward equalization, viz., a final price. But the actual market prices never reach this final state. The various market prices about which we can get information were determined under different conditions. It is impermissible to confuse averages computed from them with the final prices.
Only with regard to fungible commodities negotiated on organized stock or commodity exchanges is it permissible, in comparing prices, to assume that they refer to the same quality. Apart from such prices negotiated in exchanges and from prices of commodities the homogeneity of which can be precisely established by technological analysis, it is a serious blunder to disregard differences in the quality of the commodity in question. Even in the wholesale trade of raw textiles the diversity of the articles plays the main role. A comparison of prices of consumers' goods in mainly misleading on account of the difference in quality. The quantity traded in one transaction too is relevant in the determination of the price paid per unit. Shares of a corporation sold in one large lot bring a different price than those sold in several small lots.
It is necessary to emphasize these facts again and again because it is customary nowadays to play off the statistical elaboration of price data against the theory of prices. However, the statistics of prices is altogether questionable. Its foundations are precarious because circumstances for the most part do not permit the comparison of the various data, their linking together in series, and the computation of averages. Full of zeal to embark upon mathematical operations, the statisticians yield to the temptation of disregarding the incomparability of the data available. The information that a certain firm sold at a definite date a definite type of shoes for six dollars a pair relates a fact of economic history. A study of the behavior of shoe prices from 1923 to 1939 is conjectural, however sophisticated the methods applied may be.
Catallactics shows that entrepreneurial activities tend toward an abolition of price differences not caused by the costs of transportation and trade barriers. No experience has ever contradicted this theorem. The results obtained by an arbitrary identification of unequal things are irrelevant.
2. Valuation and Appraisement
The ultimate source of the determination of prices is the value judgments of the consumers. Prices are the outcome of the valuation preferring a to b. They are social phenomena as they are brought about by the interplay of the valuations of all individuals participating in the operation of the market. Each individual, in buying or not buying and in selling or not selling, contributes his share to the formation of the market prices. But the larger the market is, the smaller is the weight of each individual's contribution. Thus the structure of market prices appears to the individual as a datum to which he must adjust his own conduct.
The valuations which result in determination of definite prices are different. Each party attaches a higher value to the good he receives than to the good he gives away. The exchange ratio, the price, is not the product of an equality of valuation, but, on the contrary, the product of a discrepancy in valuation.
Appraisement must be clearly distinguished from valuation. Appraisement in no way depends upon the subjective valuation of the man who appraises. He is not intent upon establishing the subjective use-value of the good concerned, but upon anticipating the prices which the market will determine. Valuation is a value judgment expressive of a difference in value. Appraisement is the anticipation of an expected fact. It aims at establishing what prices will be paid on the market for a particular commodity or what amount of money will be required for the purchase of a definite commodity.
Valuation and appraisement are, however, closely connected. The valuations of an autarkic husbandman directly compare the weight he attaches to different means for the removal of uneasiness. The valuations of a man buying and selling on the market must not disregard the structure of market prices; they depend upon appraisement. In order to know the meaning of a price one must know the purchasing power of the amount of money concerned. It is necessary by and large to be familiar with the prices of those goods which one would like to acquire and to form on the ground of such knowledge an opinion about their future prices. If an individual speaks of the costs incurred by the purchase of some goods already acquired or to be incurred by the purchase of goods he plans to acquire, he expresses these costs in terms of money. But this amount of money represents in his eyes the degree of satisfaction he could obtain by employing it for the acquisition of other goods. The valuation makes a detour: it goes via the appraisement of the structure of market prices; but it always aims finally at the comparison of alternative modes for the removal of felt uneasiness.
It is ultimately always the subjective value judgments of individuals that determine the formation of prices. Catallactics in conceiving the pricing process necessarily reverts to the fundamental category of action, the preference given to a over b. In view of popular errors it is expedient to emphasize that catallactics deals with the real prices as they are paid in definite transactions and not with imaginary prices. The concept of final prices is merely a mental tool for the grasp of a particular problem, the emergence of entrepreneurial profit and loss. The concept of a "just" or "fair" price is devoid of any scientific meaning; it is a disguise for wishes, a striving for a state of affairs different from reality. Market prices are entirely determined by the value judgments of men as they really act.
If one says that prices tend toward a point at which total demand is equal to total supply, one resorts to another mode of expressing the same concatenation of phenomena. Demand and supply are the outcome of the conduct of those buying and selling. If, other things being equal, supply increases, prices must drop. At the previous price all those ready to pay this price could buy the quantity they wanted to buy. If the supply increases, they must buy larger quantities or other people who did not buy before must become interested in buying. This can only be attained at a lower price.
It is possible to visualize this interaction by drawing two curves, the demand curve and the supply curve, whose intersection shows the price. It is no less possible to express it in mathematical symbols. But it is necessary to comprehend that such pictorial or mathematical modes of representation do not affect the essence of our interpretation and that they do not add a whit to our insight. Furthermore it is important to realize that we do not have any knowledge or experience concerning the shape of such curves. Always, what we know is only market prices — that is, not the curves but only a point which we interpret as the intersection of two hypothetical curves. The drawing of such curves may prove expedient in visualizing the problems for undergraduates. For the real tasks of catallactics they are mere byplay.
3. The Prices of the Goods of Higher Orders
The market process is coherent and indivisible. It is an indissoluble intertwinement of actions and reactions, of moves and countermoves. But the insufficiency of our mental abilities enjoins upon us the necessity of dividing it into parts and analyzing each of these parts separately. In resorting to such artificial cleavages we must never forget that the seemingly autonomous existence of these parts is an imaginary makeshift of our minds. They are only parts, that is, they cannot even be thought of as existing outside the structure of which they are parts.
The prices of the goods of higher orders are ultimately determined by the prices of the goods of the first or lowest order, that is, the consumers' goods. As a consequence of this dependence they are ultimately determined by the subjective valuations of all members of the market society. It is, however, important to realize that we are faced with a connection of prices, not with a connection of valuations. The prices of the complementary factors of production are conditioned by the prices of the consumers' goods. The factors of production are appraised with regard to the prices of the products, and from this appraisement their prices emerge. Not the valuations but the appraisement are transferred from the goods of the first order to those of higher orders. The prices of the consumers' goods engender the actions resulting in the determination of the prices of the factors of production. These prices are primarily connected only with the prices of the consumers' goods. With the valuations of the individuals they are only indirectly connected, viz., through the intermediary of the prices of the consumers' goods, the products of their joint employment.
The tasks incumbent upon the theory of the prices of factors of production are to be solved by the same methods which are employed for treatment of the prices of consumers' goods. We conceive the operation of the market of consumer's goods in a twofold way. We think on the one hand of a state of affairs which leads to acts of exchange; the situation is such that the uneasiness of various individuals can be removed to some extent because various people value the same goods in a different way. On the other hand, we think of a situation in which no further acts of exchange can happen because no actor expects any further improvement of his satisfaction by further acts of exchange. We proceed in the same way in comprehending the formation of the prices of factors of production. The operation of this market is actuated and kept in motion by the exertion of the promoting entrepreneurs, eager to profit from differences in the market prices of the factors of production and the expected prices of the products. The operation of this market would stop if a situation were ever to emerge in which the sum of the prices of the complementary factors of production — but for interest — equaled the prices of the products and nobody believed that further price changes were to be expected. Thus we have described the process adequately and completely by pointing out, positively, what actuates it and, negatively, what would suspend its motion. The main importance is to be attached to the positive description. The negative description resulting in the imaginary constructions of the final price and the evenly rotating economy is merely auxiliary. For the task is not the treatment of imaginary concepts, which never appear in life and action, but the treatment of the market prices at which the goods of higher orders are really bought and sold.
This method we owe to Gossen, Carl Menger, and Böhm-Bawerk. Its main merit is that it implies the cognition that we are faced with a phenomenon of price determination inextricably linked with the market process. It distinguishes between two things: (a) the direct valuation of the factors of production which attaches the value of the product to the total complex of the complementary factors of production, and (b) the prices of the single factors of production which are formed on the market as the resultant of the concurring actions of competing highest bidders. Valuation as it can be practiced by an isolated actor (Robinson Crusoe or a socialist board of production management) can never result in a determination of such a thing as quotas of value. Valuation can only arrange goods in scales of preference. It can never attach to a good something that could be called a quantity or magnitude of value. It would be absurd to speak of a sum of valuations or values. It is permissible to declare that, due allowance being made for time preference, the value attached to a product is equal to the value of the total complex of complementary factors of production. But it would be nonsensical to assert that the value attached to a product is equal to the "sum" of the values attached to the various complementary factors of production. One cannot add up values or valuations. One can add up prices expressed in terms of money, but not scales of preference. One cannot divide values or single out quotas of them. A value judgment never consists in anything other than preferring a to b.
The process of value imputation does not result in derivation of the value of the single productive agents from the value of their joint product. It does not bring about results which could serve as elements of economic calculation. It is only the market that, in establishing prices for each factor of production, creates the conditions required for economic calculation. Economic calculation always deals with prices, never with values.
The market determines prices of factors of production in the same way in which it determines prices of consumers' goods. The market process is an interaction of men deliberately striving after the best possible removal of dissatisfaction. It is impossible to think away or to eliminate from the market process the men actuating its operation. One cannot deal with the market of consumers' goods and disregard the actions of the consumers. One cannot deal with the market of the goods of higher orders while disregarding the actions of the entrepreneurs and the fact that the use of money is essential in their transactions. There is nothing automatic or mechanical in the operation of the market. The entrepreneurs, eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor. The entrepreneurs are eager to outdo one another by bidding higher prices than their rivals. Their offers are limited on the one hand by their anticipation of future prices of the products and on the other hand by the necessity to snatch the factors of production away from the hands of other entrepreneurs competing with them.
The entrepreneur is the agency that prevents the persistence of a state of production unsuitable to fill the most urgent wants of the consumers in the cheapest way. All people are anxious for the best possible satisfaction of their wants and are in this sense striving after the highest profit they can reap. The mentality of the promoters, speculators, and entrepreneurs is not different from that of their fellow men. They are merely superior to the masses in mental power and energy. They are the leaders on the way toward material progress. They are the first to understand that there is a discrepancy between what is done and what could be done. They guess what the consumers would like to have and are intent upon providing them with these things. In the pursuit of such plans they bid higher prices for some factors of production and lower the prices of other factors of production by restricting their demand for them. In supplying the market with those consumers' goods in the sale of which the highest profits can be earned, they create a tendency toward a fall in their prices. In restricting the output of those consumers' goods the production of which does not offer chances for reaping profit, they bring about a tendency toward a rise in their prices. All these transformations go on ceaselessly and could stop only if the unrealizable conditions of the evenly rotating economy and of static equilibrium were to be attained.
In drafting their plans, the entrepreneurs look first at the prices of the immediate past, which are mistakenly called present prices. Of course, the entrepreneurs never make these prices enter into their calculations without paying regard to anticipated changes. The prices of the immediate past are for them only the starting point of deliberations leading to forecasts of future prices. The prices of the past do not influence the determination of future prices. It is, on the contrary, the anticipation of future prices of the products that determines the state of prices of the complementary factors of production. The determination of prices has, as far as the mutual exchange ratios between various commodities are concerned,2 no direct causal relation whatever with the prices of the past. The allocation of the nonconvertible factors of production among the various branches of production3 and the amount of capital goods available for future production are historical magnitudes; in this regard the past is instrumental in shaping the course of future production and in affecting the prices of the future. But directly the prices of the factors of production are determined exclusively by the anticipation of future prices of the products. The fact that yesterday people valued and appraised commodities in a different way is irrelevant. The consumers do not care about the investments made with regard to past market conditions and do not bother about the vested interests of entrepreneurs, capitalists, landowners, and workers, who may be hurt by changes in the structure of prices. Such sentiments play no role in the formation of prices. (It is precisely the fact that the market does not respect vested interests that makes the people concerned ask for government interference.) The prices of the past are for the entrepreneur, the shaper of future production, merely a mental tool. The entrepreneurs do not construct afresh every day a radically new structure of prices or allocate anew the factors of production to the various branches of industry. They merely transform what the past has transmitted in better adapting it to the altered conditions. How much of the previous conditions they preserve and how much they change depends on the extent to which the data have changed.
The economic process is a continuous interplay of production and consumption. Today's activities are linked with those of the past through the technological knowledge at hand, the amount and the quality of the capital goods available, and the distribution of the ownership of these goods among various individuals. They are linked with the future through the very essence of human action; action is always directed toward the improvement of future conditions. In order to see his way in the unknown and uncertain future man has within his reach only two aids: experience of past events and his faculty of understanding. Knowledge about past prices is a part of this experience and at the same time the starting point of understanding the future.
If the memory of all prices of the past were to fade away, the pricing process would become more troublesome, but not impossible as far as the mutual exchange ratios between various commodities are concerned. It would be harder for the entrepreneurs to adjust production to the demand of the public, but it could be done nonetheless. It would be necessary for them to assemble anew all the data they need as the basis of their operations. They would not avoid mistakes which they now evade on account of experience at their disposal. Price fluctuations would be more violent at the beginning; factors of production would be wasted; want satisfaction would be impaired. But finally, having paid dearly, people would again have acquired the experience needed for a smooth working of the market process.
The essential fact is that it is the competition of profit-seeking entrepreneurs that does not tolerate the preservation of false prices of the factors of production. The activities of the entrepreneurs are the element that would bring about the unrealizable state of the evenly rotating economy if no further changes were to occur. In the world-embracing public sale called the market, they are the bidders for the factors of production. In bidding, they are the mandataries of the consumers, as it were. Each entrepreneur represents a different aspect of the consumers' wants, either a different commodity or another way of producing the same commodity. The competition among the entrepreneurs is ultimately a competition among the various possibilities open to men to remove their uneasiness as far as possible by the acquisition of consumers' goods. The decisions of the consumers to buy one commodity and to postpone buying another determine the prices of factors of production required for manufacturing these commodities. The competition between the entrepreneurs reflects the prices of consumers' goods in the formation of the prices of the factors of production. It reflects in the external world the conflict which the inexorable scarcity of the factors of production brings about in the soul of each individual. It makes effective the subsumed decisions of the consumers as to what purpose the nonspecific factors should be used for and to what extent the specific factors of production should be used.
The pricing process is a social process. It is consummated by an interaction of all members of the society. All collaborate and cooperate, each in the particular role he has chosen for himself in the framework of the division of labor. Competing in cooperation and cooperating in competition, all people are instrumental in bringing about the result, viz., the price structure of the market, the allocation of the factors of production to the various lines of want satisfaction, and the determination of the share of each individual. These three events are not three different matters. They are only different aspects of one indivisible phenomenon which our analytical scrutiny separates into three parts. In the market process they are accomplished uno actu. Only people prepossessed by socialist leanings who cannot free themselves from longing glances at socialist methods speak of three different processes in dealing with the market phenomena: the determination of prices, the direction of productive efforts, and distribution.
A Limitation on the Pricing of Factors of Production
The process which makes the prices of the factors of production spring from the prices of products can achieve its results only if, of the complementary factors not replaceable by substitutes, not more than one is of absolutely specific character, that is, is not suitable for any other employment. If the production of a product requires two or more absolutely specific factors, only a cumulative price can be assigned to them. If all factors of production were absolutely specific, the pricing process would not achieve more than such cumulative prices. It would accomplish nothing more than statements like this: as combining 3 a and 5 b produces one unit of p, 3a and 5b together are equal to 1p and the final price of 3a+5b is — due allowance being made for time preference — equal to the final price of 1p. As entrepreneurs who want to use a and b for purposes other than the production of p do not bid for them, a more detailed price determination is impossible. Only if a demand emerges for a (or for b) on the part of entrepreneurs who want to employ a (or b) for other purposes, does competition between them and the entrepreneurs planning the production of p arise and a price for a (or for b) comes into existence, the height of which determines also the price of b (or a).
A world in which all the factors of production are absolutely specific could manage its affairs with such cumulative prices. In such a world there would not exist the problem of how to allocate the means of production to various branches of want satisfaction. In our real world, things are different. There are many scarce means of production which can be employed for various tasks. There the economic problem is to employ these factors in such a way that no unit of them should be used for the satisfaction of a less urgent need if this employment prevents the satisfaction of a more urgent need. It is this that the market solves in determining the prices of the factors of production. The social service rendered by this solution is not in the least impaired by the fact that, for factors which can be employed only cumulatively, no other than cumulative prices are determined.
Factors of production which can be used in the same ratio of combination for the production of various commodities but do not allow of any other use, are to be considered as absolutely specific factors. They are absolutely specific with regard to the production of an intermediary product which can be utilized for various purposes. The price of this intermediary product can be assigned to them cumulatively only. Whether this intermediary product can be directly apperceived by the senses or whether it is merely the invisible and intangible outcome of their joint employment makes no difference.
4. Cost Accounting
In the calculation of the entrepreneur, costs are the amount of money required for the procurement of the factors of production.
The entrepreneur is intent upon embarking upon those business projects from which he expects the highest surplus of proceeds over costs and upon shunning projects from which he expects a lower amount of profit or even a loss. In doing this, he adjusts his effort to the best possible satisfaction of the needs of the consumers. The fact that a project is not profitable because costs are higher than proceeds is the outcome of the fact that there is a more useful employment available for the factors of production required. There are other products in the purchase of which the consumers are prepared to allow for the prices of these factors of production. But the consumers are not prepared to pay these prices in buying the commodity the production of which is not profitable.
Cost accounting is affected by the fact that the two following conditions are not always present:
First, every increase in the quantity of factors expended for the production of a consumers' good increases its power to remove uneasiness.
Second, every increase in the quantity of a consumers' good requires a proportional increase in the expenditure of factors of production or even a more-than-proportional increase in their expenditure.
If both these conditions were always and without any exception fulfilled, every increment z expended for increasing the quantity m of a commodity g would be employed for the satisfaction of a need viewed as less urgent than the least-urgent need already satisfied by the quantity m available previously. At the same time, the increment z would require the employment of factors of production to be withdrawn from the satisfaction of other needs considered as more pressing than those needs whose satisfaction was foregone in order to produce the marginal unit of m. On the one hand, the marginal value of the satisfaction derived from the increase in the quantity available of g would drop. On the other hand, the costs required for the production of additional quantities of g would increase in marginal disutility: factors of production would be withheld from employments in which they could satisfy more urgent needs. Production must stop at the point at which the marginal utility of the increment no longer compensates for the marginal increase in the disutility of costs.
Now these two conditions are present very often, but not generally without exception. There exist many commodities of all orders of goods whose physical structure is not homogeneous and which are therefore not perfectly divisible.
It would, of course, be possible to conjure away the deviation from the first condition mentioned above by a sophisticated play on words. One could say, half a motorcar is not a motorcar. If one adds to half a motorcar a quarter of a motorcar, one does not increase the "quantity" available; only the perfection of the process of production which turns out a complete car produces a unit and an increase in the "quantity" available. However, such an interpretation misses the point. The problem we must face is that not every increase in expenditure increases proportionately the objective use-value, the physical power of a thing to render a definite service. The various increments in expenditure bring about different results. There are increments the expenditure of which remains useless if no further increments of a definite quantity are added.
On the other hand — and this is the deviation from the second condition — an increase in physical output does not always require a proportionate increase in expenditure or even any additional expenditure. It may happen that costs do not rise at all or that their rise increases output more than proportionately. For many means of production are not homogeneous either and not perfectly divisible. This is the phenomenon known to business as the superiority of big-scale production. The economists speak of the law of increasing returns or decreasing costs.
We consider — as case A — a state of affairs in which all factors of production are not perfectly divisible and in which full utilization of the productive services rendered by every further indivisible element of each factor requires full utilization of the further indivisible elements of every other of the complementary factors. Then in every aggregate of productive agents, each of the assembled elements — every machine, every worker, every piece of raw material — can be fully utilized only if all the productive services of the other elements are fully employed too. Within these limits the production of a part of the maximum output attainable does not require a higher expenditure than the production of the highest possible output. We may also say that the minimum-size aggregate always produces the same quantity of products; it is impossible to produce a smaller quantity of products even if there is no use for a part of it.
We consider — as case B — a state of affairs in which one group of the productive agents (p) is for all practical purposes perfectly divisible. On the other hand, the imperfectly divisible agents can be divided in such a way that full utilization of the services rendered by each further indivisible part of one agent requires full utilization of the further indivisible parts of the other imperfectly divisible complementary factors. Then increasing production of an aggregate of further indivisible factors from a partial to a more complete utilization of their productive capacity requires merely an increase in the quantity of p, the perfectly divisible factors. However, one must guard oneself against the fallacy that this necessarily implies a decrease in the average cost of production. It is true that within the aggregate of imperfectly divisible factors each of them is now better utilized, that therefore costs of production as far as they are caused by the cooperation of these factors remain unchanged, and that the quotas falling to a unit of output are decreasing. But on the other hand, an increase in the employment of the perfectly divisible factors of production can be attained only by withdrawing them from other employments. The value of these other employments increases, other things being equal, with their shrinking; the price of these perfectly divisible factors tends to rise as more of them are used for the better utilization of the productive capacity of the aggregate of the not-further-divisible factors in question. One must not limit the consideration of our problem to the case in which the additional quantity of p is withdrawn from other enterprises producing the same product in a less efficient way and forces these enterprises to restrict their output. It is obvious that in this case — competition between a more and a less efficient enterprise producing the same article out of the same raw materials — the average cost of production is decreasing in the expanding plant. A more general scrutiny of the problem leads to a different result. If the units of p are withdrawn from other employments in which they would have been utilized for the production of other articles, there emerges a tendency toward an increase in the price of these units. This tendency may be compensated by accidental tendencies operating in the opposite direction; it may sometimes by so feeble that its effects are negligible. But it is always present and potentially influences the configuration of costs.
Finally we consider — as case C — a state of affairs in which various imperfectly divisible factors of production can be divided only in such a way that, given the conditions of the market, any size which can be chosen for their assemblage in a production aggregate does not allow for a combination in which full utilization of the productive capacity of one factor makes possible full utilization of the productive capacity of the other imperfectly divisible factors. This case c alone is of practical significance, while the cases A and B hardly play any role in real business. The characteristic feature of case C is that the configuration of production costs varies unevenly. If all imperfectly divisible factors are utilized to less than full capacity, an expansion of production results in a decrease of average costs of production unless a rise in the prices to be paid for the perfectly divisible factors counterbalances this outcome. But as soon as full utilization of the capacity of one of the imperfectly divisible factors is attained, further expansion of production causes a sudden sharp rise in costs. Then again a tendency toward a decrease in average production costs sets in and goes on working until full utilization of one of the imperfectly divisible factors is attained anew.
Other things being equal, the more production of a certain article increases, the more factors of production must be withdrawn from other employments in which they would have been used for the production of other articles. Hence — other things being equal — average production costs increase with the increase in the quantity produced. But this general law is by sections superseded by the phenomenon that not all factors of production are perfectly divisible and that, as far as they can be divided, they are not divisible in such a way that full utilization of one of them results in full utilization of the other imperfectly divisible factors.
The planning entrepreneur is always faced with the question: to what extent will the anticipated prices of the products exceed the anticipated costs? If the entrepreneur is still free with regard to the project in question, because he has not yet made any inconvertible investments for its realization, it is average costs that count for him. But if he has already a vested interest in the line of business concerned, he sees things from the angle of additional costs to be expended. He who already owns a not fully utilized production aggregate does not take into account average cost of production but marginal cost. Without regard to the amount already expended for inconvertible investments he is merely interested in the question whether or not the proceeds from the sale of an additional quantity of products will exceed the additional cost incurred by their production. Even if the whole amount invested in the inconvertible production facilities must be wiped off as a loss, he goes on producing provided he expects a reasonable4 surplus of proceeds over current costs.
With regard to popular errors, it is necessary to emphasize that if the conditions required for the appearance of monopoly prices are not present, an entrepreneur is not in a position to increase his net returns by restricting production beyond the amount conforming with consumers' demand. But this problem will be dealt with later in section 6.
That a factor of production is not perfectly divisible does not always mean that it can be constructed and employed in one size only. This, of course, may occur in some cases. But as a rule it is possible to vary the dimensions of these factors. If out of the various dimensions which are possible for such a factor — e.g., a machine — one dimension is distinguished by the fact that the costs incurred by its production and operation are rendered lower per unit of the productive services than those for other dimensions, things are essentially identical. Then the superiority of the bigger plant does not consist in the fact that it utilizes a machine to full capacity while the smaller plant utilizes only a part of the capacity of a machine of the same size. It consists rather in the fact that the bigger plant employs a machine which operates with a better utilization of the factors of production required for its construction and operation than does the smaller machine employed by the smaller plant.
The role played in all branches of production by the fact that many factors of production are not perfectly divisible is very great. It is of paramount importance in the course of industrial affairs. But one must guard oneself against many misinterpretations of its significance.
One of these errors was the doctrine according to which in the processing industries there prevails a law of increasing returns, while in agriculture and mining a law of decreasing returns prevails. The fallacies implied have been exploded above.5 As far as there is a difference in this regard between conditions in agriculture and those in the processing industries, differences in the data bring them about. The immobility of the soil and the fact that the performance of the various agricultural operations depends on the seasons make it impossible for farmers to take advantage of the capacity of many movable factors of production to the degree which conditions in manufacturing for the most part allow. The optimum size of a production outfit in agricultural production is, as a rule, much smaller than in the processing industries. It is obvious and does not need any further explanation why the concentration of farming cannot be pushed to anything near the degree obtaining in the processing industries.
However, the inequality in the distribution of natural resources over the earth's surface, which is one of the two factors making for the higher productivity of the division of labor, puts a limit to the progress of concentration in the processing industries also. The tendency toward a progressive specialization and the concentration of integrated industrial processes in only a few plants is counteracted by the geographical dispersion of natural resources. 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. While in some branches of the processing industries the utmost concentration is the most adequate method or reducing costs, in other branches a certain degree of decentralization is more advantageous. In the servicing trades, the disadvantages of concentration become so great that they almost entirely overweigh the advantages derived.
Then a historical factor comes into play. In the past, capital goods were immobilized on sites on which our contemporaries would not have set them. It is immaterial whether or not this immobilization was the most economical procedure to which the generations that brought it about could resort. In any event the present generation is faced with a fait accompli. It must adjust its operations to the fact and it must take it into account in dealing with problems of the location of the processing industries.6
Finally there are institutional factors. There are trade and migration barriers. There are differences in political organization and methods of government between various countries. Vast areas are administered in such a way that it is practically out of the question to choose them as a seat for any capital investment no matter how favorable their physical conditions may be.
Entrepreneurial cost accounting must deal with all these geographical, historical, and institutional factors. But even apart from them there are purely technical factors limiting the optimum size of plants and firms. The greater plant or firm may require provisions and procedures which the smaller plant or firm can avoid. In many instances the outlays caused by such provisions and procedures may be overcompensated by the reduction in costs derived from better utilization of the capacity of some of the not-perfectly-divisible factors employed. In other instances, this may not be the case.
Under capitalism, the arithmetical operations required for cost accounting and the confrontation of costs and proceeds can easily be effected as there are methods of economic calculation available. However, cost accounting and calculation of the economic significance of business projects under consideration is not merely a mathematical problem, which can be solved satisfactorily by all those familiar with the elementary rules of arithmetic. The main question is the determination of the money equivalents of the items which are to enter into the calculation. It is a mistake to assume, as many economists do, that these equivalents are given magnitudes, uniquely determined by the state of economic conditions. They are speculative anticipations of uncertain future conditions and, as such, depend on the entrepreneur's understanding of the future state of the market. The term fixed costs is also in this regard somewhat misleading.
Every action aims at the best possible supplying of future needs. To achieve these ends it must make the best possible use of the available factors of production. However, the historical process which brought about the present state of factors available is beside the point. What counts and influences the decisions concerning future action is solely the outcome of this historical process, the quantity and the quality of the factors available today. These factors are appraised only with regard to their ability to render productive services for the removal of future uneasiness. The amount of money spent in the past for their production and acquisition is immaterial.
It has already been pointed out that an entrepreneur who, by the time he has to make a new decision, has expended money for the realization of a definite project, is in a different position from that of a man who starts afresh. The former owns a complex of inconvertible factors of production which he can employ for certain purposes. His decisions concerning further action will be influenced by this fact. But he appraises this complex not according to what he expended in the past for its acquisition. He appraises it exclusively from the point of view of its usefulness for future action. The fact that he has spent more or less for its acquisition is insignificant. This fact is only a factor in determining the amount of the entrepreneur's past losses or profits and the present state of his fortune. It is an element in the historical process that brought about the present state of the supply of factors of production and, as such, it is of importance for future action. But it does not count for the planning of future action and the calculation regarding such action. It is irrelevant that the entries in the firm's books differ from the actual price of such inconvertible factors of production.
Of course, such consummated losses or profits may motivate a firm to operate in a different way from which it would if it were not affected by them. Past losses may render a firm's financial position precarious, especially if they bring about indebtedness and burden it with payments of interest and installments on the principal. However, it is not correct to refer to such payments as a part of fixed costs. They have no relation whatever to the current operations. They are not caused by the process of production, but by the methods employed by the entrepreneur in the past for the procurement of the capital and capital goods needed. They are only accidental with reference to the going concern. But they may enforce upon the firm in question a conduct of affairs which it would not adopt if it were financially stronger. The urgent need for cash in order to meet payments due does not affect its cost accounting, but its appraisal of ready cash as compared with cash that can only be received at a later day. It may impel the firm to sell inventories at an inappropriate moment and to use its durable production equipment in a way that unduly neglects its conservation for later use.
It is immaterial for the problems of cost accounting whether a firm owns the capital invested in its enterprise or whether it has borrowed a greater or smaller part of it and is bound to comply with the terms of a loan contract rigidly fixing the rate of interest and the dates of maturity for interest and principal. The costs of production include only the interest on the capital which is still existent and working in the enterprise. It does not include interest on capital squandered in the past by bad investment or by inefficiency in the conduct of current business operations. The task incumbent upon the businessman is always to use the supply of capital goods now available in the best possible way for the satisfaction of future needs. In the pursuit of this aim he must not be misled by past errors and failures the consequences of which cannot be brushed away. A plant may have been constructed in the past which would not have been built if one had better forecast the present situation. It is vain to lament this historical fact. The main thing is to find out whether or not the plant can still render any service and, if this question is answered in the affirmative, how it can be best utilized. It is certainly sad for the individual entrepreneur that he did not avoid errors. The losses incurred impair his financial situation. They do not affect the costs to be taken into account in planning further action.
It is important to stress this point because it has been distorted in the current interpretation and justification of various measures. One does not "reduce costs" by alleviating some firms' and corporations' burden of debts. A policy of wiping out debts or the interest due on them totally or in part does not reduce costs. It transfers wealth from creditors to debtors; it shifts the incidence of losses incurred in the past from one group of people to another group, e.g., from the owners of common stock to those of preferred stock and corporate bonds. This argument of cost reduction is often advanced in favor of currency devaluation. It is no less fallacious in this case than all the other arguments brought forward for this purpose.
What are commonly called fixed costs are also costs incurred by the exploitation of the already available factors of production which are either rigidly inconvertible or can be adapted for other productive purposes only at a considerable loss. These factors are of a more durable character than the other factors of production required. But they are not permanent. They are used up in the process of production. With each unit of product turned out, a part of the machine's power to produce is exhausted. The extant of this attrition can be precisely ascertained by technology and can be appraised accordingly in terms of money.
However, it is not only this money equivalent of the machine's wearing out which the entrepreneurial calculation has to consider. The businessman is not merely concerned with the duration of the machine's technological life. He must take into account the future state of the market. Although a machine may still be technologically perfectly utilizable, market conditions may render it obsolete and worthless. If the demand for its products drops considerably or disappears altogether, or if more efficient methods for supplying the consumers with these products appear, the machine is economically merely scrap iron. In planning the conduct of his business, the entrepreneur must pay full regard to the anticipated future state of the market. The amount of "fixed" costs which enter into his calculation depends on his understanding of future events. It is not to be fixed simply by technological reasoning.
The technologist may determine the optimum for a production aggregate's utilization. But this technological optimum may differ from that which the entrepreneur, on the ground of his judgment concerning future market conditions, enters into his economic calculation. Let us assume that a factory is equipped with machines which can be utilized for a period of ten years. Every year, 10 percent of their prime costs is laid aside for depreciation. In the third year, market conditions place a dilemma before the entrepreneur. He can double his output for the year and sell it at a price which (apart from covering the increase in variable costs) exceeds the quota of depreciation for the current year and the present value of the last depreciation quota. But this doubling of production trebles the wearing out of the equipment and the surplus proceeds from the sale of the double quantity of products are not great enough to make good also for the present value of the depreciation quota of the ninth year. If the entrepreneur were to consider the annual depreciation quota as a rigid element for his calculation, he would have to deem the doubling of production as not profitable, as additional proceeds lag behind additional cost. He would abstain from expanding production beyond the technological optimum. But the entrepreneur calculates in a different way, although in his accountancy he may lay aside the same quota for depreciation every year. Whether or not the entrepreneur prefers a fraction of the present value of the ninth year's depreciation quota to the technological services which the machines could render him in the ninth year, depends on his opinion concerning the future state of the market.
Public opinion, governments and legislators, and the tax laws look upon a business outfit as a source of permanent revenue. They believe that the entrepreneur who makes due allowance for capital maintenance by annual depreciation quotas will always be in a position to reap a reasonable return from the capital invested in his durable producers' goods. Real conditions are different. A production aggregate, such as a plant and its equipment, is a factor of production whose usefulness depends on changing market conditions and the skill of the entrepreneur in employing it in accordance with the change in conditions.
There is in the field of economic calculation nothing that is certain in the sense in which this term is used with regard to technological facts. The essential elements of economic calculation are speculative anticipations of future conditions. Commercial usages and customs and commercial laws have established definite rules for accountancy and auditing. There is accuracy in the keeping of books. But they are accurate only with regard to these rules. The book values do not reflect precisely the real state of affairs. The market value of an aggregate of durable producers' goods may differ from the nominal figures the books show. The proof is that the stock exchange appraises them without any regard to these figures.
Cost accounting is therefore not an arithmetical process which can be established and examined by an indifferent umpire. It does not operate with uniquely determined magnitudes which can be found out in an objective way. Its essential items are the result of an understanding of future conditions, necessarily always colored by the entrepreneur's opinion about the future state of the market.
Attempts to establish cost accounts on an "impartial" basis are doomed to failure. Calculating costs is a mental tool of action, the purposive design to make the best of the available means for an improvement of future conditions. It is necessarily volitional, not factual. In the hands of an indifferent umpire, it changes its character entirely. The umpire does not look forward to the future. He looks backward to the dead past and to rigid rules, which are useless for real life and action. He does not anticipate changes. He is unwittingly guided by the prepossession that the evenly rotating economy is the normal and most desirable state of human affairs. Profits do not fit into his scheme. He has a confused idea about a "fair" rate of profit or a "fair" return on capital invested. However, there are no such things. In the evenly rotating economy, there are no profits. In a changing economy, profits are not determined with reference to any set of rules by which they could be classified as fair or unfair. Profits are never normal. Where there is normality, i.e., absence of change, no profits can emerge.
5. Logical Catallactics Versus Mathematical Catallactics
The problems of prices and costs have been treated also with mathematical methods. There have even been economists who held that the only appropriate method of dealing with economic problems is the mathematical method and who derided the logical economists as "literary" economists.
If this antagonism between the logical and the mathematical economists were merely a disagreement concerning the most adequate procedure to be applied in the study of economics, it would be superfluous to pay attention to it. The better method would prove its preeminence by bringing about better results. It may also be that different varieties of procedure are necessary for the solution of different problems and that for some of them one method is more useful than the other.
However, this is not a dispute about heuristic questions, but a controversy concerning the foundations of economics. The mathematical method must be rejected not only on account of its barrenness. It is an entirely vicious method, starting from false assumptions and leading to fallacious inferences. Its syllogisms are not only sterile; they divert the mind from the study of the real problems and distort the relations between the various phenomena.
The ideas and procedures of the mathematical economists are not uniform. There are three main currents of thought which must be dealt with separately.
The first variety is represented by the statisticians who aim at discovering economic laws from the study of economic experience. They aim to transform economics into a "quantitative" science. Their program is condensed in the motto of the Econometric Society: "Science is measurement."
The fundamental error implied in this reasoning has been shown above.7 Experience of economic history is always experience of complex phenomena. It can never convey knowledge of the kind the experimenter abstracts from a laboratory experiment. Statistics is a method for the presentation of historical facts concerning prices and other relevant data of human action. It is not economics and cannot produce economic theorems and theories. The statistics of prices is economic history. The insight that, ceteris paribus, an increase in demand must result in an increase in prices is not derived from experience. Nobody ever was or ever will be in a position to observe a change in one of the market data ceteris paribus. There is no such thing as quantitative economics. All economic quantities we know about are data of economic history. No reasonable man can contend that the relation between price and supply is, in general or in respect of certain commodities, constant. We know, on the contrary, that external phenomena affect different people in different ways, that the reactions of the same people to the same external events vary, and that it is not possible to assign individuals to classes of men reacting in the same way. This insight is a product of our aprioristic theory. It is true the empiricists reject this theory; they pretend that they aim to learn only from historical experience. However, they contradict their own principles as soon as they pass beyond the unadulterated recording of individual single prices and begin to construct series and to compute averages. A datum of experience and a statistical fact is only a price paid at a definite time and a definite place for a definite quantity of a certain commodity. The arrangement of various price data in groups and the computation of averages are guided by theoretical deliberations which are logically and temporally antecedent. The extent to which certain attending features and circumstantial contingencies of the price data concerned are taken or not taken into consideration depends on theoretical reasoning of the same kind. Nobody is so bold as to maintain that a rise of a percent in the supply of any commodity must always — in every country and at any time — result in a fall of b percent in its price. But as no quantitative economist ever ventured to define precisely on the ground of statistical experience the special conditions producing a definite deviation from the ratio a : b, the futility of his endeavors is manifest. Moreover, money is not a standard for the measurement of prices; it is a medium whose exchange ratio varies in the same way, although as a rule not with the same speed and to the same extent, in which the mutual exchange ratios of the vendible commodities and services vary.
There is hardly any need to dwell longer upon the exposure of the claims of quantitative economics. In spite of all the high-sounding pronouncements of its advocates, nothing has been done for the realization of its program. The late Henry Schultz devoted his research to the measurement of elasticities of demand for various commodities. Professor Paul H. Douglas has praised the outcome of Schultz's studies as "a work as necessary to help make economics a more or less exact science as was the determination of atomic weights for the development of chemistry."8 The truth is that Schultz never embarked upon a determination of the elasticity of demand for any commodity as such; the data he relied upon were limited to certain geographical areas and historical periods. His result for a definite commodity, for instance potatoes, do not refer to potatoes in general, but to potatoes in the United States in the years from 1875 to 1929.9 They are, at best, rather questionable and unsatisfactory contributions to various chapters of economic history. They are certainly not steps toward the realization of the confused and contradictory program of quantitative economics. It must be emphasized that the two other varieties of mathematical economics are fully aware of the futility of quantitative economics. For they have never ventured to make any magnitudes as found by the econometricians enter into their formulas and equations and thus to adapt them for the solution of particular problems. There is in the field of human action no means for dealing with future events other than that provided by understanding.
The second field treated by mathematical economists is that of the relation of prices and costs. In dealing with these problems the mathematical economists disregard the operation of the market process and moreover pretend to abstract from the use of money inherent in all economic calculations. However, as they speak of prices and costs in general and confront prices and costs, they tacitly imply the existence and the use of money. Prices are always money prices, and costs cannot be taken into account in economic calculation if not expressed in terms of money. If one does not resort to terms of money, costs are expressed in complex quantities of diverse goods and services to be expended for the procurement of a product. On the other hand, prices — if this term is applicable at all to exchange ratios determined by barter — are the enumeration of quantities of various goods against which the "seller" can exchange a definite supply. The goods which are referred to in such "prices" are not the same to which the "costs" refer. A comparison of such prices in kind and costs in kind is not feasible. That the seller values the goods he gives away less than those he receives in exchange for them, that the seller and the buyer disagree with regard to the subjective valuation of the two goods exchanged, and that an entrepreneur embarks upon a project only if he expected to receive for the product goods that he values higher than those expended in their production, all this we know already on the ground of praxeological comprehension. It is this aprioristic knowledge that enables us to anticipate the conduct of an entrepreneur who is in a position to resort to economic calculation. But the mathematical economist deludes himself when he pretends to treat these problems in a more general way by omitting any reference to terms of money. It is vain to investigate instances of nonperfect divisibility of factors of production without reference to economic calculation in terms of money. Such a scrutiny can never go beyond the knowledge already available; namely that every entrepreneur is intent upon producing those articles the sale of which will bring him proceeds that he values higher than the total complex of goods expended in their production. But if there is no indirect exchange and if no medium of exchange is in common use, he can succeed, provided he has correctly anticipated the future state of the market, only if he is endowed with a superhuman intellect. He would have to take in at a glance all exchange ratios determined at the market in such a way as to assign in his deliberations precisely the place due to every good according to these ratios.
It cannot be denied that all investigations concerning the relation of prices and costs presuppose both the use of money and the market process. But the mathematical economists shut their eyes to this obvious fact. They formulate equations and draw curves which are supposed to describe reality. In fact they describe only a hypothetical and unrealizable state of affairs, in no way similar to the catallactic problems in question. They substitute algebraic symbols for the determinate terms of money as used in economic calculation and believe that this procedure renders their reasoning more scientific. They strongly impress the gullible layman. In fact they only confuse and muddle things which are satisfactorily dealt with in textbooks of commercial arithmetic and accountancy.
Some of these mathematicians have gone so far as to declare that economic calculation could be established on the basis of units of utility. They call their methods utility analysis. Their error is shared by the third variety of mathematical economics.
The characteristic mark of this third group is that they are openly and consciously intent upon solving catallactic problems without any reference to the market process. Their ideal is to construct an economic theory according to the pattern of mechanics. They again and again resort to analogies with classical mechanics which in their opinion is the unique and absolute model of scientific inquiry. There is no need to explain again why this analogy is superficial and misleading and in what respects purposive human action radically differs from motion, the subject matter of mechanics. It is enough to stress one point, viz., the practical significance of the differential equations in both fields.
The deliberations which result in the formulation of an equation are necessarily of a nonmathematical character. The formulation of the equation is the consummation of our knowledge; it does not directly enlarge our knowledge. Yet, in mechanics, the equation can render very important practical services. As there exist constant relations between various mechanical elements and as these relations can be ascertained by experiments, it becomes possible to use equations for the solution of definite technological problems. Our modern industrial civilization is mainly an accomplishment of this utilization of the differential equations of physics. No such constant relations exist, however, between economic elements. The equations formulated by mathematical economics remain a useless piece of mental gymnastics and would remain so even it they were to express much more than they really do.
A sound economic deliberation must never forget these two fundamental principles of the theory of value: First, valuing that results in action always means preferring and setting aside; it never means equivalence or indifference. Second, there is no means of comparing the valuations of different individuals or the valuations of the same individuals at different instants other than by establishing whether or not they arrange the alternatives in question in the same order of preference.
In the imaginary construction of the evenly rotating economy, all factors of production are employed in such a way that each of them renders the most valuable service. No thinkable and possible change could improve the state of satisfaction; no factor is employed for the satisfaction of a need a if this employment prevents the satisfaction of a need b that is considered more valuable than the satisfaction of a. It is, of course, possible to describe this imaginary state of the allocation of resources in differential equations and to visualize it graphically in curves. But such devices do not assert anything about the market process. They merely mark out an imaginary situation in which the market process would cease to operate. The mathematical economists disregard the whole theoretical elucidation of the market process and evasively amuse themselves with an auxiliary notion employed in its context and devoid of any sense when used outside of this context.
In physics we are faced with changes occurring in various sense phenomena. We discover a regularity in the sequence of these changes and these observations lead us to the construction of a science of physics. We know nothing about the ultimate forces actuating these changes. They are, for the searching mind, ultimately given and defy any further analysis. What we know from observation is the regular concatenation of various observable entities and attributes. It is this mutual interdependence of data that the physicist describes in differential equations.
In praxeology, the first fact we know is that men are purposively intent upon bringing about some changes. It is this knowledge that integrates the subject matter of praxeology and differentiates it from the subject matter of the natural sciences. We know the forces behind the changes, and this aprioristic knowledge leads us to a cognition of the praxeological processes. The physicist does not know what electricity "is." He knows only phenomena attributed to something called electricity. But the economist knows what actuates the market process. It is only thanks to this knowledge that he is in a position to distinguish market phenomena from other phenomena and to describe the market process.
Now, the mathematical economist does not contribute anything to the elucidation of the market process. He merely describes an auxiliary makeshift employed by the logical economists as a limiting notion, the definition of a state of affairs in which there is no longer any action and the market process has come to a standstill. That is all he can say. What the logical economist sets forth in words when defining the imaginary constructions of the final state of rest and the evenly rotating economy and what the mathematical economist himself must describe in words before he embarks upon his mathematical work, is translated into algebraic symbols. A superficial analogy is spun out too long, that is all.
Both the logical and the mathematical economists assert that human action ultimately aims at the establishment of such a state of equilibrium and would reach it if all further changes in data were to cease. But the logical economist knows much more than that. He shows how the activities of enterprising men, the promoters and speculators, eager to profit from discrepancies in the price structure, tend toward eradicating such discrepancies and thereby also toward blotting out the sources of entrepreneurial profit and loss. He shows how this process would finally result in the establishment of the evenly rotating economy. This is the task of economic theory. The mathematical description of various states of equilibrium is mere play. The problem is the analysis of the market process.
A comparison of both methods of economic analysis makes us understand the meaning of the often-raised request to enlarge the scope of economic science by the construction of a dynamic theory instead of the mere occupation with static problems. With regard to logical economics, this postulate is devoid of any sense. Logical economics is essentially a theory of processes and changes. It resorts to the imaginary constructions of changelessness merely for the elucidation of the phenomena of change. But it is different with mathematical economics. Its equations and formulas are limited to the description of states of equilibrium and nonacting. It cannot assert anything with regard to the formation of such states and their transformation into other states as long as it remains in the realm of mathematical procedures. As against mathematical economics the request for a dynamic theory is well substantiated. But there is no means for mathematical economics to comply with this request. The problems of process analysis, i.e., the only economic problems that matter, defy any mathematical approach. The introduction of time parameters into the equations is no solution. It does not even indicate the essential shortcomings of the mathematical method. The statements that every change involves time and that change is always in the temporal sequence are merely a way of expressing the fact that, as far as there is rigidity and unchangeability, there is no time. The main deficiency of mathematical economics is not the fact that it ignores the temporal sequence, but that it ignores the operation of the market process.
The mathematical method is at a loss to show how, from a state of nonequilibrium, those actions spring up which tend toward the establishment of equilibrium. It is, of course, possible to indicate the mathematical operations required for the transformation of the mathematical description of a definite state of nonequilibrium into the mathematical description of the state of equilibrium. But these mathematical operations by no means describe the market process actuated by the discrepancies in the price structure. The differential equations of mechanics are supposed to describe precisely the motions concerned at any instant of the time traveled through. The economic equations have no reference whatever to conditions as they really are in each instant of the time interval between the state of nonequilibrium and that of equilibrium. Only those entirely blinded by the prepossession that economics must be a pale replica of mechanics will underrate the weight of this objection. A very imperfect and superficial metaphor is not a substitute for the services rendered by logical economics.
In every chapter of catallactics, the devastating consequences of the mathematical treatment of economics can be tested. It is enough to refer to two instances only. One is provided by the so-called equation of exchange, the mathematical economists' futile and misleading attempt to deal with changes in the purchasing power of money.10 The second can be best expressed in referring to Professor Schumpeter's dictum according to which consumers, in evaluating consumers' goods "ipso facto also evaluate the means of production which enter into the production of these goods."11 It is hardly possible to construe the market process in a more erroneous way.
Economics is not about goods and services; it is about the actions of living men. Its goal is not to dwell upon imaginary constructions such as equilibrium. These constructions are only tools of reasoning. The sole task of economics is analysis of the actions of men, is the analysis of processes.
- 1. Sometimes the difference in price as established by price statistics is apparent only. The price quotations may refer to various qualities of the article concerned. Or they may, complying with the local usages of commerce, mean different things. They may, for instance, include or not include packing charges; they may refer to cash payment or to payment at a later date; and so on.
- 2. It is different with regard to the mutual exchange ratios between money and the vendible commodities and services. Cf. below, pp. 410–411.
- 3. The problem of the nonconvertible capital goods is dealt with below, pp. 503–509.
- 4. Reasonable means in this connection that the anticipated returns on the convertible capital used for the continuation of production are at least not lower than the anticipated returns on its use for other projects.
- 5. Cf. Above, p. 130.
- 6. For a thoroughgoing treatment of the conservatism enjoined upon men by the limited convertibility of many capital goods, the historically determined element in production, see below, pp. 503–514.
- 7. Cf. Above, pp. 31, 55-56.
- 8. Cf. Paul H. Douglas in Econometrica, VII, 105.
- 9. Cf. Henry Schultz, The Theory and Measurement of Demand (University of Chicago Press, 1938), pp. 405–427.
- 10. Cf. below, p. 399.
- 11. Cf. Joseph A. Schumpeter, Capitalism, Socialism and Democracy (New York, 1942), p. 175. For a critique of this statement, cf. Hayek, ?The Use of Knowledge in Society,? Individualism and the Social Order (Chicago, 1948), pp. 89 ff.