Economics of the Free Society
Chapter V: The World of Goods and the Flow of Production
“The world is like a shop stocked full of goods. They are on sale for work—toil may buy them.”1
FRIEDRICH VON LOGAU (1604-1655)
1. The Social Product and the National Income
Now that we have studied the structure of the division of labor and discovered in money the indispensable auxiliary of that division of labor, let us go a step further and examine more closely the process which unfolds on these bases, namely, how goods are supplied and distributed.
Let us emphasize at once that the concept “economic good” must be understood in a very broad sense; i.e., it includes all those things which serve as means for satisfying wants. In our economic system these are things for which, as a rule, a price must be paid. Hence, this concept embraces not only material goods as such, but also a wide variety of services (a lawyer’s counsel, a physician’s examination, a scholar’s lecture, a singer’s concert) and a final category that may be grouped under the loose designation of “rights and relationships” (right to use a dwelling, patents and copyrights, a physician’s practice, the “goodwill” of a firm, etc.). The criterion of price does not always suffice to characterize an economic good. This is especially true in respect to those collective goods which, as in the case of measures taken to ensure internal and external security (e.g., protection against epidemics), satisfy a collective need. These goods the state “produces” and distributes according to the system of collective economy. Thus the work done by a civil servant is an economic good albeit there is no “market” for it. Indeed, it is because of this very circumstance, as we have shown previously (Chapter II, Note 5), that we cannot always be sure that such a “good” answers to a general need.
A procedure which proves useful on several counts is to consider, in concrete terms, the total output of goods and services produced by the nation in a given period of time, say a year. This total yearly output we may term the social product (or gross national product), a helpful abstraction of which we shall make use frequently henceforth. It should be remarked that the total of available goods is not identical with the total of consumable goods. A large part of the gross national product is composed not of consumption goods, but of producer goods (capital) which serve for the maintenance of the apparatus of production (renovation, replacement) and also for the extension of that apparatus (expansion, net investment, accumulation of capital). To determine the net national output (i.e., the supply of commodities and services which constitute a real addition to the national economy and which are over and above those required to maintain the productive apparatus intact), we must subtract from the total output (gross product) those goods and services needed for replacement purposes. This subtraction we may designate as “the costs of doing business.” Anyone who has ever figured out an income tax will know what this means. An economy in which reserves are not built up to the necessary extent would “eat” its capital; it would “feed on its own substance.” Its productive apparatus would fall, bit by bit, into a state of disrepair and, as a consequence, national output would become smaller and smaller in the future. This, in fact, is what occurred in many countries during and after both World Wars.
2. The Essence of Production
Of the many heads under which we can classify goods, there is one which takes precedence over all others. The essential note of an economic good is its scarcity in the sense with which we have now become familiar. For certain goods, this scarcity is immediately given, viz., for those goods which cannot be increased by production. Such are the paintings of the old masters or rare vintage wines. The true significance of this category of scarce goods will become clear to us when we consider that it includes such important and irreplaceable goods as land (though pedants might insist that land can be increased in quantity by building dikes to wrest it from the sea). And then there is the most important and productive good of all-human labor power. Certainly, it cannot be “produced” in the ordinary sense of the word. In contradistinction to these goods whose scarcity is immediately and unalterably given, there is the great mass of goods which can be increased by production, a circumstance which, as we have seen, does not preclude their possessing the quality of scarceness, but is of sufficient importance to merit our close study.
These considerations are illustrated in the following example. We have seen that the production of coal is nothing else, at bottom, than a change in its location. Coal is of no use to the inhabitants of West Virginia so long as it has not been brought to the surface. Nor is West Virginian coal which has been brought to the surface of any use to the inhabitants of Pittsburgh until it has been transported to that city. What mysterious difference is there between the vertical and the horizontal movement of coal? To satisfy a want, a good must not only exist as such, but it must be in the place where it is demanded. Moreover, it must be in that place at the time when it is demanded. And there are a number of other requirements which we as consumers ordinarily expect “goods” to meet: we prefer goods to be available in a wide range of choices; we expect not to have to become connoisseurs in order to be able to rely on the quality of the goods we buy; and we attached increasing value to customer conveniences, to elegant shops, courteous service, attractive packaging, home deliveries, and many other things. All these things, of course, the manufacturer can undertake to do and, in fact, often does (shoe shops run by shoe manufacturers). Nevertheless, in these instances as elsewhere, the principle of the division of labor has proved its worth: most such accessory operations are better performed by enterprises specialized for the purpose. Trade, transportation, and speculation fulfill these intermediate “service” functions. Their apparently autonomous character should not be permitted to obscure the fact that they are really “producing” utilities and services without which the material goods would have for us little or no value. Such enterprises are, indeed, no less “productive” than those concerned with producing material goods. To wax indignant over the difference between the factory price and the retail price (“retail markup”) is no more rational than to complain of a “manufacturing markup,” i.e., of the increase in the value of the product added within the factory. This does not exclude the possibility that in both cases avoidable costs and wasteful practices will be present, but these are defects which can be most effectively eliminated by competition of greater or lesser degree. If, in recent years, the retail markup has noticeably increased in many sectors of the economy, this merely expresses the fact that we attach increasing value to such ancillary activities.
3. The Economic Process as a Whole
We have now managed to marshal practically all the data which we need to acquire understanding of the individual parts of the economic process. By making a number of simplifying assumptions, in particular, that the social division of labor and the price system are the dominant features of the economic system and that we are concerned with a “closed economy” (one, i.e., without foreign trade), we may picture the operation of the economy in global terms as follows. There is, first, production in the broad sense of that activity which makes available the largest quantities and most numerous kinds of goods possible. Following our previous assumption, this total output is then exchanged on the several markets and its value determined by means of price formation (circulation of goods). The formation of prices, in turn, determines by way of the formation of income that share of the total output which accrues to each individual (distribution). Finally, these shares are used or consumed by the individual economic units. What we have done thus far is to list the several parts of the economic process in their logical order, a procedure which does not imply their successive occurrence in time. We do not suggest, for example, that during a given period of time goods are produced, are later apportioned to the recipients by circulation and distribution, and are finally consumed. In reality, all of these operations take place simultaneously. The economic process is thus a simultaneous process and one in which all the parts are intimately connected to each other and conditioned by each other. This network—which represents a major difficulty in the understanding of theoretical economics—will become even more apparent in the course of the subsequent analysis.
To simplify our inquiry, we have thus far admitted a number of hypotheses, the first of these being that the total output (gross national product) of the economy equals the total supply of the economy in a given time period. This follows naturally from our admission that the whole of production enters the market. But since the producers buy each other’s products, the gross national product (i.e., total supply) must, in a state of equilibrium, also equal total demand. If in any considerable degree this is not the case, we are then faced with that total disturbance of the economy known as a crisis. It is a truism, moreover, that the gross national product is always equal to the gross income of the economy during the period in question. The latter we may define, initially, as the sum of the various money incomes, incomes which are converted into real goods only by the exchange of “vouchers” acceptable in the “general store” of the national economy; in other words, incomes are converted into goods by market demand. We must, therefore, distinguish between the formation of income and the use of income. But here again we must reckon with the possibility of a twofold disturbance. In the first place, the expenditure (use) of income may be retarded because income earners may hesitate a long time before spending their money (deceleration of the speed of circulation of money, hoarding, deflation) . Secondly, the expenditure of income may not correspond to the actual composition of output. In such case, the producers have produced at cross purposes. In this connection, it is necessary to direct attention to the three ways in which income may be used: (1) to obtain goods for immediate use (consumption); (2) to obtain producer goods for the maintenance of the productive apparatus (replacement); (3) to obtain producer goods for the purpose of expanding the productive apparatus (accumulation of capital). This division of the different kinds of income use must correspond, in a state of equilibrium, to the composition of the national output. Otherwise, we shall again have to reckon with the emergence of a state of disequilibrium (crisis). But this is a discussion we have reserved for a special chapter.
In our analysis of the economic process thus far, we have assumed a “closed economy”; that is to say we have deliberately ignored the actual connection of the domestic economy with the rest of the world. If we now relax this assumption, we find that the domestic economy is joined to the world economy by a multitude of transactions and activities involving the exchange of goods and services, and of a corresponding number of payments made to foreign countries and received from them. This connection may be clearly seen and statistically measured by grouping the various foreign transactions and payments of a nation under several principal headings, somewhat in the manner of a firm’s balance sheet. The balance of payments of a country is so constructed as to show payments (in domestic currency) received from abroad on the plus or credit side of the balance, and payments to foreign countries on the debit or minus side of the balance. The principal categories of such a balance of payments are: (1) the savings account which shows the net total yield (+ or—) of (1) the merchandise account (the “balance of [visible] trade”), (2) the services account (tourism, transportation, insurance, banking services, copyright payments, etc.), (3) the investment income account (dividends and interest received from abroad or paid to abroad), (4) unilateral transfers (receipts or payments); (II) the investment account which shows the total of capital investments by foreigners in the domestic economy and total investments by domestic residents in other countries; (III) the cash account which shows the increase or decrease in a country’s holdings of foreign exchange and/or gold. This yields the following scheme in which the plus or minus sign in each case indicates whether the transaction in question is to be assigned to the credit or debit (active or passive) side of the balance of payments.
I. The Savings Account
1. The balance of trade (visible)
(a) merchandise exports (+)
(b) merchandise imports (–)
2. The services account
(a) services of residents to foreigners, also called “invisible exports” (+)
(b) services of foreigners to residents, also called “invisible imports” (–)
3. The investment income account
(a) dividends and interest received from abroad (+)
(b) dividends and interest paid abroad (–)
4. Unilateral transfers (aid and gifts)
II. The Investment Account
1. Capital imports (+)
2. Capital exports (–)
III. The Cash Account
1. Increase of monetary reserves (–)
2. Decrease of monetary reserves (+)
It is clear that a net surplus yielded by the algebraic sum of the items in any of the above categories may be offset by a net deficit in another category (or categories). Thus in the balance of payments of Switzerland for the year 1959, the large net deficit in the (visible) trade balance was offset by a still larger net surplus yielded by the other items in the Savings Account so that this account as a whole showed a substantial surplus (+ 758 million Swiss francs). This surplus in turn was offset partly by a net debit in the investment account (excess of capital exports over capital imports) and partly in an increase of Swiss monetary reserves. Different was the situation yielded by the West German balance of payments for 1960 in which both the Savings Account and the Investment Account closed with large net credits. The Savings Account was “active” because of the extremely large (favorable) balance of (visible) trade which more than offset the large deficit on services account. The Investment Account yielded a net surplus because of the substantial excess of capital imports over capital exports. The net surplus resulting from the sum of the Savings Account and the Investment Account was offset in turn by a debit on cash account, that is, by a correspondingly large increase in Germany’s monetary reserves (of almost DM 8 billion [about $2 billion]). In this growth of German monetary reserves was reflected the aforementioned (p. 106) “imported inflation.”
To qualify the balance of payments as active or passive has meaning only to the extent that we abstract from the balance of payments as an accounting device and omit certain accounts (the offsetting ones) in order to focus attention on the disposition of others. Customarily, the cash account is neglected in determining whether the balance of payments is active or passive; it is said to be active (or in surplus) when the algebraic sum of all the accounts except the cash account yields a net surplus, and passive (or in deficit) in the converse case in which the sum of all the accounts except the cash account yields a net deficit. Alternately, one may focus attention solely on the cash account, qualifying the balance of payments as active when monetary reserves increase and passive when they decline. But even here it is not necessarily true that an active balance of payments is something good and a passive balance something bad. Indeed, an active balance of payments can represent a danger for the economy as shown in the example of the imported inflation in West Germany and in other European countries at the present writing (1962). Conversely, a passive balance of payments of a certain duration and amount can serve to restore a disturbed equilibrium of international payments.
It is under no circumstances permissible, however, to see in an active balance of payments the proof of the riches and capital wealth of a country nor in a passive or deficitary balance of payments proof of the poverty and capital insufficiency of an economy. The activity or passivity of the balance of payments involves merely the external equilibrium of an economy (which is, in turn, primarily dependent on monetary factors), not the quantity of commodities and real capital of which it disposes. For years West Germany achieved balance of payments surpluses because it was a comparatively cheap country, but West Germany was made not one penny richer on that account. The United States has suffered for years from a balance of payments deficit, thanks chiefly to the wage policies of American labor unions, and has become a comparatively expensive country. But the United States is today far richer than it was when the world still suffered from a “dollar shortage.” France, too, was not poor and insolvent because it suffered from a passive balance of payments thanks to the financial mis-economy of the Fourth Republic. And France did not become rich and solvent overnight merely because the De Gaulle government changed the international value of the franc, put an end to inflation, and thereby converted the balance of payments deficit into a surplus.
4. The Factors of Production
Of what then do the expenditures made in production consist? If we push our inquiry still farther back, we find that all these expenditures may be traced finally to three categories of production elements (factors of production) which in turn are not further divisible: labor, land, and capital.
Similarly, little difficulty is experienced in comprehending the significance of land (or Nature in general) as a factor of production. Its role in production is characterized by the fact that it serves simultaneously as a location (cf. Chapter III, Note 1) and as a reservoir of the raw materials and the energy which lie dormant in the land. The latent energy and the raw materials of the earth, to the exploitation of which primary organic production (agriculture, forestry, fishing) and primary inorganic production (mining) are devoted, comprise the final and most basic sources of mankind’s supply of goods. In common with the labor factor of production, land exhibits the special characteristic of not forming a homogeneous mass but of falling (according to its location or to its varying content of raw materials) into innumerable sub-classes. The location of the land is of especial importance because, in contrast to the other factors of production, land is immovable: Mohammed must, in truth, always go to the mountain.
Labor and land are things easily grasped, their importance is self-evident and their role in production is clear. Everyone knows that they are indispensable, that they represent ultimate elements of production which are not reducible to any further common denominator. But what about the factor of production we call capital? Here begin the difficulties.
Let us start with a fairly simple situation in which capital will figure—the production of grain. When we say that for this purpose we require capital in addition to land and labor, what do we mean? Concretely, we visualize the following requirements: tools, draft animals, seed, fertilizer, farm buildings, machines, and lastly, a supply of foodstuffs (subsistence fund) to be consumed during the time which elapses between sowing and harvesting. This is a roundabout way of expressing the fact that man cultivates the land not only with the bare strength of his arms but with all sorts of auxiliary means as well. But what is the justification for regarding these auxiliary means as a third independent factor of production? Cannot all such items be subsumed under labor and land? For example, a plough contains wood and iron and its manufacture requires the expenditure of a certain amount of labor. The truth is, however, that the plough contains still a third component whose presence, though not immediately visible, can be ascertained by a process of deduction. Let us assume that the farmer makes the plough himself and that in consequence he will have to employ a part of his time in the production of a plough instead of in the production of food. For the farmer, this entails a diminishment of his current supply of consumption goods. As long as he is engaged in making the plough, either he will eat less or he will live from a supply of foodstuffs which he has previously stored up. Should he choose the latter alternative, he will still have had, during some former period, to reduce his consumption in an amount corresponding to his present stock of such foodstuffs. This restriction of consumption pays for itself in the future, however, for a plough, compared with primitive forms of cultivation, will result in an enormous increase in yield. Thus we see that the production of a plough requires not only the combined services of land and labor but a further essential condition—the restriction, in one form or another, of consumption. It is only after this current sacrifice is compensated in the future by the larger yield obtained thanks to the plough that the balance, so to speak, is struck. Until then, the farmer is obliged to wait for the rewards due to his work and to his restriction of consumption. We arrive at the same result if we come somewhat closer to reality and assume that the farmer does not make the plough himself but orders it made by the smith. The smith is then paid in money which the farmer could otherwise have used to buy consumption goods.
By this renunciation of complete enjoyment at the present moment in favor of the future, i.e., by “waiting,” capital acquires the character of an independent factor of production, a factor which cannot be subsumed under either land or labor. Since present supplies can be diminished in favor of the future only within fixed limits, the capital factor of production is always scarce. This is a point of the greatest importance and one which has to be borne constantly in mind. Were it not for this fact, it would be difficult to understand why all the scythes in the world have not long since been replaced by mechanical reapers, all the sewing needles by sewing machines, all bicycles by automobiles, and all streetcars by subways. Hence it is that we are obliged to pay a price for this scarce “something” just as we do for butter or for string, and this price is nothing other than interest.
“Waiting,” the essential ingredient of the capital factor of production, may take different forms. The form it takes in the case of the (purchased) plough is clear. The money which has been “put” into the plough has been withheld from current consumption uses and the farmer must wait until the extra yield obtained with the plough offsets the amount of his investment. The same principle is involved in building a house where the landlord must wait until the sum of his rents equals the costs of constructing the house. In either case we have to do with that kind of “waiting” which is associated with the investment of capital (fixed capital). The purpose of this capital investment is to provide means of production which are to be used over several production periods. But the farmer must take into account still another kind of waiting. Between the plowing and the seeding of the soil and the sale of the harvest stretches a period of several months: in autumn, there are expenditures for labor, seed, and fertilizer which are recovered only after the sale of crops in the summer of the following year. In the meantime, the farmer and his family must live; he must, therefore, have either a supply of consumption goods in reserve or a sum of money for the purchase of such consumption goods. Here again, a period of waiting is involved, but waiting of a different character than that which we observed in the first instance. The farmer must await repayment (for the duration of the period of production) not only for the labor, raw materials, and auxiliary equipment used in the process of production but also for the consumption goods required during this process (subsistence fund). Waiting of this type involves the use of what is termed working capital (circulating capital). The relation of fixed capital to working capital is the same as that of a meat-grinding machine to the meat which is put through it.
Naturally, it is not required that the producer himself do the “waiting.” By obtaining a loan he can, in effect, shift the burden of waiting onto the shoulders of some other person, the latter receiving his indemnification in the form of interest. Depending upon the kind of “waiting” involved, the credit thus obtained is either an investment credit or an operating credit. The possibility of obtaining such a credit obviously changes nothing with respect to the fact that for the capital thus supplied someone must undergo a period of “waiting,” of adjournment of his consumption irrespective of whether this occurs in some sector of the national economy or—as in the case of an international transfer of capital—of the world economy.
Finally, we must touch briefly on that aspect of capital which renders it so repugnant to the adversaries of our capitalist system, the socialists, and one to which we too cannot remain indifferent. This is the circumstance that capital is not only an elementary factor of production but, in its current context, also a source of private income for which apparently no services are rendered in return. Both notions must be kept rigorously distinct, however. Saying that capital is an indispensable factor of production does not imply that we are taking a position on the question of who should own this factor of production. The first point is uncontested whereas perennial controversy rages around the question of the ownership of capital. Naturally, even a socialist state cannot do without capital as a factor of production since in a socialist state, as in any other, it will be necessary to economize so that worn-out machines can be replaced and new ones built. The Russian Five Year Plan is nothing if not such a socialist method of creating capital on a colossal scale. It is not the use of capital which distinguishes the socialist from the capitalist economy, but only the fact that this capital, under socialism, belongs to the state. But we must not imagine that we have refuted socialism simply because we can show that capital is necessary even in a socialist state. No serious socialist questions the necessity of capital; what he demands is that it belong to the “community.” Whether this demand is reasonable or not is a question we have reserved for discussion in another place.
5. The Combination of the Factors of Production
In deciding whether to buy a washing machine, our housewife will be guided by still another consideration—the relation between the prices of the two factors of production. Where labor is less costly as compared to capital (i.e., where wages are low and interest rates high), the washing machine would prove uneconomical. Where these conditions are reversed, it will pay to use such a machine. This explains why in America many more machines are used—in the home as well as in industry and everywhere else—than in Europe, and why in Europe more machines are used than in Asia. It is for the same reason that in American agriculture, labor is much more sparingly used in relation to land and capital than is the case in Europe. In most Asian countries, labor is the cheapest of the factors while land and capital are the dearest; in the United States, labor is the dearest of the factors and land and capital the cheapest. In China, human labor is so cheap that it figures as an important source of motive power in the public transportation system (ricksha coolies). No further explanation is needed to show that in all these cases the price relationships existing among the several factors of production reflect the supply relationships of these factors in the national economy: that factor of production which is at a given moment the “scarcest” is also the dearest, and since it is the dearest it is used, perforce, sparingly. A socialist economy must be guided by similar considerations if it wishes to dispose economically of the several factors of production. A principle of primordial importance is herewith revealed, one which not only enables us to understand how the prices of the factors of production are formed (the wages of labor, the rent of land, and interest) but which also shows that the optimum combination of the factors in a given country is determined by the individual economic structure of that country. Once again we observe that what may be technically impressive is by no means always what is best economically.
It is now clear that one of the chief tasks of the organizer of production—the one who in industry is called the entrepreneur—consists in a continual search for the most advantageous combination of the factors of production. Since all producers tend to aim at this objective, they all collaborate in the formation of the prices of the factors of production. The optimum combination at any given moment is decisively influenced by the fact that the quantity of one of the factors cannot be continually increased without ultimately causing a fall in the yield due to such increase. It is this process which is meant when in agriculture we speak of a “law of diminishing returns.” This means that if to a given area of land we apply ever greater amounts of labor and capital, there occurs a fall in the rate of yield following an initially over-proportionate increase of yield. Here is a truth which everyone can verify experimentally by subjecting some hapless tomato plant to ever heavier doses of artificial fertilizer. This law applies generally to the whole of production in the sense just illustrated, viz., that the continual addition of new increments of one of the factors of production to fixed quantities of the others produces an increased yield which is at first over-proportional and then under-proportional. This is such a commonplace and undisputed principle that cooks make use of it daily. The first dose of salt that is put into a given quantity of potatoes greatly enhances their taste while the utility of succeeding doses becomes increasingly doubtful. The cook knows that there is an optimum combination of potatoes and salt. Thus we arrive at the momentous principle that for every type of production the factors must stand in a harmonious relationship to one another, since otherwise the yield of the one will develop disproportionately to the yields of the others. The average office can certainly benefit by the employment of at least one stenographer, but if the manager of that office hires a second he soon becomes aware that she is by no means as indispensable as the first, that a third stenographer would be even less valuable, etc. Their productivity declines and it is clear that the productivity of the last stenographer hired—the “marginal productivity” of this species of productive factor called labor—can hardly be higher but also hardly lower than her wage.
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2The original German verse runs as follows:
“Die Welt ist wie ein Kram, hat Waren ganze Haufen,
Um Arbeit stehen sie feil and sind durch Fleiss zu kaufen.”
