Economics of the Free Society

The unequal distribution of income in all the civilized countries raises a host of economic, statistical, sociological and political questions for which we must refer the reader to a special—although not too extensive—literature. For the conceptual and statistical clarification of the phenomenon we are indebted to V. Pareto (especially in his Cours d’Economie politique (Vol. 2 [Lausanne, 1897]). He found that the inequality of income distribution in all advanced countries exhibited such regularity that it could even be expressed in a mathematical formula (Pareto’s first law). He believed further that it could be shown that inequality of income distribution lessens as average income per capita increases (Pareto’s second law). This second law of Pareto is in agreement with what we established on pp. 192 ff. For excellent work in this field see also Edwin Cannan, especially Wealth (London, 1914), and the work of his pupils: Hugh Dalton, Some Aspects of the Inequality of Incomes in Modern Communities (London, 1920); F.C. Benham, The Prosperity of Australia (London, 1928); W.H. Hutt, Economists and the Public (London, 1936), pp. 313 ff. See also the standard work of A.C. Pigou, The Economics of Welfare (4th ed.; London, 1932); Bertrand de Jouvenel, The Ethics of Redistribution (Cambridge, 1951); Einkommensbildung und Einkommensverteilung, papers at conference of Verein für Sozialpolitik ar Cologne, 1956. A collation and interpretation of statistical data from several countries may be found in: Colin Clark, The Conditions of Economic Progress (2nd ed.; London, 1950).

Although we find little awareness in classical theory of the distinction between the personal and the functional distribution of income (classical theory was concerned almost exclusively with the latter), the classicists succeeded, nevertheless, in laying the foundations for a scientific study of the problem of distribution by breaking down individual income into definite income-types (wages, rent, and “capital profits”). In this regard, we may point to the still accepted classical view that production and distribution (formation of value and formation of income) are closely connected with one another, and that income formation is subject to the laws governing the whole of the economic process. This idea was developed with especial vigor and clarity by Ricardo. The classical doctrine, of course, did not progress so far as to conceive of the individual categories of income as being in themselves price phenomena. Consequently, it was constrained to construct a number of special theories, but without being able to join these together into a coherent whole. The weakness of these special theories was subsequently one of the main reasons why the classical concept of an economically determined distribution (by categories) had to give way almost completely to that agnostic-activist view which was defended throughout the nineteenth century by the adversaries of the classical school, the socialists and the historical school. The belief that the established power relationships in society are the determining factors, and that consequently a change in distribution could only be effected by state decree or the pressure of labor unions, found increasingly wide acceptance. The result was that progress in the theoretical analysis of the problem of distribution, which the classicists had carried rather far forward, was halted for a considerable period of time. Ultimately, modern theory, applying the marginal principle in this field as it had in others, arrived at solutions which, though largely confirming the results of classical theory, established the problem on a new and broader foundation. For the first time it was possible to have a total view of income distribution deduced not from arbitrary special theories but from the general principles of value and price theory. The concept which has proved itself of the greatest usefulness in this connection is that of the “marginal productivity” of the factors of production. The classicists, it must be admitted (especially Ricardo and J.H. von Thünen), did have an inkling of this concept, but the first complete exposition of the principle and its establishment as the basis of distribution theory, we owe to the American J.B. Clark in his The Distribution of Wealth (New York, 1899). The “imputation of costs” theory developed by the Austrian School leads, fundamentally, to a similar set of conclusions. As a result of the recognition that functional distribution (or factorial distribution) is really the outcome of the formation of the prices of the factors of production, the classical doctrine of an economically determined distribution was proven in a most convincing way. How sound this modern theory of distribution is can be ascertained by its readiness to concede the more or less considerable degree of “play” which must be allowed to the undetermined factors in distribution, and its willingness to admit such corrections and adjustments as may therefore be necessary. One of the accomplishments for which are indebted to modern distribution theory is its clear distinction between the personal and the functional distribution of income. This is shown most notably in E. Cannan, History of the Theories of Production and Distribution in English Political Economy from 1776 to 1848 (London, 1893).

On the many and complex aspects of the theory of wages the following literature is recommended: R. von Strigl, Angewandte Lohntheorie (Vienna, 1926); J. Marschak, Die Lohndiskussion (1931); J.R. Hicks, The Theory of Wages (London, 1932); W.H. Hutt, The Theory of Collective Bargaining (London, 1930); P.H. Douglas, The Theory of Wages (London, 1934); Ch. Cornélissen, Théorie du salaire et du travail salarlé (Paris, 1908); A. Amonn, Das Lohnproblem (2nd ed.; Berne, 1945); D. Robertson, Wages (London, 1955). On the relationships between wage theory and cyclical theory see Wilhelm Röpke, Crises and Cycles, op. cit. On the interrelationships of wage and interest theory see the classical study of F.W. Taussig, Wages and Capital (first published in 1896, new ed., London, 1935).

Of the many complexities of the theory of wages we shall select only one for mention here. Repeated efforts have been made to get around the fact that wages are economically determined. Thus it has been argued that an arbitrary increase in wages will of itself so change the known economic determinants (the “original” factors in our text) that the new wage increase ceases to be arbitrary. What the proponents of this view try to prove, in other words, is that a rise in wages can increase the productivity of labor. This “theory of high wages” is met under two forms. According to the one, high wages cause an increase in the productivity of labor since it increases both the capacity and the will to produce of the workers. Insofar as this idea is not simply a product of the confusion of cause and effect, it involves a thesis which has no general validity in the first place and is unprovable in the second. The other variant of the “theory of high wages” reposes on the notion that high wages will indirectly cause an increase in mass purchasing power, thus stimulating mass production with a resultant increase in productivity (purchasing power theory of wages). In spite of the numerous errors with which this theory (most popular in the United States) bristles, it contains a modicum of truth, especially in connection with certain findings of cyclical theory. But this bit of truth in purchasing power theory cannot be considered as anything more than as a kind of broadening of the “zone of indeterminism” in wage determination.

With the extension and solidification of modern labor union power the problem of the wage as a “monopoly price” has assumed increasing importance. See Henry C. Simons, “Some Reflections on Syndicalism” in Economic Policy for a Free Society (Chicago, 1948); Fritz Machlup, Monopolistic Wage Determination as a Part of the General Problem of Monopoly (Washington, D.C.: Chamber of Commerce of the United States, 1947); J.A. Schumpeter, “The March into Socialism,” American Economic Review, May 1950; Charles E. Lindblom, Unions and Capitalism (New Haven, 1949); The Impact of the Union, ed. D.M. Wright (New York, 1951).

The existence of manual labor alongside machine production shows us how different, even within the same industry, is the “intensity” of capital (to which Marx applied the somewhat confusing appellation “the organic composition of capital”). Whether the one or the other kind of production is more suitable is something which, in our economic system, is decided by the ratio of interest to wages. In East Asia, for example, this ratio is so unfavorable to the use of machinery that human labor power (ricksha coolies) plays a role even in the transport of persons, a thing which would be impossible if wage levels were higher. The varying intensity of capital is a fact which Ricardo himself found embarrassing in constructing his theory of profit.

Entrepreneur’s profit is differentiated from other kinds of income in that it does not constitute an integral part of the costs of production (and hence is not a determining cause of price). Rather, it is itself a product of the process of price formation, a sort of ex post facto income as it were. It is just because of this that we experience difficulty in assigning to entrepreneur’s profit its proper functional importance. In all such cases in which a surplus profit remains after the costs of doing business have been paid, we speak of rents. Since rent in the usual sense (ground rent) also contains such an element, the term came gradually to be applied to this phenomenon exclusively. Strictly speaking, however, this usage is incorrect and distracts attention from the essential character of ground rent as a type of cost income. Literature: H. von Mangoldt, Die Lehre vom Unternehmergewinn (1855), a pathmaking book by a German economist who only now is receiving his proper due; J. Niehans, article “Unternehmereinkommen”, Handwörterbuch der Sozialwissenschaften, 1959; J. Schumpeter, The Theory of Economic Development (Cambridge [Mass.], 1934); A. Amonn, “Der Unternehmergewinn” in Die Wirtschaftstheorie der Gegenwart, Vol. 3 (1928); D.H. MacGregor, Enterprise, Purpose, and Profit (Oxford, 1934). There is, finally, a copious and especially high level American literature on the subject, in particular, F.H. Knight, Risk, Uncertainty, and Profit (New York, 1921), a standard work, especially on the element of risk in entrepreneur’s profit; A.E. Monroe, Value and Income (Cambridge [Mass.], 1931); F.B. Hawley, Enterprise and the Productive Process (New York, 1907); Clare E. Griffin, Enterprise in a Free Society (Chicago, 1949).

It is to a group of non-Marxist economists that we owe thanks for drawing attention in recent years to the problem of economic calculation, that is, to the method by which the economic system makes a rational allocation of its productive resources. This is, in fact, the central problem of a collectivist state: how to arrive at a halfway rational method of economic calculation in the absence of the free formation of the prices of the factors of production, especially of land and capital. See L. von Mises, Socialism (London, 1936); T.J.B. Hoff, Eco-nomic Calculation in the Socialist Society (London, 1949); Pohle-Halm, Kapitalismus und Sozialismus (4th ed.; 1931); B. Brutzkus, Die Lehren des Marxismus im Lichte der russischen Revolution (1928), a book which combines penetrating analysis with an interesting evaluation of the Russian experiment (an English translation is contained in the first part of Economic Planning in Soviet Russia [London, 1935]); F.A. von Hayek (ed.), Collectivist Economic Planning (London, 1935); F.A. von Hayek, Individualism and Economic Order (Chicago, 1948); W. Röpke, article “Sozialisierung,” Handwörterbuch der Staatswissenschaften, 4th ed.; R.L. Hall, The Economic System in a Socialist State (London, 1936); W. Röpke, Civitas Humana (London, 1948). The immensity of the problem of rational economic calculation in the collectivist state, with which the above literature is concerned, finds additional confirmation in the failure of all efforts in Russia to establish a genuine collectivist system. On the realities of collectivism see: W.H. Chamberlin, A False Utopia: Collectivism in Theory and Practice (London, 1937); W. Lippmann, The Good Society (Boston, 1937); L.E. Hubbard, Soviet Labour and Industry (London, 1942); A. Baykov, The Development of the Soviet Economic System (London, 1946); J. Jewkes, Ordeal by Planning (London, 1948); W. Eucken, “On the Theory of the Centrally Administered Economy: An Analysis of the German Experiment,” Economica, May and August, 1948; A. Müller-Armack, Wirtschaftslenkung und Marktwirtschaft (Hamburg, 1947); W. Röpke, Mass und Mitte (Erlenbach-Zurich, 1950), pp. 86-134; W. Röpke, The Problem of Economic Order (Cairo, 1951).

A continuing plebiscite or popular referendum in a socialist state must be considered as impossible, from which it follows that socialism is incompatible with genuine democracy and individual freedom, and hence necessarily presupposes a totalitarian state. Extensive and still unrefuted argumentation for the truth of this highly significant thesis, one confirmed also by all previous experience, may be found in the following works: W. Lippmann, op. cit.; F.A. von Hayek, The Road to Serfdom (Chicago, 1944); W. Röpke, Civitas Humana, op. cit. The effort made by J.A. Schumpeter in Capitalism, Socialism, and Democracy (2nd ed.; New York, 1947) to refute these arguments must be regarded as unsuccessful (see F.A. von Hayek, “The Use of Knowledge,” American Economic Review, September 1945; W. Röpke, “Kapitalismus, Sozialismus und Demokratie” in Gegen die Brandung [2nd ed.; Erlenbach-Zurich, 1959], pp. 354-362).

The essence of interest may be understood from a study of the essence of capital (see Chapter V, pp. 130 ff. and Note 9). The difficulties of capital theory reappear in the theory of interest; current scientific discussion of the one and the other is equally intense. The point of departure for the study of these matters is still the pathmaking work of Böhm-Bawerk on capital and interest theory, (Eng. tr. by George D. Huncke and Hans F. Sennholz, Capital and Interest, 3 volumes [South Holland, 111.; 1959]); see also the article “Zins”, Handwörterbuch der Staatswissenschaften, 4th ed., revised and expanded by F.X. Weiss. Until Böhm-Bawerk, theories of capital and interest were thoroughly unsatisfactory. He set the theories on their proper foundation by stressing as the central fact of his explanation the time dimension of capital and interest (the sacrifice of the present in favor of the future, “waiting”). The underlying idea to which Böhm-Bawerk gave expression dominates all of modern interest theory. The form in which he expressed himself, however, has left his findings open to many legitimate criticisms, especially since they do not comprise a complete or unified theory. In point of fact, the “agio” theory of Böhm-Bawerk, the “scarcity” theory of Cassel (The Theory of Social Economy [1932]), the “impatience” theory of Irving Fisher, the marginal productivity theory of interest (a model explanation of which is to be found in E. Cannan, An Economist’s Protest [London, 1927], pp. 285 ff.), and related theories are, at bottom, only variations on the same fundamental theme. It is to be noted that the modern time-difference theory, which is the leitmotif of all these variations, should not be confused with the abstinence theory of Senior to which we drew attention in another section (Chapter II, Note 4, p. 38). Interest ought not to be paid as a reward for a sacrifice, but because “waiting” is necessarily scarce by reason of the greater attractiveness of current consumption and the unlimited demand for capital which would develop if there were no interest. Nor should it be thought that interest is something which is required to induce men to create capital. The supply of capital is more often than not inelastic, i.e., largely independent of the rate of interest. A certain amount of saving would take place without interest. It is even possible that not a few individuals, in their desire to draw a given amount of interest-income, would save more where the interest rate is low than where it is high (see W. Röpke, Die Theorie der Kapitalbildung [1929]). From the foregoing we may conclude that the function of interest is more to regulate and to sift the demand for capital than to regulate its supply. We may summarize by saying that the existence, rate, and function of interest are explainable in terms of the time factor. In our economic system, interest is the “time gland,” so to speak, which balances the present and the future in the national economy, and which ensures that scarce capital in each case will be rationally distributed among the several competing uses for it. Its counterpart is rent which, as a sort of “space gland,” has the function of ensuring spatial order in the economy. Most recent literature: F.A. von Hayek, The Pure Theory of Capital (London, 1941); J.R. Hicks, Value and Capital (Oxford, 1939); J.M. Keynes, “Alternative Theories of the Rate of Interest,” Economic Journal, June 1937, pp. 246-248; J.M. Fleming, “The Determination of the Rate of Interest,” Economica, August, 1938, pp. 333-341; W. Eucken, Kapitaltheoretische Untersuchungen (1934); R. v. Strigl, Kapital und Produktion (Vienna, 1934); F.A. Lutz, Zinstheorie (Zürich-Tübingen, 1956).

Quite outside the contemporary explanation of interest in terms of the time dimension are two other theories of interest: the dynamic theory and the theory of exploitation. According to the dynamic theory, represented chiefly by J. Schumpeter (The Theory of Economic Development, op. cit.), interest is possible only in a progressing and developing economy and not in a static one. According to the exploitation theory, held for the most part by socialists (Marx, Franz Oppenheimer, and most recently Hans Peter in Grundprobleme der theoretischen Nationalökonomie, Vol. 1 [1953], pp. 85 ff.), interest is interpreted as an enrichment arising from changing power relationships. For a critique of both theories see F.X. Weiss, supplement to the article “Zins,” Handwörterbuch dei Staatswissenschaften, 4th ed.

From the beginning it was recognized that the problem of interest is not only a real (natural) problem, but also a monetary one. It is precisely this fact which adds to the complexity of interest rate theory and which has been too long ignored in the literature. The monetary theory of interest has become nevertheless increasingly important. A pioneer in this field is the Swede Knut Wicksell (originally in his book Interest and Prices [1898], more recently in his Lectures on Political Economy, ed. Robbins, Vol. 2, [London, 1935]). Additional readings: L.A. Hahn, Volkswirtschaftliche Theorie des Bankkredits (3rd ed., 1930); L. von Mises, Theory of Money and Credit (New York, 1934); F.A. von Hayek, The Pure Theory of Capital, op. cit.;, Frank A. Fetter, “Interest Theory and Price Movements,” American Economic Review, Supplement, March 1927; D.H. Robertson, Banking Policy and the Price Level (3rd ed., London, 1932); J.M. Keynes, A Treatise on Money (London, 1930); J.M. Keynes, The General Theory of Employment, Interest and Money (London, 1936); F. Machlup, Börsenkredit, Industriekredit und Kapitalbildung (Vienna, 1931); W. Röpke, “Kredit und Konjunktur,” Jahrbücher für Nationalökonomie, March-April 1926; W. Röpke, Crises and Cycles (London, 1936), pp. 111 ff.; Hans Gestrich, Kredit und Sparen (2nd ed., Godesberg, 1948); W. Lautenbach, Zins, Kredit und Produktion (Tübingen, 1952); F.A. Lutz, op. cit.

Here again we are confronted with difficulties which were passed over in the text in order not to distract the reader’s attention from fundamentals. We may best begin with the Ricardian theory of rent, the extraordinary durability of which is proven by the fact that it still holds an important place in contemporary theory. Ricardo laid the greatest possible stress on the differential character of ground rent. Rent for Ricardo is not an element of costs; hence it is not a cause but a consequence of the prices of agricultural products. Since for all producers the price of grain in the market will be the same, whether it is produced on rich or poor land, on land far removed from the market or near to it, or with much or little labor and capital, a differential gain will accrue to the land having the lower costs of production. If there should be, perchance, a rise in the price of grain, this will not be because rent has increased; rather, rent in-creases because the price of grain (perhaps on account of increasing population) has gone up. In this way, Ricardo believed he had completely eliminated the land factor of production as an element in the formation of prices of agricultural products.

Ricardo’s theory of rent remained for a long time the most durable part of his work and is still regarded as correct by many economists. It cannot, however, be accepted any longer within the framework of modern theory; at least not in the form which Ricardo gave it. The fact is that rent appears in quite another light if viewed in the theoretical scheme of modern economics. Rent is now seen to be the price paid for the use of the factor of a production “land”; like every other price, it is determined by the scarcity of the factor. This price which is paid for the use of land is also a real cost element and corresponds to the modern view of costs as a reflection of the utility which could have been obtained from another use of the factor. In other words: rent expresses the fact that land which is used for one purpose cannot be used for another; it indicates that land of a certain type is scarce and by its amount shows the degree of that scarcity. The function of rent, then, is to make these facts known and to see to it that the best possible use is made of land of a given quality or location. Consequently, rent will always appear where land of a given quality or location becomes scarce. It follows that differential rent is basically nothing else than the price of a factor of production which, just as the prices of other factors of production, is an integral part of value (price) calculation, since it represents an element of cost in the subjective sense of a sacrifice of alternative uses (opportunity cost). Even a socialist economy must take the scarcity of land into account since if it did not, land would be treated as a free good and the state itself would be in the position of having abetted the ensuing waste. The difficulty, however (which was spared the reader in the text), lies in the fact that the real cost character of rent is revealed only insofar as a piece of land actually has an alternative use. If, however, the land in question has a specific use, e.g., the land of a famous vineyard, we cannot explain the rent which is paid for it in terms of the other uses to which it could be put, since these other uses practically do not exist. In this case, the pure rent character (differential gain) of rent cannot be denied. See Franz X. Weiss, “Die Grundrente im System der Nutzwertlehre,” Die Wirtschaftstheorie der Gegenwart, Vol. 3 (Vienna, 1928); A. v. Navratil, “Rentenprinzip und Grundrente,” Zeitschrift für die gesamte Staatswissenschaft, Vol. 94, 1933; O. v. Zwiedineck-Südenhorst, Allgemeine Volkswirtschaftslehre (1932), pp. 234 ff.; Hubert D. Henderson, Supply and Demand, op. cit.

On urban rents: Adolf Weber, “Die städtische Grundrente,” Die Wirtschaftstheorie der Gegenwart, Vol. 3, (Vienna, 1928); F. von Wieser, “Die Theorie der städtischen Grundrente,” Gesammelte Abhandlungen (1929), pp. 126 ff.

Advertising limits the freedom of economic choice of the consumer no more and no less than election propaganda limits the freedom of voters. Nor is this freedom of the consumer constrained by the fact that his decisions are guided by a whole set of motivations and influences of which advertising is only one. The choice of the consumers remains always free in the sense that in the economic democracy of the market we cast our votes in accordance with our preferences. But this freedom, it should be noted, exists only in the market economy, not in the collectivist “command economy.” Of course, it is true that advertising frequently causes a want to appear where none existed before, and induces us to purchase something which we otherwise would have done without. Surely, however, it does not conflict with our concept of a rational human economy if the producer steps out of his role of a waiter standing by for his orders and recommends something new on the menu or wine list. Even orange juice originally achieved its popularity as the result of advertising. But who has bitter thoughts about advertising when he drinks a glass of orange juice? Be this as it may, advertising has aroused many severe criticisms which may be found elsewhere. In this connection, see: W. Röpke, Mass und Mitte (Erlenbach-Zurich, 1950), pp. 200-218; W. Röpke, A Humane Economy, op. cit., pp. 137-138; E.A. Lever, Advertising and Economic Theory (London, 1947); Herbert Wilhelm, Werbung als wirtschaftstheoretisches Problem (1961).